In the past decade, inflation in the United States has risen by an average of 2.4 percentage points per year. To help mitigate the effect of inflation on savings, the U.S. Treasury issues "Treasury Inflation-Protected Securities," or TIPS. You can buy these securities directly from the Treasury or through mutual funds. TIPS provide a fixed interest rate applied to principal adjusted for inflation. At maturity, the investor is paid the adjusted principal or original principal, whichever is greater, TreasuryDirect explains. TIPS may help mitigate effects of inflation on long-term investments. How much of your retirement funds should be in TIPS depends on several factors.
At each quarterly meeting, the Federal Reserve Board members issue inflation predictions for the coming three years and for "the longer term." For example, in April 2012, the board predicted inflation rate increases of 1.9 to 2.0 percentage points for 2012, 1.6 to 2.0 for 2013, 1.7 to 2.0 for 2014, and 2.0 for the longer run. These numbers -- combined with the current rate of inflation -- form a useful guide for investors to predict the percentage of their 401(k) returns that could be wiped out by inflation on an annual basis. As the longer-term inflation prediction rises, investors may wish to put a greater share of their retirement funds into inflation-protected securities. However, it is important to remember that these are projections only and are not guaranteed to reflect how much inflation will actually occur.
Current Economic Conditions
Current economic conditions may affect your perception of coming inflation in a way that is not yet reflected in the quarterly inflation projections. For example, many economists argue that higher government spending is associated with higher levels of inflation. An investor who feels that government spending is likely to grow may be wise to invest more of his 401(k) in TIPS.
Other Investment Opportunities
In any 401(k), the goal is to maximize returns while staying under an acceptable level of risk. TIPS bonds are very safe, but even with the added inflation-adjusted return they may underperform other investments. Especially over the longer term, stocks will usually earn dramatically higher returns than inflation-protected securities -- albeit with a higher level of risk. Investors must consider the options from which they are likely to receive the best returns and allocate their money accordingly while maintaining their own level of risk comfort.
Other Inflation-Protected Investments
If you wish to include inflation-protected investments in your 401(k), additional options are available. Gold historically has offered a hedge against inflation, maintaining its value in inflation-adjusted dollars. You can buy gold as bullion, in collector's coins or in a gold mutual fund. Other inflation-protected investments include other precious metals, such as silver, or commodities funds, such as those that invest in oil or agricultural products, any of which may provide a hedge against long-term inflation risk.
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