This post was part of a series on building a portfolio of mutual funds or Exchange Traded Funds. Much of the series has been moved to articles on the Portfolios menu:

• Basic Portfolios: Some simple ideas that work remarkably well.
• Diversify: Effective ways to diversify with bonds and stocks, globally.
• Factor Investing: Specialized portfolios that employ techniques from academic research.
• Respond to Inflation: Realistic options for inflation-protection, near-term and long-term. (Not yet moved, this topic is covered below, in this post.

On the topic of inflation, Andrew Ang's fine textbook, Asset Management, offers many good insights, to which I am much indebted (see his chapter 11). I've superimposed my own analysis, however, and sometimes relied on additional sources.

It's helpful, I think, to focus on inflation with three sets of questions:

• Near-term: At a given time and for the next year or two, how should an investor's portfolio adapt to inflation or, equally important, to deflation? This question matters if, and only if, you plan to spend some of your investments in the next year or two.
• Long-term: What investments, if held a long time, will best protect against inflation? Do the same investments protect against deflation? And how long is long enough?
• Correlates: Both near-term and long-term, what investments (if any) are correlated with inflation (or deflation)? If one applies diversification criteria, do any of the popular candidates, such as TIPS, commodities, and real estate, truly add value?

An important conclusion will be that sensible protection against inflation and deflation is possible, but by different methods for the near-term than for the long-term. Furthermore, the popular candidates may not be the best or the only methods you should consider.

Here's an interesting test. You come to me in December, asking "What will inflation be next year?" I caution that nobody knows the perfect answer, but one indicator is quite good and amazingly simple. "It has correlated 0.64 with next year's inflation for the past 100 years," I proclaim. Then I show you data for the past century, using the chart below. Can you guess what my indicator is?

No, it's not the price of oil or gold. It's not the return on inflation-indexed bonds, or the median price of homes, or any exotic financial product. And it's a lot simpler than the economic model favored by this year's hot economist. It's last year's inflation. Yup. Next year's inflation is pretty well predicted by inflation over the most recent 12 months. That's because inflation (or lack of it) tends to persist. *

Despite the dire tone of some articles and commentary, inflation is not like a thief in the night who steals your heirloom jewelry, sets your home ablaze, and swiftly vanishes before dawn, leaving your wealth devastated. He's more like the unwelcome guest, your financially reckless cousin, who emails you one day and shows up on your couch the next, feasts from your pantry, maxes all your credit accounts, totals your car, and requires strenuous measures to be evicted, leaving you poor, thin, weary, and forgiveably ungracious after a prolonged ordeal.

The point is that you'll know when inflation is becoming a problem. One of the more obvious clues will be that interest rates are rising. That clue, as it happens, also defines your best defense.

T-Bills
As Ang and others before him have pointed out, the asset most strongly correlated with inflation and the best single hedge against it is a 3-month Treasury Bill. As inflation rises or falls, the interest rate on T-Bills tends to follow. Because T-Bills can be redeemed and reinvested at the newest rate every three months, the response to inflation, although lagging somewhat, is timely. 

Even so, it's not a perfect hedge, mainly because policies of the Federal Reserve sometimes (not always!) hold T-Bill rates below the inflation rate. That happened for nearly two decades during the Great Depression and World War II, and again, more recently, for six years and still counting since the financial panic of 2008-2009.

These limitations notwithstanding, a T-Bill offers good protection against inflation for expenses you know you will have to pay within the next year or so. Here's a concrete example:

• A hypothetical saver needs $1000 per month to pay expenses that are not covered by her other sources of income, such as work, Social Security, or an annuity.
• In late December, she has $3000 in a bank account (earning next to nothing) to cover her expenses through March. She withdraws $12,000 from her investment or retirement account, and buys a 3-month T-Bill. (She can do so easily and with no fees whatsoever at www.treasurydirect.gov.)
• In April, she redeems the T-Bill and puts enough in her bank account to cover the next three months' expenses. If her expenses have risen (or fallen) a bit in the past three months, she sensibly increases (or decreases) the amount set aside in her bank account, thus maintaining a smooth standard of living. (To simulate these adjustments, I exactly matched them to the change in consumer prices, up or down, for the previous quarter.) The remainder gets reinvested in a new 3-month T-Bill.
• She does the same in July and October.
• At the end of December, she looks at the amount she will get by redeeming the most recent T-Bill, to see if it will cover the first three months of the coming year. She wants it to cover her real expenses, which may have risen above $1000 per month because of inflation over the past year.

