With inflation reaching its highest levels since the early 1980s, the topic of rising prices has been on the minds of many financial advisors and their clients. And though many hoped that the spike in inflation that began in autumn of 2021 would pass within a few months (once holiday season demand cooled and COVID-related supply chain issues worked themselves out), it has instead persisted for longer than many originally predicted.
In the early days of this inflationary spike, the most common (and perhaps the best) advice for clients may have been to simply “wait it out”, since a brief rise in prices – uncomfortable as it may have been – was unlikely to have enough of an impact on long-term planning to warrant any drastic changes. But even though we are still a long way from the kind of inflation that plagued the economy in the 1970s and 1980s (when inflation averaged over 9% for a 9-year stretch), the continued rise in prices may have many advisors (and their clients) wondering if there is more that they can do to better position themselves for a prolonged bout with inflation.
One place to start may be to better understand how inflation is personally affecting each client. The headline Consumer Price Index (CPI) number that we see constantly represents an average inflation rate for the entire U.S. economy, but in reality, different households experience inflation in different ways depending on their lifestyle and where they live. Advisors can help clients calculate their own ‘personal’ inflation rate (and a downloadable template is included to make it easier to do so).
Another immediate way that advisors can help ease the impact of inflation for clients is to create a cash management strategy (i.e., a system for knowing how much cash to keep on hand and where to keep it) to avoid them having more cash on hand than is necessary (since, with interest rates on bank accounts so low, the excess cash is almost guaranteed to lose value to inflation even if inflation does fall back to pre-2021 levels).
Advisors can also address different ways clients can protect their savings for retirement and other long-term goals against inflation. The conversation could start with the one asset that is likely already in most clients’ portfolios: U.S. stocks, which have a lengthy track record of outperforming inflation over long time horizons. Additionally, advisors can discuss the role of TIPS in a portfolio (and answer some common questions such as whether it is risky to buy TIPS when inflation is at a multi-decade high, and whether it is better to buy TIPS directly or within a mutual fund or ETF). And because clients may have questions about other types of assets that are often associated with hedging inflation risk – such as gold, commodities, REITS, and, most recently, cryptocurrencies – advisors can help by discussing the actual track records of these assets to help clients make a more informed choice about how to strengthen their portfolios against persistent inflation.
There are other practical areas to give useful advice, such as tax planning (where clients might experience “bracket creep”, and therefore higher taxes, due to their income rising faster than the inflation rate used by the IRS) and property insurance (where, with construction materials and labor costs among the fastest-rising prices across the country, homeowners may find their existing insurance coverage is no longer sufficient to ensure the replacement value of their property).
Finally, advisors can ‘zoom out’ to the long view of clients’ financial projections for retirement, and address clients’ concerns about whether the plan’s existing inflation assumptions (which may predate the current inflation spike) are still realistic – and discuss how, when looking at the market’s expectations for future inflation in the form of the TIPS breakeven rate, investors still seem to be betting on a return to ‘normal’ inflation numbers after a short-lived increase. (Which bodes even better for clients’ plans given that investors have historically overestimated their inflation predictions!)
Ultimately, even though the goal of many advisors at the moment may be to encourage clients to continue to stay the course and avoid making rash decisions, there are still concrete ways that advisors can help clients better position themselves to withstand the current spike of inflation and improve their situation for the long term without drastically altering their existing plans. And even if this inflationary environment proves to be short-lived, the work advisors with their clients now can help them be better prepared for future unexpected increases in inflation – which, though we can’t control when they may happen, we can plan to help ensure they don’t get in the way of our clients’ ability to reach their goals.
Since the Fall of 2021, the U.S. has been experiencing its highest levels of ongoing inflation in over 40 years. Though many people predicted that the spike in prices would pass relatively quickly as pandemic-related supply chain issues worked themselves out, inflation has proven more persistent than expected. And while the Federal Reserve has started to raise interest rates as a way to cool inflation down, that strategy could take time.
