Inflation is back in the news these days, thanks to President Obama‘s new budget proposal. That proposal adjusts the way inflation gets calculated in an attempt to raise tax revenue and stem the rise of Social Security spending by slowing the rise in the Consumer Price Index.
No matter how it gets officially calculated, inflation is a real threat to your long-run ability to make ends meet. You need an effective way to fight that threat, especially now that potential changes to the official calculations are likely to slow the automatic benefits you’re used to getting from the old method.
Pick your Risk
In this era of abysmally low interest rates, there are no safe and surefire ways to protect yourself from the ravages of inflation. Even recent issues of TIPS bonds — the U.S. government’s Treasury Inflation Protected Securities, which are designed to help investors fight inflation — currently carry negative interest rates. That means investors will still lose money in real terms after those bonds adjust for inflation.
The real question these days isn’t whether you take risks with your money to try to keep pace with inflation — it’s what risks you take just to keep treading water in real terms.
In that light, owning the stocks of companies that pay dividends, have regularly increased their dividend payments, and look capable of continuing to raise their dividend payments just might be the best inflation fighter available to your arsenal.
Why Dividends May Be Your Best Bet
There are three key reasons to believe that successful companies can continue to raise their dividends at least as fast as inflation: accounting, real growth, and cost-cutting.
Accounting: Consider a company that likes to pay a dividend equal to 50 percent of its after-tax earnings to its shareholders as a reward for the risks of owning its stock. If its costs rise in line with inflation and it can pass a similar increase down the line to its customers (whose costs would also be rising in line with inflation), then it has an automatic gain in profits and dividends, in line with that inflation. The table below shows how it works:
|First Year||Second Year, After 3% Inflation|
|Profit After Tax||$65,000||$66,950|
Data from author’s calculations.
In reality, not all costs or prices rise exactly in line with inflation, but the general concept still holds.
Real growth: Of course, most companies wouldn’t be satisfied to just keep pace with inflation; they’re trying to grow their businesses in real terms, as well.