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Canada’s official inflation rate is holding steady at 2.2 per cent but if you have a taste for real-world purchases like food it’s more like 4.7 per cent.
The threat of inflation is always real for Canadians investing for retirement because increases in the cost of living ultimately eat into returns.
The Bank of Canada has its bag of monetary tricks to keep inflation in check but political pressure in the U.S. to artificially lower interest rates leaves everyone vulnerable.
Income from defined benefit pensions (DB), the Canada/Quebec Pension Plan (CPP/QPP) or Old Age Security (OAS) are automatically tied to inflation but Canadians who invest through defined contribution pensions (DC), self directed Registered Retirement Savings Plan (RRSP) or Tax Free Savings Account (TFSA) aren’t so lucky.
There are steps you can take in your investment portfolio to lower the risk from increases in the cost of living. The objective of a hedge is to add protection without sacrificing return potential.
Here are four ways to put that protection into your portfolio.
Commodity equities
Equity markets generally advance with inflation (to a point), so it’s good to stay invested and diversified across sector and geographic lines. But some equities actually contribute more to – and benefit more from – inflation. Commodities like crude oil, lumber, grain and metals often take the lead. That means bigger profits for commodity producers.
Investing in commodities also provides a hedge against a falling Canadian dollar because they are traded in U.S. dollars.
You can invest in specific commodities on the futures market through exchange traded funds (ETFs), or purchase shares in commodity-producing companies directly or through ETFs or mutual funds.
Short-term fixed income
Proper portfolio diversification also includes safe fixed income, such as government bonds. Dedicating a significant portion to fixed income in a portfolio will cushion it from volatility on the equity side. How much of your portfolio should be dedicated to fixed income depends on your tolerance for risk and how soon you need the cash.
The best and safest fixed income returns right now are Guaranteed Investment Certificates (GICs) with one-year returns at about 3.5 per cent.
Yields on GICs tend to move with inflation but there is also a way to hedge against fluctuating yields through a strategy called laddering where maturities are staggered over time to take advantage of the best going rates when they mature.
You can also hedge fixed income with inflation-adjusted products such as annuities or real return bonds, but the added cost of that protection could eat into overall returns if inflation does not become a problem.
Real estate investment trusts
The real estate sector is currently in a slump but prices tend to move with inflation over longer periods of time, which could present a buying opportunity.
A recent report from RBC found nearly half of wealth accumulation in Canada has been driven by home ownership over the past three decades, but there is a way to diversify real estate holdings into other real estate sub-sectors through Real Estate Investment Trusts.
REITs are companies that own and operate residential, commercial and industrial real estate that generate income from rents and capital gains through price appreciation.
Fixed-rate mortgage
Higher inflation leads to higher borrowing rates, which makes home owners with variable rate mortgages especially vulnerable.
The best way to hedge against fluctuations in variable rate mortgages is to lock into a fixed-rate mortgage for several years. Fixed rate mortgages won’t fall if overall interest rates fall, but knowing they won’t rise will help you sleep at night.
As it turns out, 5-year fixed and variable rate mortgages are running even at about 3.5 per cent. This could be a great opportunity to lock in.