America’s baby boomers—those born between 1946 and 1964—face a problem that could weigh on the economy for years to come: The longer it takes for the economy to recover, the less money they’ll have to spend in retirement.

Policy makers have long worried that Americans aren’t saving enough for old age. And lately, current and prospective retirees have been hit on many fronts at once: They have less money, they earn less on what they have, their houses aren’t rising in value and the prospect of working longer to make up the shortfall has dimmed significantly in a lousy job market.

“We will have to learn to make do with a lot less in material things,” says Gary Snodgrass, a 63-year-old health-care consultant in Placerville, Calif. The financial crisis, he says, slashed his retirement savings 40% and the value of his house by about half.

Banks, home buyers and bond issuers are all benefiting as the U.S. Federal Reserve holds short-term interest rates near zero to support a recovery. But for many of the 36 million Americans who will turn 65 over the next decade—and even for the 45 million who have another decade to go— the resulting low bond yields, combined with a volatile stock market, are making a dire retirement picture look even worse.

Low yields present retirees with a difficult choice: Accept the lower income offered by safer bonds, or take the risk of staying in the stock market. Either way, their predicament could put a long-term damper on the consumer spending that typically drives U.S. growth.

“If these rates stay as low as they are, then a lot more people are going to be hurting,” says Jack Van Derhei, research director at the Employee Benefit Research Institute. The non-partisan outfit estimates that if current conditions persist, nearly three in five baby boomers will be at risk of running short of money in retirement. “There are going to be many luxury items that will simply have to be eliminated,” for retirees to make ends meet.

Despite the market’s rebound from the lows of 2009, nest eggs remain severely impaired. As of the first quarter of 2010, net household assets—homes, 401(k) plans, pension assets and other investments minus debts—stood at $54.6 trillion, down 18% from the end of 2007. That’s an average of about $171,000 per person, much of which is concentrated in the hands of the wealthiest.

At the same time, the return people can hope to earn on their assets has fallen, particularly for those who switch into bonds or annuities to guarantee a fixed income. The average yield on U.S. government, corporate and mortgage bonds stands at about 2.4%, while stock-market valuations suggest a long-term return of about 6%. At those levels of return, some 59% of people aged 56 to 62 will be at risk of not having enough money to cover basic living and health-care costs in retirement, estimates Mr. Van Derhei. If market returns are higher—8.9% for stocks and 6.3% for bonds—the picture isn’t a lot better: The percentage at risk falls to about 47%.

Before the recession hit, many economists assumed people would solve their retirement problems simply by staying in the work force longer. Now, “the recession has blown that idea out of the water,” says Alicia Munnell, director of the Center for Retirement Research at Boston College and co-author of a 2008 book that advocated working longer.

Older workers, who typically fared better than their younger counterparts in recessions, have been hit just as hard by layoffs this time around. As a result, the fraction of people 65 or older who are working has leveled off after a long period of growth. As of July, it stood at 15.9%, down from 16.3% in mid-2008.

For the rest of this article, go to the Wall Street Journal.

The following article from Investor’s News is an eye opener. It is so easy to think investing is easy – think again. And, enjoy reading this article and take heed.

Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole.

A 68-year-old psychologist in Napa, California, Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was suddenly down by more than 50 percent.

The broker had invested much of it in a range of exchange- traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors. An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets–tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas.

The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund, an ETF designed to track the price of light, sweet crude. “This seems to be something good,” Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn’t make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell 7.4 percent. What was going on?

For the rest of this article, go to Investors in commodity ETFs getting “eaten alive”

As you consider different strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.

Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—

1. Hedging the immediate effects of inflation, or;
2. Earning a total return that outpaces inflation over time.

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.

In a total return strategy, an  you attempt to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. For this strategy to work you have to be willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.

To insulate a portfolio from unexpected inflation risk, you may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS) with both strategies. Let’s consider each of these:

Stocks
Stocks have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure some periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.

Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.

Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, you receive the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.

However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.

Commodities
Commodity futures, as well as oil and gold (which is now being pitched on every TV channel on the dial), are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.

You should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. You should carefully review your financial circumstances and investment goals before making changes to your portfolio.

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.

• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.

• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.

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Endnotes
1 Real return calculation:  (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.

Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.

The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

James L. Davis, Vice President, Dimensional Fund Advisors

Investors are concerned about inflation, and rightly so. Average annual inflation in the US between 1929 and 2008 was nearly 3.3%. A dollar at the end of 2008 had about the same purchasing power as eight cents did at the beginning of 1929. Protecting the purchasing power of an investment portfolio is a genuine concern.

