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Get real: Focus on real after-tax returns

Why a retiree may want a strategy focused on taxes and inflation, not just returns.

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When you think of the worst periods for investors, grizzly bear markets probably come to mind like those following the 2008 financial crisis, the bursting of the 2000 dot-com bubble, and, of course, the Great Depression of the 1930s. But by some measures, the late 70s, early 80s, and, surprisingly, the 1940s, were even worse. The reason: high inflation and rising taxes.

“We hear a lot about what the ‘market’ does, but retirees shouldn’t focus on that alone,” says Matthew Kenigsberg, senior quantitative analyst in Fidelity’s Strategic Advisers. “What will really determine their lifestyles are the returns they can generate after inflation and taxes.” In other words, investors may want to focus not on nominal pretax returns (a.k.a. total returns), but rather on after-tax real returns, which is what remains after taxes and inflation are accounted for.

After decades of low inflation and relatively low and stable taxes, investors may have forgotten just how big an impact they can have. But government deficits could lead to higher tax rates, and monetary stimulus could lead to higher inflation. So, if you are approaching retirement and will require your portfolio to support a given lifestyle even if taxes and inflation rise, consider strategies designed to help provide resilience in the face of rising taxes and inflation. Two potential strategies: the use of so-called “real return” investments that aim to outpace inflation, and Roth retirement savings accounts, which are funded with after-tax money but offer tax-free earnings, provided certain condition are met.

To understand why focusing on real after-tax returns is so important, look at the chart below. Note the gaps between the nominal pretax returns posted by typical portfolios made up of major indexes and their real after-tax returns. As you can see, that gap—which represents the combined drag imposed on the portfolio by taxes and inflation—can be large, varies greatly, and sometimes causes the direction of real after-tax returns to diverge sharply from that of nominal pretax returns.

Consider 1983 (you can drag the red vertical bar into place with your mouse pointer—no need to click), when the 10-year annualized nominal pretax return on a 60% equity/40% bond portfolio was 11.54%, but the real after-tax return was minus 0.96%—a difference of 12.5 percentage points. (See disclosures for portfolio definitions.) More recently, the gap for the 60/40 portfolio has been much smaller—as little as 3.5 percentage points—so it’s easy to see why people have grown less concerned about it.

(Note: All the time periods here use the historical federal tax bracket for someone who earned the equivalent of $250,000 a year. [See chart below.] State and local taxes aren’t considered; they could make the gap between nominal pretax and real after-tax returns even greater.)

Key takeaways

  • When measured by real after-tax returns to typical portfolios, the worst times for investors were not the well-known bear markets but the times that paired high inflation with rising tax rates.
  • Historically, tax rates and inflation have tended to move more or less together.
  • During certain periods of acutely rising inflation and taxes, like the 10-year periods ending in 1948 and 1981, the 40/60 portfolio—usually thought of as more conservative than the 60/40 portfolio—actually provided less protection.
  • A real return 40/60 strategy, which replaces half the fixed income in a conventional 40% stock/60% bond portfolio with real-return assets, would in general have held up better during periods of high inflation like the 40s and 70s, but fared less well during bond bull markets like the 80s and 90s.
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Rising inflation and taxes can wallop retirees

Retirees living off their investments are particularly at risk from inflation and taxes. At worst, rising inflation and taxes may force retirees to increase withdrawals to maintain their lifestyle—which could mean they might run out of money prematurely in retirement, need to cut back their lifestyle, consider returning to work, or some combination of these outcomes.

“Taxes and inflation both can eat into the buying power of an investor’s portfolio,” according to Joanna Bewick, lead manager of Fidelity Strategic Real Return Fund (FSRRX) and Fidelity Strategic Income Fund (FSICX). “Even low levels of inflation can really erode buying power and turn fixed income into shrinking income.”

We haven’t seen sharp rises in taxes and inflation recently, so let’s go back in time and see what would have happened to one of today’s typical retirees if he or she had retired when the tax and inflation environment wasn’t so benign. Imagine Sally, a hypothetical retiree who leaves work in 1940 and spends the equivalent of $150,000 a year in today’s dollars. To simplify, let’s assume Sally’s retirement savings are in an IRA, even though those accounts didn’t exist at the time. You can see when inflation is higher (grey bars at the bottom) and effective tax rates are up (black and red dots), the amount she needs to withdraw to maintain that same lifestyle (green bar) grows significantly.

Sally’s lifestyle needs would have grown from $150,000 to $437,445 between 1940 and 1971 based on the inflation seen over that time. And in order to be left with $437,445 after paying income taxes on an inflation adjusted 1971 schedule, she would have needed to withdraw $930,377 from an IRA (the effective rate is 53%, as shown on the chart). To be sure, this is a highly simplified example, and it focuses on a period that saw extraordinarily rapid increases in tax rates and generally high inflation, but it does illustrate the potential danger that taxes and inflation can pose to a retiree.

