Built for these times: LifePath® and inflation

Feb 22, 2022
  • BlackRock

Given recent high inflationary readings, we are writing to provide context as to how this relates to LifePath target date funds inequitable effects and find ways to build a better retirement for all.

Inflation has always been a lurking concern for retirement savers because it raises the uncomfortable prospect of potentially outliving one’s savings or having to change how you spend in retirement.For the past three decades, inflation in the U.S. has hovered around 2% - a steep departure from the rapid rise experienced in the past year.1

With the Consumer Price Index having jumped over 7% in January from a year ago2, it’s no surprise inflation is making headlines. But one headline is conspicuously absent: Retirement investors can turn to target date funds to mitigate inflation risk.

At BlackRock, this concept is central to our investment philosophy. We began thinking about this problem when we pioneered the target date fund in 1993 and have been evolving it ever since. These age-based, asset allocated funds are gradually become more conservative as participants near retirement, and are designed with inflation in mind. These findings led us to update our LifePath model to deliberately incorporate an inflation glidepath into our investment framework in 2019.

In the sections that follow, we aim to provide clarity on the driving forces of inflation today and demonstrate how LifePath is built to address them.

What’s driving inflation this time?

A balanced amount of inflation encourages healthy economic growth. If there’s too little, people delay their planned purchases in anticipation of lower prices. If it’s too high, prices rise faster than consumers can keep up with, which inevitably leads to demand falling and the economy slowing down. This is what our central bank and others around the world are carefully deliberating today: How soon and by how much do they need to raise interest rates? If they go too far, they risk a premature slowdown; and if they do too little, they risk potentially exacerbating inflationary dynamics.

In the near- to medium-term, our view is that inflation’s future direction will be heavily influenced by supply chain issues which have been further complicated by the asynchronous restart to the world’s economies. At the same time, consumer demand for ‘goods’ has picked up and has remained elevated above pre-pandemic levels, especially as economic stimulus and tight labor markets have been supporting such spending. Consumer demand for ‘service’ related purchases, however, remains below pre-pandemic levels, which should gradually revert alongside continued easing of pandemic-related restrictions. This should have offsetting effects on overall inflation, as the ‘goods’ side of the economy has been disproportionately affected by the pandemic.

U.S. spending breakdown

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Sources: BlackRock Investment Institute and U.S. Bureau of Economic Analysis and IHS Market, with data from Haver Analytics, December 2021.

What does this mean for retirement investors?

In the context of investing for retirement, we analyse the impact of inflation on wage growth and asset class performance.

Typically, wages outpace inflation. Since 2000, wage growth has been higher than inflation 72% of the time, and wage growth (across multiple metrics) has never had a negative 12-month period. While recent real earnings reports have indicated that wages are trailing inflation, LifePath’s asset allocation accounts for these short-term anomalies.

U.S. wage growth

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Source: Refinitiv DataStream, BlackRock Investment Institute. Feb 11, 2022.

BlackRock’s research shows that most asset classes will provide returns equal to or above the inflation rate, given a sufficiently long investment horizon. However, some do a better job diversifying a broad portfolio in periods when inflation is high, or when inflation rates exceed levels that were anticipated. Our approach to incorporating inflation-sensitive asset classes is rooted in understanding the nuanced ways that inflation can affect a portfolio in different economic regimes.

Commodities are a capital-efficient hedge for short-inflation shocks and are highly responsive to short-term changes in inflation. TIPS provide an effective inflation hedge over the medium-term, especially as it relates to fixed income, as their price and coupon payments are directly indexed to changes in CPI whereas traditional ‘nominal’ bonds are not. If inflation is higher than nominal interest rates, traditional bond returns will not keep pace with the rising cost of living. Real Estate’s inflation protection is unique in its ability to pass through increases in rents as well as through capital appreciation. These two components diversify traditional equity risk over the longer-term, while also providing inflation protection in the shorter-term.

There is no ‘silver bullet’ to defend a portfolio against inflation. Its effects can show up in different ways, and over varied time periods. We deliberately account for these scenarios within LifePath. TIPS, Real Estate, and Commodities each have their own unique properties and therefore differ regarding their responsiveness to inflation. A broad portfolio becomes more adept in diversifying the risks inflation can pose when combined in optimal amounts across the lifecycle.

Inflation sensitivity varies by asset class

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Source: Morningstar Direct data as of 31 December 2021. Beta measurements are taken from common inception dates of three indices shown above since 1 March 2005. Inflation is represented by the IA SBBI US Inflation Index. Past performance is not a reliable indicator of future results. Beta is measured against the IA SBBI US Inflation index, which is a US CPI proxy created by Ibbotson. You cannot invest directly in an unmanaged index

LifePath holds allocations to these asset classes – in optimal amounts for investors at all stages of their journey, as the impact of inflation is felt differently depending on your age. The need for short-term inflation sensitive assets for individuals in the early-to mid-career is quite low, given their long investment horizon and relatively high equity allocation. Conversely, those nearing retirement require more, as the transition from spending their wages to spending from retirement savings draws nearer.

In the past year, inflation hedging asset classes like Commodities and Real Estate have returned 26.09% and 27.11% respectively beating inflation which increased 7.0% in 2021; similarly, while TIPS have trailed inflation, they have outperformed the Bloomberg U.S. Aggregate bond index by over 600 basis points.

U.S. inflation: 1998 – Present

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Source: Bloomberg as of 31 December 2021. All returns are cumulative for the time periods shown. "REITs" represented by the FTSE/EPRA NAREIT Developed TR USD index, "Commodities" represented by Bloomberg Commodity Index, "TIPS" represented by Bloomberg US Treasury TIPS Index. "Global Equities" represented by the MSCI World NR Index, "US Bonds" by the Bloomberg US Aggregate Bond Index TR All "End" dates reflect data as of 12/31 of each respective year. Past performance indicative of future results. Index data provided for illustrative purposes only. Indexes are unmanaged and it is not possible to invest directly in an index.

The bottom line:

The million-dollar question, of course, is what happens next? Will inflation prove transitory or more permanent? No one knows. But the bottom line is: How it affects someone’s retirement savings depends largely on where they are in life, and how they react to it.

Younger investors, who have longer investment horizons and greater equity allocations, are less impacted by short-term spikes in inflation. Meanwhile, investors closer to retirement benefit from LifePath’s inflation-sensitive assets.

Given the prominent role that a target date fund plays within the participant’s retirement journey, it’s paramount that plan sponsors pay close attention to the underlying asset allocation. In the long run, the benefit of having compounded contributions over a full lifecycle will yield better participant outcomes.