Capital Ideas^™ 
Investment insights from Capital Group

Inflation seems to be on everyone’s minds these days. From groceries to home prices, the recent spike in inflation touches nearly every aspect of life. According to U.S. Department of Labor data, the consumer price index climbed 7% in 2021, the largest 12-month gain since June 1982.

As earlier generations of retirees can attest, higher inflation may, over time, erode the purchasing power of retirement savings. Sustained levels of high inflation may prevent retirement income from keeping up with price increases in goods and services.

With that in mind, you and your plan sponsor clients may want to review their plan’s investment options — especially their target date fund (TDF) — to understand how they seek to manage inflation risks for participants.

Younger participants: Growth strategies to outpace the cost of living

Equities have long been considered a traditional inflation hedge over the long term. Thus, the growth-oriented component of the target date glide path may be particularly important to younger participants who want to accumulate wealth and may have more time to recover from any potential market losses.

When it comes to inflation, however, not all equities are created equal. Target date managers may or may not have the flexibility to invest in underlying funds that invest in equities that are typically more resilient to inflation, such as:

• Dividend-paying stocks, whose earnings and income may rise along with prices for goods and services
  
• Value stocks, especially in inflation-resistant industries like manufacturing and materials
• Financial and utilities stocks, which may benefit from higher interest rates and prices charged for essential services
• Specialty sectors like real estate investment trusts (REITs), precious metals and commodities

In inflationary environments like this, Capital Group looks for companies with pricing power, those with the flexibility to raise their prices because of strong brands or because they provide essential services. As consumer prices continue to rise, we seek to uncover companies that can sustain pricing power as it may prove to be a competitive advantage during inflationary periods.

Older participants: Income strategies to preserve purchasing power

Retirees and those close to retirement could look to TDFs to help protect against volatility while providing income that keeps up with rising prices. This puts the emphasis on the fixed income portion of the glide path.

One increasingly popular fixed income inflation protection strategy is the use of U.S. Treasury Inflation-Protected Securities (TIPS), which adjust their income levels based on inflationary expectations. When large, unexpected pricing shocks cause inflation to exceed those expectations, TIPS can also provide capital appreciation opportunities.

As target date solutions committee member Wesley Phoa recently pointed out: “If the U.S. is indeed entering an environment of high and volatile inflation, our research suggests TIPS can provide a useful inflation hedge.”

TIPS may not be a standard inflationary hedge in core bond funds because they are not included in the Bloomberg U.S. Aggregate Bond Index benchmark. The American Funds Target Date Retirement Series® does tactically utilize underlying fixed income strategies that hold TIPS as a potential buffer against inflationary shocks.

Interest rate hikes are the typical policy response to inflation, which can stress many fixed income securities, especially higher-yielding ones. TDFs utilizing fixed income strategies that maintain a disciplined approach to the four roles of fixed income that don’t chase the yield curve in pursuit of higher income may be better positioned against inflation risks in a dynamic macroeconomic environment like the one we are in now.

At Capital Group, our TDF series is not as dependent on fixed income because of the inclusion of dividend-paying stocks. Still, inflation is a big concern, as fixed income portfolio manager Pramod Atluri explains: “We are laser focused on inflation because that’s the biggest risk to investors’ portfolios over the near term. If we are wrong about inflation, we will be wrong on the upside, so it makes sense to protect against that outcome.”

Inflation and the glide path

Managing inflation within a glide path can be challenging. You want to ensure there is enough equity for younger participants to build wealth and an appropriate fixed income allocation for older participants that need capital preservation.

To support this overall goal of building and preserving wealth, Capital Group takes a “glide path within a glide path” approach whereby equity and bond holdings evolve in both amount and type over time. In addition to this, we allow for a degree of asset class flexibility within both our underlying equity and bond strategies to help manage investment risks, like inflation, so the series can quickly adapt to address market conditions.

The bottom line for plan sponsor clients

The investment community is still discussing whether this latest bout of inflation is “transient” or “sticky,” but you may not have the luxury to wait for their conclusions. Your clients need to know how their investments are positioned for inflation, and that provides an opportunity to show your value when it is most needed.

To get a better understanding of how our target date solution manages inflation risk, read our white paper.