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What if you retired in a time period with more modest inflation and tax rates, such as that seen recently? Let’s consider Marcus, a hypothetical investor retiring in 1980. At the start of retirement, Marcus, like Sally, plans to spend today’s equivalent of $150,000. Because the period from 1980 through 2011 saw sharply falling tax rates and low inflation—exactly the opposite of Sally’s experience during 1940–71—Marcus’s withdrawals would have grown much more slowly than Sally’s, and they would have been much less volatile.

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Investors have options

Investors do have options to try to handle the challenges of taxes and inflation, such as the type of account they use to fund their retirement, and their portfolio mix.

Traditional IRAs and 401(k) and Roth options offer different tax benefits when it comes to planning for retirement. Roth accounts are funded with after-tax money, so tax rates at the time of withdrawal won’t have as much of an impact. By contrast, the traditional tax-deductible IRA defers taxes until withdrawal. That deferral exposes you to the risk of rising tax rates, though it would benefit you if your tax rate falls in retirement.

Similarly, the choice between an investment mix designed to track and hopefully outpace inflation—a real return strategy—and a more traditional strategy can have trade-offs. In a low-inflation environment, a real-return strategy has tended to lag a more conventional asset mix. In a rising inflation rate world, real-return strategies historically tended to outperform.

"After a decade of low inflation, some investors have become somewhat complacent about the threat of inflation, but even low levels of inflation can really erode buying power—and the risk of higher inflation down the road is real," says Bewick. "So, in my opinion, it’s an incomplete strategy to be investing in fixed income—whether it’s traditional bond income or nontraditional non-bond income—without considering inflation protection.”

Diversification is also key—though it guarantees neither a profit nor loss prevention. “By diversifying, you get lower volatility and generally better results than if you hold just one asset class,” says Bewick. For diversification, Bewick’s Strategic Real Return fund keeps roughly 30% of assets in TIPS (Treasury Inflation-Protected Securities), 25% in floating-rate securities, 25% in commodities, and 20% in real estate. Let’s look at four hypothetical strategies to illustrate how a real-return strategy and a Roth account might impact retiree outcomes:

  • A traditional IRA holding a conventional 40/60 stock/bond mix
  • A Roth IRA holding a conventional 40/60 stock/bond mix
  • A traditional IRA holding a real-return 40/60 stock/bond mix*
  • A Roth IRA holding a real-return 40/60 stock/bond mix*

In the real-return 40/60 strategy, half the fixed income exposure of the conventional 40/60 strategy (30% of the portfolio) is assumed to be replaced with a real-return strategy that provides returns equal to the inflation rate plus 1%. (For details about the hypothetical portfolios see the disclosures.) While such a return wouldn’t always be possible to achieve, this will demonstrate the pluses and minuses of the approach.

So what would have happened in a lower inflation and tax environment? Let’s revisit Marcus’s situation, with a retirement that starts in 1980. Given that environment, a conventional 40/60 stock/bond mix in a traditional IRA would have been far and away the best performer. As tax rates came down, the benefits of a Roth were much less than a traditional IRA, and as interest rates fell, traditional fixed income performed well, while the real-return assets underperformed because inflation gradually diminished as a significant threat.

Real-return assets are subject to a number of risks. For instance, floating rate loans are subject to restrictions on resale, price changes, and greater risk of default; REITs are affected by changes in real estate values or economic conditions, which can have a positive or negative effect on issuers in the real estate industry; and commodity-linked investments may be affected by overall commodities market movements and other factors that affect the value of a particular industry or commodity.

But what would have happened in a rising tax, high inflation era? In other words, what would have happened to those same portfolios for Sally’s 1940 retirement?

In that higher inflation and tax environment, the pattern of performances for the four strategies would have been reversed—the two Roth accounts would have delivered the best performance, and the real-return 40/60 would have outperformed the conventional 40/60. Within the traditional IRA, the real-return 40/60 portfolio lasted six years longer than the conventional strategy, and in the Roth IRA, the real-return 40/60 would have resulted in a much higher ending balance. In this case, the benefits of tax and inflation protection far outweighed the disadvantages.

“There is no free lunch here, but it may be worth asking which risk you are more comfortable with—the risk of underperforming in a market that is generally beneficial for investors, or the risk that, amid higher inflation and taxes, you spend your savings down earlier than you expected,” says Kenigsberg.

Preparing for the future

For investors on the brink of retirement, this may be particularly relevant given the current Roth conversion opportunity and the uncertainty surrounding tax rates going forward.

  • If you expect your marginal tax rates to rise, or regard it as a serious risk, consider a Roth or Roth conversion.
  • If you’re concerned about inflation, consider a real-return strategy—which might include assets such as TIPS, floating rate loans, REITs, or asset classes that have historically outpaced inflation, such as commodities.
  • Real-return strategies held inside Roth accounts may be an effective defense against taxes and inflation rising together, an event that history shows to be a serious risk for retirees.