With the headlines that inflation has drawn in the national media (as well as the impact that rising prices have had on consumers’ everyday finances), inflation is a widespread area of interest. But since inflation of the kind we’re currently experiencing has not been this high since the early 1980s, many financial advisors – and their clients – may not have needed to have conversations in the recent past to address how high inflation rates would impact financial planning.
With this in mind, here are eight conversations that financial advisors can have with their clients around inflation that range from recommending potential strategies that clients can adopt to better position or protect themselves in the face of inflation, to providing context around our current moment and offering reassurance about how they are doing in the long-term picture. Notably, having a conversation about a subject that is top-of-mind – and potentially anxiety-laden – for many clients can help advisors add value and build trust to deepen their relationships with them.
1. Help Clients Calculate Their ‘Personal’ Inflation Rate
The first question about higher-than-expected inflation that many clients are likely to have for their advisor is, “How does this affect my plan?”. For many clients, persistent inflation could mean having to choose between increasing their spending to maintain their current lifestyle (which could decrease their current plan’s chances of success) or making changes to their lifestyle to keep the same level of spending. Near-daily headlines about record inflation might be stressful for clients – particularly those who are retired or approaching retirement, who have a finite amount of retirement savings to live on.
But the inflation rates in the headlines might not reflect the actual inflation a client might be experiencing. The Consumer Price Index (CPI), which the U.S. Bureau of Labor Statistics calculates each month by combining the separate rates of inflation of a ‘basket’ of goods and services, is the inflation rate often used to describe the average inflation rate across the entire economy and is referred to as ‘headline inflation’. But, while the CPI can be a useful gauge of how much prices have gone up, on average, across the country, it is less useful to describe the impact inflation has had on any one individual or household.
This is because everyone spends money in different ways and inflation is not always consistent across geographic regions, which means that even households with similar lifestyles might experience different levels of inflation depending on where they live. For example, the budget of a retired couple living in a condo in the city will look completely different from that of a family of four with a house in the suburbs. Accordingly, individual households could have very different personal rates of inflation compared with the CPI’s average for the entire country.
Furthermore, inflation has been more severe in certain categories than in others; as the chart below shows, oil, gasoline, and used vehicles have seen the biggest increase in prices over the last year, while health care and housing costs have seen the smallest rise.
The difference between the headline inflation reported through the CPI and a household’s personal inflation rate matters for advisors and their clients because, if a client is going to make adjustments to their lifestyle based on inflation, they should be based on the inflation rate they are actually experiencing, which is not necessarily the same as the one reflected by headline inflation.
Advisors can add context to headline inflation by helping clients determine their own personal inflation rates based on the way they actually spend money using a spreadsheet similar to the one provided below. This can help clients better understand how inflation has affected their spending, and whether they should make an adjustment to their spending or withdrawal rates to maintain the long-term sustainability of their plan.
By using this customizable template, advisors can work with clients to compare their current spending to the previous year to determine the client’s personal inflation rate. The template lists common categories of expenses (which can be added to or deleted as needed). The advisor or client can fill in the amount the client spent on each category during the last month, and during the same month in the previous year (e.g., March of 2022 and March of 2021). The sheet automatically calculates the difference in spending for each category and computes a total personal inflation rate at the bottom.
If the client already has some way of tracking their expenses via an app like Mint or YNAB (or if the advisor has been helping them do so with collaborative software like Tiller Money), it might be relatively easy to track down the data needed to fill out the sheet. Otherwise, it is possible to use bank and/or credit card statements to pull together the numbers for each category.
Of course, what ultimately matters to the client is the bottom line of how much they are spending overall, and how that relates to their ability to save for and reach their goals in the long term. But gaining some understanding of how the underlying categories break down can create useful insights and, if the client does decide to make a change to their lifestyle to adjust their spending, this level of understanding can help them identify which changes might have the biggest short-term impact.
