If you have switched on the news at any point in the last two to three years, there’s little doubt that you have seen a story on inflation. It’s everywhere and is a particularly important consideration for those nearing or in retirement.

In this article, we look at inflation risk and potential ways to navigate the issue.

What is inflation risk for retirees?

Inflation risk refers to the potential for rising prices to erode purchasing power over time. For example, if inflation was to consistently remain at the midpoint of the Reserve Bank of Australia’s target range (2.5%), one dollar today would be worth roughly half as much in 29 years’ time. Why is this a problem for retirement planning? Because many people live for thirty years or more after retirement.

It is therefore vital to seek investments capable of producing capital growth – so that income returns are generated from an increasingly larger capital base, and / or investments which deliver returns that outpace inflation.

Nominal vs real returns

Understanding the difference between nominal and real returns for any investor is important. Nominal returns refer to the ‘raw’ return on an investment over a given timeframe. If a $1.00 asset increases in value by $0.05, and over the same period delivers $0.02 in income – its nominal return is 7% ($0.05 + $0.02 = $0.07, which is 7% of the $1.00 starting value).

If inflation over the same period is 2%, then the real return of that asset is 5% (7% – 2% = 5%). Real returns factor in inflation.

Inflation doesn’t impact all investments in the same way. Importantly, some assets that are considered ‘defensive’, can represent a poor defence against the impact of inflation.

When defensive investments fail to defend

Investments such as bonds, annuities and cash are often considered to be defensive, because they are perceived to be more stable than assets such as shares. It’s important to note that these kinds of assets don’t offer much protection against the impact of inflation.

As an example, if a bond pays 5%, but inflation spikes to 7.8% (as it did briefly in December 2022), then the nominal return does not outpace inflation, resulting in a negative real return.

Additionally, as a central bank raises interest rates to curb inflation, the value of certain types of bonds fall as newer bonds offer a higher yield to investors.

Commercial property as an inflation hedge

Real asset classes, such as commercial property, are often employed as a hedging strategy against inflation.

Potential for capital growth

Firstly, commercial property carries with it capital growth potential.

Rising inflation can result in the increased cost of building materials. When interest rates are raised in an effort to curb inflation, borrowing costs increase. This makes constructing new dwellings less viable and attractive, and can limit the pipeline of new stock coming to market. In turn, this leads to increased prices for existing stock. If the value of an investment in a property increases at the rate of inflation or higher, then the purchasing power of that capital base is not eroded by inflation.

Rental income that outpaces inflation

Secondly, leases are often tied to inflation. Many commercial property leases include fixed annual rental increases, often set above the long-term inflationary outlook or tied to specific increases in inflation.

For example, a lease on an industrial property may have annual rental increases which are the higher of a fixed percentage or inflation. This ensures rental growth should always outperform inflation across the life of a lease.

The Trilogy Industrial Property Trust

The award-winning Trilogy Industrial Property Trust (Industrial Trust) holds a diverse portfolio of industrial properties located in established regional and metropolitan precincts. The aim of the Industrial Trust is to provide investors with regular income and the opportunity for capital growth over the long term.

Private real estate credit as an inflation hedge

Private real estate credit funds provide loans for real estate projects across the land, development or completed stock stage. Income for unitholders is primarily generated through interest payments from borrowers.

While the capital invested does not grow, there can be some protection against inflation.

Yields rise with interest rates

When inflation rises, central banks typically raise interest rates to reduce consumer spending. The aim of this is to curb inflation, which we recently discussed in more detail in our article on economic cycles.

As a central bank raises interest rates, a private credit real estate fund will often reflect this in the rate they charge borrowers, leading to higher yields.

The Trilogy Monthly Income Trust

The Trilogy Monthly Income Trust (Trust) is a private credit real estate fund that provides investors with exposure to returns available through loans secured by registered first mortgages over Australian property. Each loan in the portfolio is assessed by Trilogy Funds’ lending committee, comprised of a team of experienced fund managers, property and construction specialists.

The Trust finances a diverse range of property developments in the residential, commercial, industrial and retail property sectors in Australia. For over 17 years, Trilogy Funds’ managed funds, raised by investors, have enabled the successful completion of hundreds of projects nationwide.

Additional potential ways to hedge against inflation

Beyond commercial real estate and pooled mortgage investments, stocks and commodities are both common classes investors turn to in high inflationary environments.

Shares

Shares are a commonly sought-after hedge against inflation. Of course, not all shares are an effective hedge, but broadly, companies often have the power to pass increased costs onto their customers. This helps preserve profit margins, even as inflation rises, which can result in higher dividends and/or share price growth.

Historically, looking at a long-term horizon, shares tend to produce returns that outpace inflation. For example, since 1951, inflation in Australia has averaged 4.88% annually. However, across the same period, the ASX All Ordinaries Accumulation Index has returned an average of 13.4% per annum.

Of course, investing in shares also means exposing one’s capital to share market volatility – this is an important consideration. Furthermore, inflation can negatively impact some companies more than others. For instance, a company that has a highly price elastic demand for its products, does not have much power to pass on increased costs to its customers. Companies that operate in highly competitive markets may also be slow to pass on increased costs to customers.

Commodities

Commodities are basic homogeneous products bought, sold and priced in highly efficient markets. They can be inputs into a goods manufacturing process or consumed directly by households or businesses. Examples include oil, precious metals, timber and coal, as well as agricultural products such as wheat and livestock.

Similar to stocks, not all commodities are an effective hedge against inflation.

The importance of a diversified portfolio

In high inflationary environments, portfolios should be positioned to limit the potential of inflation eroding real returns. As such, investors must have sufficient exposure to a diversified mix of asset classes, so as to outpace inflation.

Of course, everyone’s circumstances and financial goals are different, and past performance is not a reliable indicator of future performance.

Retirement is an exciting time, but it is vital to prepare accordingly to ensure a maintained standard of living. Inflation risk is an added consideration for individuals and couples nearing or in retirement. To learn more about funding retirement, visit https://trilogyfunds.com.au/funding-the-three-phases-of-retirement/.

This article is issued by Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) as responsible entity for the Trilogy Industrial Property Trust ARSN 623 096 944. Application for investment can only be made on the application form accompanying the Product Disclosure Statement (PDS) dated 11 September 2023 and by considering the Target Market Determination (TMD) dated 11 September 2023 for the Trilogy Industrial Property Trust ARSN 623 096 944 available at www.trilogyfunds.com.au. The PDS and the TMD contain full details of the terms and conditions of investment and should be read in full, particularly the risk section, prior to lodging any application or making a further investment. All investments, including those with Trilogy Funds, involve risk which can lead to no or lower than expected returns, or a loss of part or all of your capital. Trilogy Funds is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed financial adviser. Investments with Trilogy Funds are not bank deposits and are not government guaranteed. Past performance is not a reliable indicator of future performance.