What it means
Inflation is the general rise in prices over time. If your income stays the same while prices climb, you can buy less each year, which is a problem for people on fixed incomes and for businesses that signed long contracts at fixed prices.
Inflation protection adds an adjustment so that payments keep pace. The most common method is indexation, where amounts are increased by the change in a published price index.
Other methods include cost of living adjustments in pensions, escalation clauses in leases, and rate resets in loans. Each of these links money amounts to a measure of rising prices, but the details can vary a great deal.
Inflation protection has a price. An inflation-protected bond usually offers a lower starting yield than an ordinary bond, and an annuity with annual increases starts with a smaller payment than a level annuity.
The buyer is trading some income today for security against rising prices later. Whether it is worth it depends on how long the money is needed and how much inflation occurs.
Over short periods, the effect is small, but over twenty or thirty years even modest inflation can halve buying power. This is why retirement planners often favour some protection.
It also helps to know what is not covered. The index may not match your personal spending, so a retiree who spends mostly on health care may see costs rise faster than the index.
Protection also relies on the issuer or counterparty being able to pay, which is another risk to consider. For a business, it is worth asking where protection is needed most.
Long contracts for rent, supplies, wages and loans can all be written with or without inflation clauses, and the choice should reflect which side of the contract is more exposed.
In practice
Real-world examples.
Example
A retiree chooses a pension that rises each year in line with consumer prices. Her first payment is lower than a fixed pension would have been. Twenty years later, the payment buys much more than a fixed one would. She reviews the choice with her adviser every few years.
Example
A landlord signs a ten-year commercial lease with annual rent increases tied to a price index. When inflation rises, so does the rent, protecting his real income. The tenant accepts because the starting rent is lower than a fixed-rent alternative. Both parties agree on a cap to limit the increase in any year.
Example
A construction contractor includes a clause that adjusts the contract price if steel costs rise more than 5%. The client agrees, and both sides avoid a dispute when prices jump. The clause is later triggered, adding $85,000 to the contract price. Neither side has to renegotiate from scratch.
Formula
Calculation
Real return = (1 + Nominal return) / (1 + Inflation rate) - 1
Suppose $100,000 earns a nominal return of 5% in a year when inflation is 3%. The real return is 1.05 / 1.03 - 1 = 0.0194, or about 1.94%.
The investor's money grows to $105,000 in dollar terms, but what it can buy has grown by only 100,000 x 0.0194 = about $1,940. An inflation-protected asset aims to make sure that the real return does not turn negative when prices rise.Case study
Seen in the real world.
Redwood Care Services is a fictional operator of residential care homes that signed a 15-year supply agreement for food and linen. The supplier offered a fixed price or a lower initial price with annual increases linked to an index.
The finance director compared the options. The fixed price was $1,000,000 a year, and the indexed price began at $900,000 and rose with the index. If inflation averaged 3%, the indexed price would pass the fixed price in the fifth year.
In this illustrative case, the director chose the fixed price because the care homes' fees were also fixed by contract and the company could not pass on increases. This showed that inflation protection helps only when it matches how money is actually earned and spent.
Watch out
Common mistakes.
- Assuming inflation protection is always better, when it usually costs a lower starting income.
- Believing the index matches personal spending, when each household and business has its own price experience.
- Forgetting counterparty risk, as the promise is only as good as the party making it, whether that is an insurer, an employer or a government.
Questions
People also ask.
What does inflation-protected mean?
It means the amounts paid are adjusted so that they keep pace with rising prices.
Is a savings account inflation-protected?
Not unless its interest rate rises at least as quickly as prices, which is not guaranteed, and in many periods savings rates have lagged behind inflation.
Which assets give inflation protection?
Examples include inflation-linked bonds, some pensions and annuities, property with indexed leases, and commodities, with differing levels of reliability.
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