2. Help Create A Cash Management Strategy (Outside The Portfolio)
The role of many financial advisors when it comes to helping clients with their cash management needs has traditionally focused on overseeing the cash in a client’s investment portfolio. However, interest rates on money market funds and cash sweep accounts have hovered near zero in the decade-plus since the financial crisis. Accordingly, the goal of cash management, in practice, is often to hold as little cash in the portfolio as possible, while ensuring there is enough available when needed to support ongoing withdrawals (e.g., for clients who are retired and funding their cost of living from portfolio withdrawals) and to pay the advisor’s fees (if they are debited directly from the portfolio).
A client would need to closely read an investment account statement to see what an advisor has done to manage the cash inside their portfolio. But when advisors help clients manage the cash outside of their portfolio – that is, helping them decide how much cash to hold and where to hold it – they can provide value that is much more immediately impactful (and visible) to the client.
One way to do this would be to start by listing out the goals that the client has for their cash. For example, they may want to have cash available for unexpected emergencies, as well as a travel fund and savings for a down payment on a home. Next, the advisor can help the client determine how much they need for each goal. If the emergency fund target is based on the client’s living expenses (e.g., 6 months’ worth), the advisor can help walk the client through their budget or expense tracking software to come up with a reasonable number (and ensure it is in line with the client’s current level of expenses, as some living costs have likely gotten more expensive due to inflation).
Finally, the advisor can help the client determine how much of their existing cash is currently available for each goal. If there is excess cash left over after accounting for each goal, the advisor can recommend a way for the client to use it in a way that does not involve sitting in a bank account and losing value to inflation (e.g., to find a way to spend the money or to invest it in a taxable brokerage account).
Once the advisor has helped the client create a cash management strategy that aligns with the client’s goals, they can discuss which types of accounts or vehicles the client can use that will be the best fit for those goals. For example, Series I savings bonds, which are currently yielding 7.12% per year, are a possible alternative for many of the purposes that individuals traditionally used savings accounts for, like emergency funds and saving for other goals in a 1-5 year time horizon (with the caveats that Series I bonds have a purchase limit of $10,000 per person per year, cannot be withdrawn until 12 months after purchase, and have a penalty of 3 months’ interest if withdrawn within five years).
Cash is key to how many people manage their day-to-day lives, and with the inflation rate surpassing 10 times the interest rates that even “high-yield” bank accounts offer (which as of this writing is around 0.5%-0.6%), now is a perfect time to talk to clients about creating a cash management strategy that ensures that no more of their cash savings will be vulnerable to erosion from inflation than is truly necessary.
Helping clients decide how much cash to hold and where to hold it can be a way for advisors to add value and gain trust in an area that is very visible to clients (after all, while many clients may only glance at their investment statement on a monthly or quarterly basis, they are more likely to know within a reasonable margin how much is in their bank accounts at any given time)!
3. Remind Clients That Stocks Are A Great Long-Term Inflation Hedge
Clients may wonder how their investments will weather the impact of inflation over time. Even if the current spike of inflation turns out to be just a small blip during an investor’s lifetime, more persistent higher inflation could pose risks to many clients’ financial plans. And with the subject top of mind, advisors may have a good opportunity to review the risks and effects of inflation over time (and how the client’s existing portfolio is positioned to withstand it).
Though they are not always mentioned in lists of inflation-hedging assets, stocks have actually proven to be among the most inflation-resistant investments. The reason stocks are sometimes overlooked is that they do not tend to move in tandem with inflation from year to year, as other assets like commodities and TIPS do. Without that close short-term correlation, clients might not make the connection of stocks protecting their savings from long-term inflation.
Over longer periods, however, stocks have consistently performed above inflation. As illustrated in the chart below, rolling periods of varying lengths between 1871 and 2021 show that U.S. stocks have never posted a negative real return for rolling periods of 20 years or longer:
Moving the horizon even farther out to 30 years, the lowest real returns averaged by U.S. stocks in the last 140 years have been 3.1%. Overall, the real returns on U.S. stocks have averaged around 6.5% (which again, is the return after accounting for the effects of inflation). So for investors looking for an asset that is likely to beat inflation over the long term, stocks (and U.S. stocks in particular) have a strong track record for doing so.
