Retirement Income Blog

 If a recession becomes severe, dollars may suffer from deflation rather than inflation. This would change the rules you have for retirement investing over the past 30 years. What should retirees consider doing if deflation sets in?

We’re familiar with the effects of inflation. Our dollars just don’t buy as much as they used to. Too much ‘easy money’ from too much credit puts more dollars into everyone’s hands so each dollar is worth less than before. So too many dollars are chasing too few goods and the prices of goods are bid up. In this typical inflationary environment, retirement investing rules are to get rid of cash and hold hard assets like real estate.

But when recession occurs, everyone becomes afraid of consuming. Businesses feel the pinch and people lose jobs. Government may try to ‘prime the pump’ by offering and instigating low interest rates. That reduces the cost of credit and hopefully to get people to begin borrowing and ‘consuming more’.

But if the turn down is too severe, very few people will be enticed to spend money. The money supply actually contracts. The results in a low demand to buy most things and can force prices down. And deflation is the general decrease in the prices of goods. Your dollars are worth more!  Rather than get rid of dollars, you want to own them and convert them selectively to assets that have fallen in value (real estate, stocks, etc).

Most retirees have no job to lose. They’re living off Social Security, pensions and their investment earnings. Most of this  retirement income may be fixed income.  Those in such a circumstance can actually benefit from deflation – mostly from the benefit of lower prices for things.

But under deflation, dollars become more valuable and debt – i.e. owing a fixed amount of dollars – becomes more of a burden. So retirees should reduce the cost of their debt by reducing payments or restructuring.

As deflation sets in you’re paying off debt in more expensive dollars. So any way to reduce the dollars you must commit to debt payments is beneficial.

Restructure your debt payments. With recessions comes falling interest rates. Take advantage of lower interest rates to restructure debt payments you can’t pay off quickly.

Refinance your home. If you have a mortgage, refinance at lower interest rate to cut your monthly costs – or to pay it off over a reduced time period.

Since the value of cash is increasing, holding it will increase your wealth – but only during deflation. Aside from preserving your emergency funds, you’ll want to hold dollars for retirement investment opportunities at low prices.

If you do have extra cash, stay aware of overly depressed investment prices and commodity prices (oil and gold)that will recover after the recession ends and present low risk retirement investing opportunities. Real estate investments – especially condos – are a typical case. It may even be worth a small remortgage of your paid off house for some investments (this strategy is not suitable for everyone as any borrowing will incur a fixed payment commitment while the return on investments is not assured).

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Perhaps noments word is scarier to a fixed income investor than inflation – especially for those who depend on the yields from bond investments for their retirement income needs. For example, inflation can reduce the payout rate of bonds over the long-term, as the higher costs of living can often weaken the purchasing power of bond’s return over time.

However, retirement investors can factor in the effects of inflation in their investment portfolios. You can also help protect your portfolio and your cash flow from inflation by adding Treasury inflation-protected securities (or TIPS) to the bond portion of a diversified investment portfolio. In these times, with talk of asset deflation TIPS are also a reliable choice as the principal is not reduced for deflation as it is increased for inflation as explained below.

TIPS were introduced a few years ago by the U.S. Treasury to offer investors a means to protect assets from inflation. TIPS help to protect against inflation by adjusting the principal amount by a rate equal to the Consumer Price Index (CPI) – the primary barometer of inflation on the consumer level. When the bond reaches maturity, the TIPS investor receives either the principal value of the bond adjusted for the CPI rate over the term of the bond or the bond’s original par value, whichever is greater upon maturity (and thus protection from deflation). The TIPS investor also receives the interest amount on the bond. Because the principal amount of the TIPS bond rises over time, this helps to protect the purchasing power of the bond. Every 6 months when the investor receives interest, the interest is based on the inflation adjusted value of the bond so your income rises with time in an inflationary environment.

TIPS can also be a suitable choice for a diversified portfolio, because they have a low correlation with stocks and other bond securities. That means they often react differently than stocks and other bonds to market and interest rate risks and can potentially reduce the volatility of your overall portfolio. However, TIPS are not a risk-proof investment. To receive the full inflation-protection potential of a TIPS holding, it must be held for the term of the bond. Also, TIPS may under perform regular Treasury bonds, should inflation remain low. In a deflationary environment, TIPS could also lose value, although investors would be guaranteed to receive at least the par value of the security upon maturity. The key is to buy and hold to maturity.

TIPS may also provide you with some tax benefits. Like other Treasury notes and bonds, TIPS are exempt form state and local income taxes but interest payments are subject to federal income tax. However, gains from inflation adjustments to the value of the TIPS’ principal are taxable in the year they occur, even though you won’t get the cash until maturity.

Should asset deflation occur, the value of stocks, real estate and other assets fall.  But since your TIPS are protected form deflation when held to maturity, your maturing TIPS would buy more of the deflated assets.

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