One of the greatest dangers to any retirement plan is that insidious erosion of purchasing power commonly known as "inflation."
A weekly trip to the gas station or supermarket is enough to drive home the point. While younger, working Americans have opportunities -- often through increased earning power -- to overcome inflation, those in retirement or close to it are particularly vulnerable.
"The greatest risk retirees face is inflation, not short-term volatility of the stock market," says Tom Orecchio, national chair of the National Association of Personal Financial Advisors. "People focus on the market today as opposed to their purchasing power 25 years from now, and that's a mistake."
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These investments can help retirees protect against it.
1. Treasury-Inflation Protected Securities
How they work: TIPS protect against inflation through their connection to the Consumer Price Index. Specifically, TIPS' principal rises with inflation and falls during deflation. If someone buys $100,000 in TIPS and inflation increases by 3 percent, the TIPS principal will be worth $103,000 by the end of the year. (Adjustments are made every six months.) When TIPS mature, investors receive the original principal amount or one that's been adjusted, whichever is greater. TIPS pay interest every six months. This interest rate is constant, but the earnings fluctuate because they're based on the inflation-adjusted principal.
Who they're good for: Retirees, and anyone else living on a fixed income.
Cost: TIPS are sold directly from the U.S. Treasury Department in increments of $100. You also can purchase shares of mutual funds that primarily invest in TIPS, such as Harbor Real Return or Vanguard Inflation-Protected Securities.
Liquidity: TIPS are very liquid. You can sell them at any point in time, though there's no guarantee you'll make money: If you sell before the TIPS maturity date you incur a risk of selling at a premium or discount of what you've paid for it.
Pros: Inflation protection.
Cons: Taxes. Investors must pay ordinary income tax rates, which can be as high as 35 percent, for the interest they receive as well as for any increase in value in the TIPS principal. Experts recommend that TIPS be held in tax-sheltered accounts such as a 401(k) or an IRA.
Risk: The value of the principal can go down, so if you sell prior to maturity, you may get less than what you paid.
2. I Bonds
How they work: I bonds are designed to keep pace with rising prices by paying a composite interest rate that's made up of two parts: an underlying fixed rate and an inflation-adjusted variable rate. The variable interest portion is tied to the CPI rate and rises and falls during the life of the bond to keep pace with prices. The fixed rate portion remains unchanged for the life of the I bond. This rate changes semiannually, on May 1 and Nov. 1, for newly issued bonds. Currently, I bonds are paying a composite rate of 5.64 percent. On Nov. 1, the underlying fixed rate was set at 0.70 percent, and the semiannual inflation rate was set at 4.92 percent. These rates will change again on May 1.
Who they're good for: Retirees who already have a hefty nest egg and therefore don't need as much growth should look to I bonds.
Cost: I bonds can be purchased electronically in amounts of $25 or more, or for a minimum $50 for paper versions, from Uncle Sam at www.treasurydirect.gov.
Liquidity: Not good. You cannot redeem I bonds for 12 months, and if you sell before five years you'll forfeit interest from the three most recent months. To avoid penalties, you must wait five years to cash out.
Pros: Safety and inflation protection. Generally, bonds won't pay you the handsome returns of stocks, but the principal is guaranteed. They're also exempt from state and local taxes, and investors can defer what they owe in federal taxes until they cash them in.
Cons: Limited growth. Even though you beat inflation, I bonds generally won't have the kind of growth as riskier investments. Lack of liquidity is also a negative.
3. Dividend-Rich Stocks
How they work: As a rule, public companies either reinvest earnings or pass them along to shareholders as dividends. For beating inflation, the second variety is hard to beat: Dividend-rich stocks provide income, but unlike fixed-income investments, they have the potential for capital growth as well. Large, established stocks, such as those in the Standard & Poor's 500, have a greater likelihood of offering dividends. Those paying the highest dividends are generally found in such sectors as industrials, utilities, financial services, pharmaceuticals and consumer staples.
Who they're good for: Most retirees need the potential growth of equities, whether they pay dividends or not. But as seniors leave the work force, the added bonus of dividends is a smart choice for individuals who will need assets that provide both growth and income.
Cost: Share prices vary depending on the company and market conditions. A commission is involved with the purchase of stocks, whether you purchase through a full-service brokerage firm or you're a self-directed investor. Costs will be lower for the latter type of firm. If you buy a diversified mutual fund that focuses on dividend-rich stocks, you'll pay an expense ratio.
