How should target date strategies hedge inflation?

Should participants invested in a target date strategy be worried about inflation eroding their retirement spending power? On an intuitive level, it would seem to be a significant concern. Retirement savers are exposed to decades of potential inflation that may undermine the future purchasing power of their savings.

Research from BlackRock, however, suggests that the combination of future earnings and investment in growth assets adequately protects future spending against inflation. The research also details when in the glidepath, and to what extent, allocations to inflation hedging asset classes would be appropriate. To understand how the research reached these conclusions, we may need to begin by asking the question: what does the target date fund hope to achieve?

Income and retirement consumption

The lifecycle consumption framework used in the BlackRock LifePath^® target date strategies is based on the recognition that people earn a limited amount of labor income during their lives, yet their income needs to support them long after they cease to earn a living. The objective of the framework is to help people maximize consumption at every point in their lives–in other words, to help them enjoy spending as much of their income as possible, while saving as efficiently as possible.

To pursue that objective, BlackRock analyzed income data from the Panel Study of Income Dynamics from the University of Michigan and the U.S. Census. Data is aggregated so we can understand the overall pattern of how income increases during a career before leveling off and declining in real terms before retirement, at which point it ceases. The following illustration shows the median income pattern for U.S. wage earners, along with their expected consumption.

Labor income and spending

The income pattern helps us establish three important factors: the pattern of consistent, maximized consumption across the lifecycle; the savings available for investment (the gap between the income and consumption until age 65); and the projected consumption level in retirement that needs to be supported by savings plus investment return. Based on this, we can project the optimal asset allocation at every point in the lifecycle based on the cash an individual can be expected to have on hand to invest based on their age and remaining future income.

Inflation and human capital

Our next step is to understand how inflation may affect retirement investors. Broadly speaking, there are two ways. The first is that a normal, expected level of inflation over time may threaten future consumption, or the purchasing power of their savings. The second is that a sudden rise in inflation, or shock inflation, may immediately reduce the purchasing power of current financial capital. The difference is critical in understanding how to hedge inflation risk.

Wouldn’t a 25-year old be better off following an inflation shock if they had an allocation to an inflation hedging asset class that reduced the effect on her current savings? Perhaps not. There are two things to keep in mind. First is their human capital, which our model defines as the current value of her future income.

It’s intuitive–and clear from a glance at the chart above–that our 25-year old has significantly more future income (and therefore human capital) than a 55-year old. Does their human capital serve as a hedge against inflation? The perhaps surprising answer is yes. The following charts compare wage growth against inflation for various age cohorts for four decades beginning in the 1970s.

Wage growth by age

For the most part, almost every age cohort saw their income outpace inflation in each decade. This suggests that a 25-year old’s income growth will likely make up for a wage shock given enough time. Even the oldest wage cohort, the 55-year olds, generally outpaced or kept up with inflation.

The second thing to keep in mind is that our 25-year old’s financial capital is likely to be invested in growth assets at the time of the inflation shocks. And as the following charts make clear, the most commonly invested asset classes saw returns that outpaced inflation during each of the last four decades.

Common asset classes against inflation, by decade

Given sufficient time, which a 25-year old most likely has, wages and asset growth are very likely to overcome losses due to an inflation shock. On the other hand, if they did have an explicit inflation hedge in place, they may face a different kind of risk: opportunity cost.

The cost of inflation hedging

Financial assets that are generally considered to be good inflation hedges, such as commodities, REITs and TIPS, are also generally considered to have modest, and in some cases, no real return expectations over time. In order to protect against inflation shocks, they would need to be held consistently in the portfolio. (That is, unless an investor hopes to move in and out of the asset class based on their inflation expectations.)

Therefore, our 25-year old would be giving up decades of potential returns to protect against a point in time inflation shock that would likely be overcome given sufficient time. That cost may not only reduce consumption during retirement (by having less financial capital due to lower returns), it may also reduce consumption during their working years since they will need to save more to offset some of the shortfall.

The following chart compares expected lifetime consumption based on our framework’s default assumptions, against the expected consumption that assumes a persistent allocation to TIPS, a sample inflation hedging asset, displacing some of the fixed income portfolio. This projection shows as much as 10% less consumption across the lifecycle.

Persistent inflation hedging may reduce lifetime spending

When is inflation hedging appropriate?

Ultimately, the decision about when to hedge against shock inflation may depend on investor preferences as well as the ability to overcome shocks through the investment growth or human capital. At a certain point, our utility framework suggests that individuals will begin to value certainty of consumption over an incremental increase in spending power. In other words, the opportunity cost becomes a reasonable “price” to pay.

In the following chart, we illustrate one possible outcome based on allocating to an inflation hedging asset class later in the glidepath. There is a reduction in consumption, but it manifests itself later and is smaller.

Consumption with delayed hedging

As a result of our research, we have expanded our lifecycle framework to identify the point in the glidepath at which to consider inflation-hedging. It is our belief that this research–to our knowledge the first to consider inflation within a lifecycle consumption maximization framework–enhances LifePath’s ability to meet its objective to help participants save efficiently and spend consistently throughout their life cycle.

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