Of course, these strategies are not without risk—including the risk presented by a low inflation era or a period of falling taxes, when these types of strategy would likely have underperformed.

“I think investors need to ask themselves which scenario is more likely: a continuation of the generally low-tax, low-inflation environment we have been in since roughly 1982, or a reversal, with rising tax and inflation rates, as we saw in the 1940s and 1970s,” says Kenigsberg. “The answer to that may help them to choose a strategy.”

Learn more

  • Research Fidelity Strategic Real Return (FSRRX) and Fidelity Strategic Income (FSICX).
  • Learn more about Roth conversions and a Roth IRA.
  • Learn how annuities can provide tax-deferral opportunities beyond IRAs or 401(k)s.
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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Past performance is no guarantee of future results.
Returns
All returns are shown as 10-year rolling using annual compound rates using data from 1926 to 2011.
Pretax nominal returns are total returns. These returns were based on a weighted composite, rebalanced annually, of Ibbotson total return indexes.
The post-tax real returns are adjusted for inflation and taxes. The post-tax values were computed by first determining the pretax terminal value at the end of each 10-year period and then reducing it by taxing all growth at the applicable ordinary income tax rates. Thus, all investments are treated as tax-deferred. (If they had been fully taxable, the differences between the pretax nominal and post-tax nominal/post-tax real returns could have been larger than those shown.) These post-tax terminal values were further reduced by the cumulative inflation (i.e., the change in Consumer Price Index—Urban) as reported by the Bureau of Labor Statistics over each 10-year period.
Taxes
The tax rates used herein to compute real after-tax returns correspond to the marginal income tax rates that applied historically, given a married, filing jointly (MFJ) investor with a taxable income equivalent to $250,000 in 2011 dollars. For example, the rate applied for the year 1957 is 47%, because in that year MFJ incomes of between $28,000 and $32,000 (corresponding to a range from $223,581 to $255,521 in 2011 dollars) were taxed at that rate. Note that for investors with taxable incomes higher or lower than $250,000, the patterns of relationships are generally similar to those shown in the interactive chart, although there are differences in magnitude. In the retirement simulations, the taxes rates shown are the effective rates that would have applied on the entire withdrawal, corrected for inflation and based on the tax tables for the appropriate year. Source: Bureau of Labor Statistics, Tax Foundation, as of Dec. 31, 2011.
60/40 Portfolio
Based on a weighted composite of the Ibbotson total return indexes: 50% S&P 500 Index, 10% U.S. small-cap stocks, 20% long-term corporate bonds, 20% U.S. intermediate-term government bonds. Past performance is no guarantee of future results. Ibbotson total return indexes track the performance of a hypothetical basket of indexes composed of various underlying constituent stock and bond indexes in the U.S. and international markets. Source: Ibbotson.
40/60 Conventional Portfolio
Based on a weighted composite of the Ibbotson total return indexes: 35% S&P 500 Index, 5% U.S. small-cap stocks, 30% U.S. long-term corporate bonds, 30% U.S. intermediate-term government bonds. Source: Ibbotson.
40/60 Real Return Portfolio
Based on a weighted composite of the Ibbotson total return indexes: 35% S&P 500 Index, 5% U.S. small-cap stocks, 15% U.S. long-term corporate bonds, 15% U.S. intermediate-term government bonds, 30% Real Return Asset (CPI + 1%). Source: Ibbotson.
Note: The Real Return Asset, which is hypothetical, is assumed to deliver a pretax nominal return equal to the annual inflation rate plus 1.0% each year. There can be no assurance that such a performance is realistic. As of the end of June 2012, the (real) yield on 10-year TIPS was –0.50%, suggesting it may be difficult to deliver inflation + 1.0% annually using TIPS, although that low yield may be a temporary aberration; the average yield on 10-year TIPS since first offered in 1997 is 2.33%, based on monthly data from Bloomberg. However, even assuming TIPS deliver the needed real yield, their total returns do not pace inflation on a year-by-year basis, as do those of this hypothetical real return asset.
Inflation
Rolling 10-year annualized inflation rate based on the CPI-U (Consumer Price Index—Urban). Data from the Bureau of Labor Statistics.
Important note
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
The S&P 500 and S&P are registered service marks of The McGraw-Hill Companies, Inc., and are licensed for use by Fidelity Distributors Corporation and its affiliates. The S&P 500 Index is an unmanaged market capitalization–weighted index of common stocks.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author or authors and are not necessarily those of Fidelity Investments. Fidelity does not assume any duty to update any of the information.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Diversification does not ensure a profit or guarantee against loss.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Generally, among asset classes, stocks are more volatile than bonds or short-term instruments and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Although the bond market is also volatile, lower-quality debt securities including leveraged loans generally offer higher yields compared with investment-grade securities, but also involve greater risk of default or price changes.
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