What does high inflation mean for your retirement savings?

After decades of steady inflation that more or less stayed within the Bank of Canada’s target range of 1% to 3%, inflation soared to a decades-high rate of 8.1% in June 2022. The central bank cranked up interest rates to squash inflation, but the rate of price growth stayed stubbornly above the 2% target for another two years.

Thankfully, this past August’s inflation print hit the bull’s-eye of 2%, and September’s CPI was even lower, at 1.6%. With the inflation beast finally tamed, the Bank of Canada and its American counterpart, the U.S. Federal Reserve, have started lowering interest rates in hopes of avoiding a recession and nailing a so-called “soft landing.”

With that ugly period of high inflation now in the rearview mirror, what’s an investor to do with their portfolio?

How inflation can affect an investment portfolio

Historically, stock and bond returns have beat inflation over long periods of time, but both assets tend to perform poorly during periods of high inflation. That’s especially true in a period of unexpectedly high inflation like we saw in 2022.

Indeed, during the high-inflationary period from 1966 to 1982, U.S. stocks delivered a 0% real rate of return (the annual rate of return adjusted for inflation).

When inflation is high, central banks tend to increase interest rates to slow down the economy. Rising interest rates push down bond prices. Rapidly rising interest rates accelerate the decline in bond prices.

Long-term federal bond prices, for example, were down 24% in 2022. That’s certainly not what most bondholders expect to see with their fixed income.

High rates don’t just impact bondholders. Companies that used relatively cheap borrowing costs to expand during the past 10 years also felt the sting of rising rates. The NASDAQ Composite Index, which mostly represents technology stocks, fell more than 32% in 2022 as interest rates soared.

There were a few bright spots during the rising-rate environment of the past few years, however, the first being the modest guaranteed investment certificate (GIC). At the start of 2022, you could buy one-year GICs paying 1.5% interest. By the end of that year, one-year GICs were paying more than 5% interest. Five-year GICs saw a similar surge in rates, moving from around 2.5% to 5% by the end of 2022.

Why persistently high inflation is concerning for investors

Like the Bank of Canada, other central banks around the world hiked their benchmark interest rates in an effort to return inflation to the low and predictable levels we’ve become accustomed to over the past 30 years.

Both the Bank of Canada and the U.S. Federal Reserve have stated that persistently high inflation is more of a threat to economies and livelihoods than the short-term pain of increased interest rates and a cooling economy. They want to avoid a repeat of the painfully high inflationary period of the 1970s at all costs, which is why rates climbed as high as they did and stayed there until central banks were confident that inflation had been squashed.

That seems like the sensible choice, given that stock and bond prices are all about future expectations. Low, predictable inflation allows businesses and consumers to confidently make plans for spending and reinvestment. Persistently high inflation brings uncertainty, which leads to volatile swings in asset prices.

The best-case scenario is a soft landing, in which inflation comes back to its target rate of 2% without tipping the economy into a recession.

What investors can do to protect retirement savings

If you’re retired, you’re approaching retirement or you’re still several years out but are planning your retirement finances, the high inflation scare of the past few years might be keeping you up at night. How can you minimize its impact on your purchasing power now and in the future?

The best defence is diversification, according to Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital in Ottawa. On an episode of their investing podcast, Rational Reminder, Felix said that investors can decrease the risk of their entire portfolio having zero or negative real returns by holding more sources of expected return in their portfolio. That includes value stocks, domestic and international stocks, and fixed income, if it makes sense in the portfolio.

“The ultimate inflation hedge, I think, is diversification, but that’s not actually a hedge. It’s just a way to deal with it,” said Felix. He cited research about the characteristics of an inflation hedge.

• It will correlate positively with inflation, including responding to unexpected inflation.
• It won’t be too volatile.
• It will have a positive real expected return.

The problem, Felix said, is that such an asset doesn’t exist. Commodities are too volatile in the short term. Gold, which is not positively correlated with inflation, is volatile and doesn’t have a positive real expected return. Inflation-protected bonds perfectly hedge against inflation, but only if your time horizon matches the duration of the bonds.

One possible, much-talked-about solution is to invest in a globally diversified portfolio with domestic and international stocks and bonds. During the 1966–1982 period of 0% real returns for U.S. stocks, Canadian and U.K. stock returns were positive and U.S. value stocks delivered a real annual return of 6.71%. Further to that, global stocks have been a great long-term inflation hedge, with a positive 5.2% real annual return going back to 1900.

Outside of that, retirees may have inflation-protected income from a workplace pension, Canada Pension Plan (CPP) payments and Old Age Security (OAS) payments. Retirees collecting CPP in 2023 and 2024 saw increases of 6.5% and 4.8% in those years, thanks to the high inflation experienced in 2022 and 2023.

Investors can also take advantage of the current higher-than-normal interest rates on GICs and high-interest savings accounts (HISAs). And fixed-rate borrowers who locked in their rates before 2022 may still enjoy another year or two of low interest rates and fixed payments.

Final thoughts

After experiencing global inflation that kept prices elevated for longer than expected, investors are understandably nervous about inflation rearing its ugly head again in the future.

Going forward, investors could consider diversifying their portfolios globally with stocks and fixed income to reduce the risk of a negative or zero real rate of return.

As Nobel Prize laureate Harry Markowitz famously said, “Diversification is the only free lunch.”

Read more about investing for retirees:

• What do rising interest rates mean for retirement savings?
• We’re living longer—here are two ways to boost retirement savings and income
• What are call options? Why should retirees care about them?
• How to pick the right ETF for your needs

About Robb Engen, QAFP

Robb Engen is a fee-only advisor who will work with you to achieve your financial goals by creating a financial plan with actionable steps along the way.