For clients asking about adding an inflation-hedging asset to their portfolios, then, it may be useful to point out the inflation-hedging properties of the stocks they likely already hold. For example, a client with a portfolio of 80%-90% stocks and a 30-plus-year time horizon until retirement may already be well protected from the impact of inflation on their portfolio, meaning it might not be necessary to add other assets specifically to counteract inflation.
For clients with a shorter investment horizon (and a smaller allocation to stocks in their portfolio), it can be useful to point out the difference between inflation protection of their savings in the long-term (which can be provided in large part by the stocks or equity funds that they already hold) and protection for their income in the short-term (which might involve assets with more of a direct short-term correlation with inflation, about which more is written below).
4. Talk About When (And How) To Add TIPS To A Portfolio
Treasury Inflation Protected Securities (TIPS) are often the first thing that comes to mind when thinking of an inflation-hedging asset, so clients may ask advisors about adding TIPS to their portfolios. Which could be a good opportunity to discuss when and how TIPS are used, and what the benefits and risks might be of buying TIPS when inflation is already at a multi-decade high as it is today.
TIPS are a type of U.S. government-issued debt whose principal value and recurring interest payments are linked to the rate of inflation. More specifically, the bond’s principal increases at the same rate as the CPI, with the interest payment (which is a fixed percentage of the principal) rising in turn. In the event of deflation (i.e., a negative CPI), the reverse occurs, and the principal and interest payments are both reduced.
The nature of TIPS makes them useful for protection against future rises in inflation. As opposed to a traditional bond, where the principal and interest payments are generally fixed and therefore can be eroded in value by inflation over time, TIPS are designed to be equivalent in inflation-adjusted value from the date the bonds are issued until they mature. However, there are multiple ways to buy and use TIPS in a portfolio, each with their own potential benefits and risks, and talking with clients about their goals and concerns about inflation protection can help advisors recommend the strategy that fits best.
There are two primary ways to invest in TIPS: Either by buying them directly through the Treasury Department via the TreasuryDirect website or by buying an ETF or mutual fund that invests in TIPS. With TIPS purchased through the Treasury, investors are guaranteed to receive at least the ‘face value’ of the debt once it matures. For example, if an investor buys 5-year TIPS with a $100 face value, they are guaranteed to receive that $100 after 5 years, even if deflation pushes the CPI below the level where it was when they purchased the TIPS. However, that doesn’t mean that investors can’t lose money on TIPS. Because they are sold by the Treasury via auction, TIPS are often sold for above their face value (for instance, the 5-year TIPS auctioned on 12/22/2021 sold for $109.43 for $100 of face value). But because investors are only guaranteed the face value, it is possible for TIPS to lose money if inflation does not rise enough to make up the difference between the face value and the purchase price.
The relationship between future inflation rates and TIPS prices gets more complex when investors have exposure to TIPS via an ETF rather than owning them directly. Because ETF prices are not directly tied to the value of the underlying assets that the ETF invests in, but rather to the market’s valuation of the ETF itself (and often its willingness to pay for exposure to the asset class followed by the ETF), TIPS ETF prices tend to incorporate not only the current level of inflation but the expectation for future changes of inflation. As a result, the price of TIPS ETFs can be more volatile than TIPS themselves and tends to swing widely in value based on perceived changes in the inflation rate.
An example of this is illustrated below, as while monthly inflation has grown relatively steadily since the beginning of 2020, the value of TIPS ETFs – as exemplified by the iShares TIPS Bond ETF – declined by over 7% between its peak in July 2021 to its current value in April 2022. With the Federal Reserve signaling its willingness to fight inflation by raising interest rates, investors have lowered their future inflation expectations, selling off their TIPS ETF holdings and causing those funds to trade at a lower price than the current value of their underlying assets.
