Wealth Management and Inflation

Inflation and Investment Portfolios

As investors know only too well, inflation can have a silent but corrosive effect on wealth, by undermining the real value of personal and pension investment portfolios. Inflation risk is real and should be factored into all areas of wealth management, from portfolio construction to
cashflow planning.

So, how best to mitigate inflation risk? Firstly, by taking a proactive approach in conjunction with your advisor, you can identify underperforming investments, improve returns on idle assets and optimise your shorter-term cash management strategies.

Balanced portfolios consisting primarily of equities and bonds have been through difficult times lately. Fixed Interest Assets – namely bonds – that often play a defensive role in times of uncertainty, have failed to do so. However, following the broadly based bond sell-off in 2022 and the continued uncertainty around interest rates, bond markets are offering investors real value now in our view. While we do not see the market settling fully until the peak in the interest rate cycle is clearer, that is likely over the coming months.

Yields on sovereign bonds are currently 3% plus, while higher yielding corporate bonds are paying more than 7% per annum. While we are advising clients to build a reasonably broad exposure to bonds, our favoured area continues to be the higher quality end of the high yield bond sector where the risk reward balance seems particularly attractive.

Other asset classes have bucked the trend: real assets, which include alternative assets such as commodities and infrastructure, are traditionally thought of as inflation hedges. Commodities are themselves contributors to consumer price inflation and tend to have a relatively low correlation to other asset classes.

While we construct investment portfolios for the long-term, the investments currently selected reflect our best views on where we see opportunities for clients in an inflationary environment. These include options for cash-management, explored in more detail below.

Inflation and Cash Management

When exploring cash-management strategies for clients, in general we are seeking investments for clients who want a return in excess of that available from cash deposits in Ireland in the medium term, and who are looking for alternatives to holding long-term cash in their portfolios.

For liquidity purposes, as well as for risk management reasons, cash will always form a part of any investment portfolio. While Central Banks have increasedinterest rates as a response to inflation, in Ireland we have yet to see banks pass these interest rate increases on to depositors. As cash continues to generate a very low return, certain highly liquid low volatility funds can be used as a cash proxy for a proportion of the portfolio which might more usually be allocated to cash.

Money Market funds are generally large, liquid funds that invest in short-term bonds. These offer investors a low-risk option for cash, although it should be stated that there will be some short-term volatility within these investment funds, albeit at very low levels. We have a number of Money Market funds on our Recommended List at present, with current yields available of around 3%.

Inflation and Retirement Planning

Directors’ retirement planning forms a core part of the service offered at Harvest Financial Services. A Director’s pension is a tax-efficient, long-term savings structure designed to provide you with income in retirement.

When considering ‘target-pension funding’, we must allow for inflation when projecting your future retirement income.

The ‘Rule of 72’ can be a useful measure of the impact of inflation over time. By simply dividing 72 by the annual interest rate, the formula can help you approximate how quickly higher prices (for food, energy, and other lifestyle expenditure) will halve the value of your pension fund, and the income you will receive from it.

The Consumer Price Index (CPI) rose by 6.1% between June 2022 and June 2023, the 21st straight month where annual CPI was in excess of 5%.

The most notable changes in the year were increases in Housing, Water, Electricity, Gas & Other Fuels (+15.7%), Recreation & Culture (+10.4%), Food & Non-Alcoholic Beverages (+10.2%) and Restaurants & Hotels (+8.3%). 

Applied to the Rule of 72 formula, June’s 6.1% CPI inflation rate halves the value of consumers’ money in roughly 12 years. (Seventy-two divided by 6.1 equals 11.80).

While inflation will hopefully fall in coming years, a 50% reduction in the purchasing power of your pension fund over 12 years is a serious consideration to say the least.

We are Here to Help

Retirement Planning is focused on objectives – your Client Advisor will be able to assist in this regard, by incorporating the impact of inflation into your retirement cashflow plan.

While it may initially be uncomfortable viewing, understanding inflation risk will help you plan to mitigate it, and ensure your retirement lifestyle matches your expectations.

Adjusting your investment portfolio to perform better in inflationary environments is critical. Higher interest rates have given rise to some new opportunities. On the other side of the coin, increased exposure to some asset classes is probably best avoided over the short term.

For any investment or retirement planning advice needed, contact Harvest at justask@harvestfinancial.ie or call us on 01-237 5500 and we will be delighted to assist.

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