Inflation is one of the biggest risks for retired investors. Martin Hawes looks at how inflation silently rusts away our spending power and what we can do to deal with it.

Inflation does its dastardly work with little notice and, if high enough, it can destroy investment portfolios and people’s lives. And so it may come to pass: after a decade of playing possum, inflation has reared its ugly head.

This means that retirees invested solely in term deposits and other fixed interest investments are being hammered at the moment. Someone who was living on interest and had $200,000 of savings last year would find that they now had only about $190,000 of savings this year (in spending power terms).

If they carried on like this and inflation remained at current levels, their savings are not going to last, and their lifestyle would reduce.

We cannot say how long this current rate of inflation will stay with us, but there is at least some risk that it will remain high for some years. If inflation is stubbornly hard to remove, that will badly damage some retirees’ finances and, therefore, their lives.

And so, with inflation high and the risk of it remaining high, retirees with savings need to take cover. Those of us relying on our savings to fund our retirement lifestyles need to be sure that we are doing what we can to mitigate the worst effects of inflation.

That means ceasing to rely on term deposits and the like and having a diversified portfolio with some investments that will perform in inflationary times.

How much income could you receive?

Unfortunately, no investment is perfectly correlated to inflation – i.e. no investment type that is certain to go up in line with inflation and which always holds its real value. It is true that there are “inflation bonds” – things like Treasury Inflation-Protected Securities (TIPS) in the USA. New Zealand also has inflation-indexed bonds, which do give returns in line with inflation. However, the way that these sorts of things are structured and taxed, means that they seldom adequately cover inflation.

That leaves us with shares and listed property: both of these things can cover a retiree for inflation. While neither is likely to be perfectly correlated and go up step by step with inflation, they will rise with inflation over time, and may even outstrip it.

Of course, not all companies listed on the share market are the same. However, on the whole, companies and the businesses that they operate can increase their prices as inflation takes hold. The increased prices will offset higher costs and lead through to additional profits. This, in turn, should drive a higher share price.

Both the additional profits (with higher dividends) and the share price growth spell higher returns for the investor. This tends to hedge portfolios against inflation. Certainly, as inflation starts to rise, shares, especially those with the ability to increase prices, will be better investments over time than interest-bearing deposits with their fixed rate of interest.

Of course, some company shares will be better than others. This may largely come down to the fact that some companies have a better ability to raise prices than others. For example, a credit card company increases its income (and profitability) simply because as prices rise, they clip a bigger ticket. On the other hand, a retailer in a highly competitive sector may really struggle to increase its prices very much. To cover inflation, Visa Inc. may do better than Hallenstein Glasson Holdings Ltd.

However, although shares may do better than fixed interest, we must recognise that the correlation between inflation and higher investment returns will not be perfectly timed. It is likely that when inflation first starts to rise and analysts talk of increased interest rates, profits and share prices of companies may actually fall. This is because the market will anticipate higher costs and, in particular, it will anticipate higher interest rates.

Higher interest rates are bad for shares because it increases the businesses’ costs; quite simply, most companies have at least some debt and as interest rates rise, so does the interest expense for companies.

Higher interest rates also affect the valuation of the companies; higher interest rates mean that investors can now get a better return with fixed interest investments, and so they want a higher return from shares to compensate them for the higher risk. Therefore, with the advent of higher interest rates, the share market will often push share prices down.

For the last few months, we have seen relatively high share market volatility as the impact of higher inflation and higher interest rates are anticipated by the market. This may continue for some time yet, but eventually this volatility will settle, and shares will start to give improved returns.

In my view, it is critical for retired investors to have exposure to shares rather than simply own nothing but fixed interest investments. In times of increasing inflation, holding an investment that gives a fixed rate of return is not a good strategy. You need some investments that can increase their income with inflation – and that means shares.

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