Ultimately, TIPS – whether bought directly from the Treasury or via an ETF – may be most useful as a way to hedge against long-term, unexpected increases in inflation, because regardless of how they are purchased, their price already reflects the market’s expectations for future inflation.
Clients who are concerned about preserving the value of their investment might prefer buying TIPS directly and holding them to maturity: The guaranteed return of TIPS’ face value ensures at least a minimum return, and even though low inflation (or deflation) might result in some loss of principal, there is a limit to what that loss could be.
With TIPS ETFs, on the other hand, there is more potential to capitalize on unexpected future increases in inflation – but there is also no limit to the loss that an investor could incur as a result of less-than expected inflation.
5. How Do Gold, Commodities, Cryptocurrencies, And REITs Perform As Inflation Hedges?
Certain asset classes like gold and other commodities have traditionally been considered to be good hedges against inflation, because (unlike the U.S. dollar or shares of stock) they represent a share of an asset with a theoretically fixed supply that cannot be expanded. As the thinking goes, these commodities will hold their value – or even appreciate in value – when the dollar declines (as it effectively does during inflationary periods).
Despite the ways in which commodities could (and perhaps should) theoretically be immune to inflation, the historical evidence of these asset classes tells a different story. Though gold performed well in the high-inflation years of the 1970s following the removal of the U.S. dollar from the gold standard, in the years since it has lagged stocks in both higher- and lower-inflationary environments.
The broader asset class of commodities (which includes gold but also other physical assets like oil, grain, lumber, and livestock) has had better results as an inflation hedge over time, and their low historical correlation to stocks and bonds has made them popular as diversifiers and inflation hedges. But during the long periods between inflation spikes, commodities have had more volatility and worse performance than equities. Meaning that investors who add commodities to their portfolios may need to endure long stretches with it acting as a drag on performance in order to realize the inflation-hedging qualities.
In addition to these traditional asset classes, many have also theorized that cryptocurrencies like Bitcoin also have inflation hedging properties. Specifically, in the case of Bitcoin, with the maximum possible number of coins in existence capped at 21 million, the cryptocurrency has a fixed supply (much like traditional physical commodities), which can – at least hypothetically – cause it to hold its value when the dollar is hit by inflation.
However, cryptocurrency, with its comparatively short performance track record (nearly the entirety of which has come in the low-inflationary environment of the 2010s), may be the hardest asset to predict for its inflation-hedging ability. The data that we do have is not promising: the price of Bitcoin rose by only 5% between the start of 2021 and mid-April 2022, with enormous up-and-down swings occurring during that time. Which means that any notion we may have of cryptocurrency being an effective inflation hedge is purely theoretical at this point.
One alternative asset class that does have a relatively consistent track record of outperformance against inflation is Real Estate Investment Trusts (REITs), which have outperformed stocks in periods of moderate and high inflation. And yet REITs have their own drawbacks as well: Many REITs are illiquid, have high expenses, and can introduce tax complications that may or may not be worth the inflation protection benefits.
When an event occurs that grabs news headlines, clients often want to know what one thing they can do to protect themselves (or conversely, to capitalize on it). Some alternative asset classes have characteristics that have linked them to inflation in conventional wisdom, but when looking closer at the historical evidence for each, or how they might be implemented in practice, they may not actually be any more effective than what is already in the client’s existing portfolio.
6. Help Clients Avoid “Tax Bracket Creep” And Find Other Tax Planning Opportunities Around Inflation
Though taxes may not be the first thing that comes to mind when people think about inflation, rising prices do have an effect on the income taxes we pay. The interaction between inflation and the tax system offers some challenges with tax planning… and along with those challenges are some valuable tax planning opportunities for advisors and their clients.
Many components of the Federal tax system are linked to inflation, including tax brackets, the standard deduction, and retirement contribution limits, among many others. This makes it so that – at least in theory – as costs (and presumably incomes) rise, the amount of taxes paid as a percentage of income remains relatively consistent. In practice, however, that isn’t quite what happens.
