Inflation-proofing your returns

After years of wallowing in a forgotten backwater, inflation has found its way back to mainstream markets, presenting another threat to investors' real returns, even as yields remain at all-time lows.

Inflation is just one of several risks faced by defined contribution (DC) investors, and needs to be considered in the broader context of a member's investment objectives. As investment managers, our purpose is to increase the real wealth of DC members and to ensure their savings pots keep up with the cost of living to support their lifestyle at retirement. In order to achieve this, the importance of regular monthly contributions over members' working lives, harnessing the compounding effect of incremental returns, cannot be underestimated. Similarly important is to provide a smooth investment journey that helps ensure members do not take fright but continue to contribute when markets go through times of stress. Such periods can provide some of the best long-term investment opportunities owing to depressed valuations. 

In this context, we believe it is important to focus on having a significant proportion of returns that have a direct linkage to inflation, protecting members' savings in real terms. Given the focus of central banks on achieving annual inflation of 2% over the long term, investors who are some way from retirement face a significant inflationary headwind if policymakers are successful. Currently the 10-year UK government bond yield stands at about 1.2%¹, well below the current UK RPI inflation rate of 3.2%², which Bank of England Governor Mark Carney believes will persist until moving towards a 2% target rate in 2020. This leaves an investment in bonds with a significant negative real return. 

Providing a smooth investment journey therefore requires careful consideration and an evaluation of the predominant risks. Within a multi-asset portfolio, inflation protection can consist of assets such as renewable energy and infrastructure, which have very little sensitivity to the economic cycle but that have very strong contractual obligations to provide inflation-linked revenues. 

In short, in the current challenging environment, constructing a portfolio with diversified sources of return is an important consideration for strategies that are designed to form a key building block of a DC default solution. Indeed, this is where much of the fee budget is spent, combining growth with a focus on capital preservation. The attraction of such an approach is that it is not wedded to any single asset class, benchmark or peer group and can allocate capital to those areas of the market that offer the best risk/reward characteristics. 

Paul Flood is portfolio manager, multi-asset team, at Newton Investment Management

1 Thomson Reuters Datastream, March 2017
2 Office of National Statistics, March 2017