Inflation is not the only issue for investors, however. An interesting strand of economic research addresses the idea that people do not simply care about their own standard of living; they are also concerned about how their living standards compare to those of other people.¹ If everyone around me is enjoying a higher standard of living over time, I do not want to be left behind in an economic sense. In the language of the papers that have been written on this topic, I want to “keep up with the Joneses.”

Figure 1 shows evidence that this may be a genuine concern for consumers. This chart shows annual observations of per capita real disposable personal income (DPI) and per capita real personal consumption expenditures (PCE) for 1929-2008. The series are in real (2000) dollars, so the upward trend is not caused by inflation. The numbers are per capita, so they do not simply reflect a growing population. Instead, this chart arguably reflects a substantial increase in living standards for US consumers over the past several decades. As a result, it shows why just keeping up with inflation is not enough. Real spending and income levels increased from around $5,000 to more than $27,000 between 1929 and 2008, representing an average increase of more than 2% per year. A consumer who just kept up with inflation would still be at the 1929 levels, while the overall level increased five-fold since then. If all I did was to keep up with inflation, the Joneses would have left me in the dust.

How well have stocks and bonds protected investors against both inflation and rising living standards? Table 1 shows some evidence for 1942-2008.² This table reports average annual returns in excess of both inflation and a measure of changes in living standards. Each year, the excess return for an index is:

R(.) is a return, and ?PCE is the relative change in PCE for the year. Table 1 shows that fixed income securities have generally not done a good job of keeping up with both inflation and the Joneses. In contrast, the average excess returns for the stock indices are reliably above zero and large enough to be economically meaningful.

At this point, the professor in me wants to ask a multiple choice question. In view of the foregoing information, what is the most appropriate response?

1. “Since I want to keep up with both inflation and the Joneses, Table 1 tells me that I’d better put my portfolio in stocks.”
2. “Inflation is all that matters. Those gains in living standards are a thing of the past.”
3. “Historically, stocks have had returns high enough to cover both inflation and living standards. However, stocks are risky (recall 2008). Therefore, like most things in economics, there is a trade-off. The right answer for me depends upon how much risk I am willing to accept. Of course I want to maintain (or increase) my living standards, but I am not willing to take on an amount of risk that will keep me awake at night. My portfolio will contain both stocks and bonds, because that’s good diversification. How much of each depends on my risk tolerance.”
4. “Capitalism is dead. All my money is going into canned goods and ammunition.”

If I am grading the exam, answer (c) gets the points. If you answered (a), I think you are ignoring the risk that went along with those stock returns in Table 1. If you answered (b), I think you are overlooking the source of our increased living standards. The rising income and consumption series in Figure 1 are the result of sustained productivity gains. Productivity increases through technological advances, and technological advances are a natural result of financial rewards for entrepreneurial activity. As long as the economy is allowed to reward innovation, there should be at least the opportunity for continued increases in living standards. If you answered (d), I have to wonder why you’re still reading this.

This discussion ignores the role of labor income in maintaining living standards. Incorporating the interrelationships among labor income, living standards, and asset returns would take the analysis to another level of complexity. Accordingly, that discussion is left for another day.

Improved living standards are a good thing, but people who don’t fully participate in the improvement can start to feel as though they are being left behind. Rising living standards can therefore present a challenge to investors who do not want to be economically worse off than friends, neighbors, and relatives (i.e., the Joneses). While some may see the emphasis on keeping up with others as shallow, those who have experienced a decline in relative living standards probably do not. Because of current fiscal and monetary policies in the US and elsewhere, many investors are focused on inflation. This analysis suggests that we should not myopically focus on inflation to the exclusion of other important factors.
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The helpful comments of Ken French, Inmoo Lee, Marlena Lee, Sunil Wahal, and Weston Wellington are gratefully acknowledged..

1. For example, see John Y. Campbell and John H. Cochrane “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior.,” Journal of Political Economy 107: 205-251.

2. The PCE data are available back to 1929, but several of the fixed income indices are not available until 1942. The year-end Treasury yield curves for 1941 and 2008 look very similar, so the fixed income excess returns in Table 1 should not be biased by a sustained one-way move in interest rates. The stock index returns may be biased upward, because 1942-1945 were very good years for stocks. Excluding these years produces average excess returns of 5.21% for All Stocks, 9.29% for Value Stocks, and 7.54% for Small Cap Stocks. The corresponding t-statistics are 2.30, 3.41, and 2.43.