For one thing, the Tax Cuts and Jobs Act of 2017 required the IRS – which formerly based its inflation adjustments on the ‘regular’ CPI – to start using an index called chained-CPI to calculate its annual inflation adjustments. Chained-CPI typically rises at a lower rate than the traditional CPI, which means that people whose incomes rise with inflation at the regular CPI rate will encounter ‘bracket creep’—in other words, since their income rises faster than the thresholds for each tax bracket, more of their income falls within the higher tax brackets, causing them to be taxed at higher effective tax rates.
The issue of bracket creep can become even more significant when adding state taxes into consideration, since 13 states currently don’t even index their tax brackets to inflation at all but remain at the same level each year—meaning that in those states any increase in income will result in higher effective tax rates.
Additionally, inflation adjustments based on chained-CPI come in August each year, meaning that any inflation changes that occur later in one tax year may be reflected not in the following tax year but in the one after that. The inflationary spike of late 2021 exemplifies this effect: Because the IRS calculated its inflation adjustment for 2022 in August 2021, it only amounted to about 3%, failing to reflect the actual inflation rate that didn’t really take off until October 2021. At the same time, the actual inflation rate for 2021 ended out at 7%!
Even though the inflation numbers of Fall 2021 will be reflected in the 2023 IRS inflation adjustment, that isn’t very helpful for workers in 2022, when they receive salary increases in line with the overall inflation rate (a not-uncommon occurrence in the current tight labor market) which may result in getting taxed at higher effective rates and potentially even pushed into higher marginal tax brackets.
For advisors whose clients could potentially be pushed into a higher tax bracket in 2022, making use of tax planning opportunities like “clumping” together charitable donations and other deductions into one year or switching from Roth to traditional IRA or 401(k) contributions can ease the effects of higher taxes—which could be much appreciated by clients at a time when higher expenses are already eating into individuals’ income, even before accounting for the impact of higher tax rates.
Another opportunity for tax planning stems from the fact that some parts of the tax code are – for whatever reason – not indexed to inflation at all, but remain fixed from one year to the next. These include (but are not limited to):
- The $10,000 cap on State and Local Taxes (SALT) that are deductible on Schedule A;
- The $200,000 ($250,000 for Married Filing Jointly) Modified Adjusted Gross Income (MAGI) threshold that triggers the Net Investment Income Tax (NIIT) of 3.8%;
- The $250,000 ($500,000 for Married Filing Jointly) exemption on capital gains for the sale of a primary residence; and
- The $3,000 limit on capital losses that are deductible against ordinary income.
Homeowners who plan to sell their homes and relocate in the next few years may be among the most affected by these parts of the tax code, as demonstrated in the example below.
Example 1: Pearl is a widowed homeowner who retired last year and is planning to move closer to her children and grandchildren. She purchased her home 30 years ago for $100,000, and today it is worth $350,000.
If Pearl sells her home today, she would realize $350,000 – $100,000 = $250,000 of gains. But because the exemption of capital gains from the sale of a primary residence is $250,000, all of her proceeds from the home sale would be excluded from income and thus are entirely tax free.
Now, suppose that Pearl decides to wait five years before selling her home and that when she is ready to sell, there is a shortage of available homes on the market. Accordingly, the value of Pearl’s house jumps to $500,000.
In this situation, Pearl would realize $500,000 – $100,000 = $400,000 on the sale. But because the exemption on capital gains has not adjusted with inflation, and has remained the same at $250,000, Pearl will now have $400,000 (total gain) – $250,000 (exemption) = $150,000 of taxable capital gains to report as a result of the sale.
Beyond being included as taxable income on its own, the impact of capital gains from the home sale also cascades into other parts of Pearl’s tax return. Not only does the additional taxable income increase the percentage of Pearl’s Social Security income that is taxed, it also increases the threshold above which her medical expenses can be deducted on Schedule A (which is currently set at 7.5% of AGI).
