Good News for Retired Clients: COLA and TIPS

For retired clients, one piece of good news is that they probably will see an increase in their Social Security benefits in 2017. The bad news is that inflation may now be heading higher, a trend that would erode the purchasing power of fixed incomes.

Since bottoming in February, U.S. inflation has been on fire. The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), upon which changes in Social Security’s Cost of Living Adjustment (COLA) are calculated, increased at an annualized rate of 5.6% from February through June.

Social Security calculates the COLA annually based on the change in the average value of the CPI-W in the months of July, August and September of the preceding year. For any year in which the calculation is negative, as it was last year, Social Security reverts to the last positive year. In this case, the index average in July, August and September of 2014 was 234.242. If the current pace of inflation continues for the next three months, the COLA for Social Security benefits payable in 2017 would be about 1.4%. While this isn’t a huge increase by historical standards, it is above the average COLA since 2009 (1.2%). In three years during this period – 2009, 2010 and 2015 – the COLA was zero, effectively freezing Social Security benefits.

Underlying the nuts and bolts of the CPI calculation, the main factor that could drive inflation higher in the years ahead is currency depreciation caused by the expanding arsenal of Central Bank monetary policy tools, which now include quantitative easing (QE), negative interest rates (NIRP), and perhaps soon “helicopter money.” Many retired clients have grown complacent about inflation and don’t think it will have great influence on their retirement standards of living. Now may be the time to nudge them to recall periods such as 1979-1981, when double-digit annual rates of U.S. inflation prevailed.

Asset classes with the best track records of holding value during inflationary times include real estate, precious metals and Treasury Inflation Protected Securities (TIPS). Perhaps not coincidentally, all of these have been strong performers in the first half of 2016.

The largest TIPS ETF, iShares TIPS Bond (TIP), returned 6.1% YTD through mid-July, and most of this gain was driven by lower U.S. Treasury yields, not higher inflation. However, CPI-linked resets in TIPS’ coupons and maturity values also can contribute to total return when inflation is rising. The combination of lower yields (driven by central bank policies) and higher inflation (driven by central bank policies) is an environment in which TIPS can shine – especially for retirees living on fixed incomes.