Liquidity: Very liquid, in theory. You can buy or sell any dividend-paying equities at any time. However, to reap lower tax benefits, you must own equities for a certain amount of time -- generally more than 60 days in a 121-day period surrounding the so-called ex-dividend date, which is the day after shareholders who are entitled to a dividend are identified.
Pros: Low taxes -- for now. Until 2010, qualified dividends are subject to capital gains taxes, which are no higher than 15 percent for individuals in tax brackets 25 percent or higher. (Individuals in lower tax brackets owe no tax on dividends starting in 2008 until Jan. 1, 2011.)
Cons: Besides the potential for capital loss, these stocks generally lack diversity. Dividend-paying stocks, or funds that invest in them, tend to concentrate on a few industries that aren't known for rapid growth.
Risk: Equities can lose money, so buying dividend-rich stocks requires homework.
4. Exchange-traded funds, or ETFs
How they work: ETFs have qualities of both stocks and funds. Though they comprise a basket of securities, they're traded like a stock, so prices vary throughout the day. But like mutual funds, ETFs can be include equities, bonds, commodities, currencies, derivatives, etc. ETFs are generally designed to mirror indexes, but that's not always so. Demand for ETFs is fueling rapid growth in their offerings. It's possible for inflation-leery individuals to find ETFs invested in high-growth stocks or dividend-rich equities.
Who they're good for: Relatively low management costs and tax efficiency make ETFs better for budget-minded retirees who are looking to invest a sum of money for years instead of weeks or months, and who may be seeking to diversify assets. They also offer a convenient, no-fuss alternative to individual securities because it's relatively easy to pick one off the shelf and plug it into a portfolio.
Price: Varies throughout the day. Commissions are charged with purchases and sales.
Liquidity: Very liquid. You can trade ETFs as frequently as you want, just as with stocks. You can place limit orders on them, short them, buy them on margin.
Pros: Low management costs and rich yields. Because most ETFs are not actively run by a manager, ETFs are generally cheaper than mutual funds.
Cons: Transaction fees. Investors must pay commissions every time they trade an ETF, so they can wind up being pricey for active traders. And dividends that are reinvested in an ETF can be subject to brokerage commissions, too.
Tax efficiency: Generally, underlying assets in an ETF are pegged to an index, so they're not traded as frequently as an actively managed mutual fund. And ETFs usually don't make large capital gain distributions to investors either, keeping taxes in check.
Risk: An ETF's market price may skew widely from its net asset value. Though it's uncommon, investors need to be aware this adds a certain level of uncertainty. ETFs are often made up of a pool of assets in a narrowly defined index or in a particular sector. That concentration can increase the risk for price declines more than actively managed funds, which tend to have more diversification.
5. Mutual Funds
How they work: Funds can be made up of a variety of underlying assets including stocks, fixed income, currencies, commodities and cash as well as a combination of these, depending on the style you choose.
A new breed of "retirement-income funds" is geared to nonworking seniors who want their assets to last for a specific number of years and keep up with inflation.
Who they're good for: For seniors looking to inflation protection or additional income, a mutual fund can provide more diversity for their investment dollar than purchasing, say, a single TIPS or dividend-yielding stock. Seniors who plan on a long retirement and who need to generate money after they leave the work force, on the other hand, may also want to consider equity-based funds designed for growth.
Cost: Prices and ongoing expenses vary. Actively managed funds are almost always more expensive than index funds.
Liquidity: If you own load funds, you may trigger front-end, back-end, deferred or other redemption fees when you sell. A short-term redemption fee, for example, is imposed on individuals who sell their fund shares within a certain amount of time, typically 30 to 60 days.
Pros: Mutual funds are diversified and run by professional managers, eliminating worry for individuals who don't have the time, expertise or desire to manage their investments themselves. This is particularly true with so-called target-date funds that automatically readjust holdings to become more conservative as investors approach retirement. Funds invested in equities have the potential to keep pace with or surpass inflation, depending on their underlying assets and performance.
Cons: Expense. Ongoing management fees can make mutual funds pricy to trade, though some index funds run very cheap. Generally, fees eat into investors' profits because they're deducted from fund assets. Actively managed funds with high turnover may generate high taxes.
Risk: Capital depreciation. Mutual funds come with no guarantees and may lose money, depending on the performance of their assets.