Additionally, if Pearl has more than $50,000 in other income in addition to the $150,000 of taxable income from the home sale, her total income would exceed the Net Investment Income Tax (NIIT) threshold of $200,000, making some of her income also subject to the 3.8% NIIT.
Finally, the spike in income from the home sale will also result in a one-year increase in Pearl’s Medicare Part B premium on account of the Income Related Monthly Adjustment Amount (IRMAA), which adds a surcharge for Medicare beneficiaries whose income increases over certain thresholds (though that increase would occur two years later).
Advisors with clients who are thinking about selling their highly appreciated homes can assess when it would make more sense, from a tax perspective, for their clients to sell in order to minimize the potential impact of the taxable income from the sale. Housing prices are amidst one of their hottest stretches ever, as home builders struggle to keep up with the demand for new homes amid issues with the supply chain for building materials. As a result, home values have spiked at a rate exceeding even that of the housing bubble that led up to the financial crisis of 2007-2008. But with the capital gains exclusion fixed at $250,000/$500,000, waiting to sell risks having the gains from the sale push above those thresholds (and being subject to NIIT, which also has a fixed threshold of $200,000/$250,000).
Though there are many factors – not all of which are financial or tax-related – that might go into the decision to buy or sell a home, the timing of the sale could have a significant impact on an individual’s taxes and the rest of their financial situation. After all, if they need the proceeds of the sale of their previous home in order to fund the purchase of their next home, paying a significant portion of those proceeds in taxes might affect what kind of home they can afford to move to, or how much debt they must take on to do so.
7. Review Property (Replacement) Values To Ensure Homes Don’t Become Underinsured
Many financial advisors who provide comprehensive planning perform periodic reviews of their clients’ property and casualty insurance policies to ensure that their assets are protected properly. With the costs of building materials and labor spiking, it could be an important time to review these policies (and homeowners’ policies, in particular) to ensure that their property is still fully covered.
Homeowners’ policies typically have a coverage limit that is usually defined as the replacement value of the property they are protecting. In other words, policies will cover the loss of a home for the amount it costs to rebuild or replace the home, up to the limit specified in the policy. If the cost to replace the home is greater than the policy’s limit, though, the homeowner is left to cover the additional cost on their own.
Example 2: Joel purchased his home four years ago. At that time, the insurance company assessed the replacement value of the home at $360,000, which became the coverage amount on Joel’s homeowner’s insurance policy.
Unfortunately, Joel’s home burned down as the result of a science experiment gone wrong. However, due to the increase in the cost of building materials and labor, it will cost $400,000 to rebuild the house.
Since Joel’s insurance policy limit is only $360,000, the insurance company will only pay that amount, with Joel being responsible for the remaining $400,000 – $360,000 = $40,000.
Undercoverage can have even more serious risks if the coverage limit drops below 80% of the home’s replacement value. The “80% Rule” included in most homeowner’s policies stipulates that the insurance company will fully cover any damages to the property only if it is insured up to at least 80% of its replacement value.
If the coverage drops below that level, any damages will only be covered proportionally to the coverage limits compared to 80% of the property’s value.
Example 3: Joel’s friend Mike bought a house 10 years ago that was originally assessed and insured at $400,000.
Since then, the home’s replacement value has risen to $600,000. Which means that Mike would need to ensure his home insurance coverage is at least 80% × $600,000 = $480,000 in order to comply with the 80% Rule.
Unfortunately, before Mike can increase his insurance coverage, there is also a fire at his house. While the fire was put out before completely destroying the home, it was not before causing $200,000 of damage.
Since Mike’s homeowner’s insurance coverage of $400,000 is less than the $480,000 required to meet the 80% Rule, the insurance company will only cover $400,000 (actual coverage) ÷ $480,000 (required coverage) = 83.3% of the cost to repair Mike’s house.
As a result, the insurance company will only pay for 83.3% × $200,000 = $166,667 of the damages, leaving Mike responsible for the remaining $33,333.
Many insurance companies automatically increase the coverage limits on policies each year, which can somewhat lower the risk of inflation causing a home to be undercovered. But there is no guarantee that the increased coverage will keep up with the home’s actual replacement value, and many homeowners don’t review their policies each year to make sure they remain fully covered. Taking a few minutes during a meeting to walk through a client’s insurance coverage and point out where they may be undercovered could save the client thousands of dollars of (potentially unexpected) expenses in the unfortunate event that their home is damaged or destroyed.
8. Ensure That Long-Term Planning Assumptions For Inflation Are Still Reasonable
One of the most common client questions about inflation – and one of the most difficult to answer – is: “How long is this level of inflation going to last?” Many financial planning projections are run with a long-term inflation assumption of around 2–3% that reflects the last 20+ years of inflation history, but even a 1% increase, when projected out over 30 years or more of a retirement horizon, can have a significant impact on a plan’s chances of being successful. And a more severe spike over the course of a decade could create the risk that retirees will need to draw down too much of their portfolio for it to be able to recover later on.
So the length of our current spike in inflation matters. But because none of us has a crystal ball with which to see the future, and because inflation is a phenomenon caused as much by human psychology as by concrete market forces, it can be very difficult to predict how and when inflation will rise and fall (as anyone who originally predicted that the current wave would subside in just a few months can tell you).
One thing we can get is an idea of investors’ expectations about future inflation, which – while certainly no guarantee of what will happen – can give us an estimate of the market’s consensus views about inflation over the next 5 – 10 years. We can measure this using 5-year or 10-year TIPS breakeven rates, which in a nutshell represent the inflation rate that would be necessary for TIPS yields (which increase or decrease with the inflation rate) to exceed that of traditional bonds of an equivalent length (which remain fixed in value once they are issued). If the actual rate of inflation exceeds the breakeven yield over the life of the bonds, the TIPS will have the higher total yield; if it is lower than the breakeven, the traditional bond will have the higher yield. The breakeven rate is the equilibrium point where the yields on TIPS and traditional bonds would be equal; in effect, then, the breakeven rate at any given time represents the market’s consensus on their expectations for future inflation.
As of this writing in April 2022, the 5-year TIPS breakeven rate is 3.31%, while the 10-year rate is 2.86%. While both of these are higher than their pre-2021 levels – and higher than inflation has been in any calendar year since 2011 – they are nowhere near the 7%-8% annual inflation rates that we have seen in recent months, showing that the markets do still expect inflation to cool off significantly in the next few years.
And there is an additional piece of information embedded within the TIPS breakeven numbers that also suggests an inflationary cooling effect. The fact that the 10-year breakeven is lower than the 5-year figure shows that markets expect inflation to decline back to more familiar levels over the next decade; if inflation averaged 3.31% over the next five years, it would need to average just 2.41% over the next five years in order to equal the 2.86% 10-year average that the 10-year breakeven implies. And that is much more in line with the average inflation rates that we have seen since the early 1990s.
One final piece of good news about what the current TIPS breakeven rate can tell us about future inflation expectations is that, in the 20-plus years of data we have since the introduction of TIPS in 1997, the TIPS breakeven rate has consistently overestimated the rate of inflation. Which means that, even if the breakeven rate is not a great predictor of what inflation will actually be, the odds are that if they are off, inflation will be even lower than the breakeven rates predict. Which means that even if inflation doesn’t fall back to the sub-2% rates experienced for much of the 2010s, a 2% inflation assumption for long-term planning continues to look reasonable given investors’ expectations for the future.
Even though the current spike in prices may likely be a temporary phenomenon, it doesn’t diminish the rising stress that many people fear around inflation, either for their current cash flow or the buying power of their savings for the future.
Ultimately, then, one of the best things advisors can do to manage their clients’ stressful feelings around inflation is to help them keep things in perspective. We can’t see into the future, but we can stay focused on what enables clients to accomplish their goals in the long term – like saving regularly, controlling risk, and investing with discipline – thereby creating extra value for clients by guiding them through challenging times in the short term.