Had this strategy been followed every year from 1934 to 2014, the results would have been as shown in the chart below. The value depicted in the chart is the surplus (or deficit) over the amount needed for the first quarter of the coming year, adjusted for inflation.

Before 1952, when interest rates were restrained by the federal government, the results were weak. On average, the amount available after a year was nearly 9% less than the amount needed for the next three months. These were desperate times, financially, and it is not clear that any one-year savings plan could have done better.

From 1952 through 2014, the results were good. On average, there was a real 1% surplus, and surpluses occurred much more often than deficits. On the assumption that future federal policies may resemble those enforced since the early 1950's, the T-Bill strategy looks attractive.

Short-Term Treasuries
What if you were willing to take a bit of a chance on longer-term bonds? For example, how about a short-term Treasury fund whose bonds have average maturities around 2 years? One might expect such a fund to respond to inflation less quickly than T-Bills, but to pay a higher rate of interest and to be penalized somewhat less when federal policies suppress the interest on T-Bills. The next chart shows the results from using 2-year Treasuries instead of 3-month T-Bills.

Clearly, there is much more variation from year to year, which is not good for budgeting. On the other hand, the average surplus for the period 1952-2014 was higher, around 2%. In several years, the surplus was a full month's expenses. Here's an idea: What if the surpluses were carried over, to offset subsequent deficits?

A variant of that idea turns out to be highly effective, perhaps the best strategy of all. It works like this:

• In the first year, save two years' expenses ($24,000 for our hypothetical saver) instead of one ($12,000).
• Use a fund of 2-year Treasuries instead of T-Bills.
• Don't spend any surplus. Don't try to replenish any deficit. Simply add next year's expenses at the end of each year, adjusted according to the past year's inflation, exactly as in the T-Bill strategy.

The extra deposit at the outset serves as a cushion, creating, in effect, a reserve fund.

This strategy accumulates unspent surpluses over time, even in difficult periods. The chart above illustrates how the strategy would have worked in three very different 26-year periods. The first period, 1934-1959, saw a toxic mix of occasional high inflation, recessions with steep deflation, and persistent suppression of Treasury rates. During this time, the strategy lost some of its reserves but never went to ground. Bear in mind that the values in the chart are real dollars (inflation adjusted). Thus, the $3000 of buying power that remained on reserve at the end of 1959 would have seemed much larger in nominal dollars. The second period, 1961-1986, spanned multiple recessions and successive years of high inflation. Yet it maintained good reserves throughout. The final period, 1988-2013, benefited from a bull market in Treasuries and ended with enough surplus to cover more than two years of inflation-adjusted expenses.

Short-Term TIPS
Originally, they were called Treasury Inflation-Protected Securities, or TIPS. But they never truly guaranteed protection from inflation, and the Treasury Department now calls them Treasury Inflation Indexed Notes or TIINs, if their maturity is five years. The new name is apt because in recent times, their value as an inflation hedge has been about as good as, well, TIIN.

Surprised? Consider this example. In October 2010, you could have bought TIPS from the Treasury Department that would mature four years and eight months later, in April 2015. Those TIPS would have paid a measly interest rate of 0.5%, which would have seemed reasonable because T-Bills paid even less. At the time, the big institutions that bid at Treasury auctions expected inflation to start rising. So they bid up the price of the TIPS, thereby forcing buyers to pay, on average, $1055 for a bond that could be redeemed in nearly five years for $1000 plus inflation. They were counting on inflation to recoup the extra $55 and then some. As it all worked out, the cumulative inflation between October 2010 and April 2015 was 8.2% (equivalent to 1.7% per year). The buyer was therefore paid about $1082 in April 2015, plus those flimsy interest payments twice a year. For the initial investment of $1055, the buyer got a real (inflation adjusted) total return of about 1% per year. The five-year bet on inflation paid off, in this case.

But what if the original buyers' expectations were wrong? It can happen. In July 2014, no one anticipated that inflation for the next 12 months would be virtually zero, but that's what it was (0.2%). If you had bid on TIPS in early 2014 expecting a 1% real return, you would be holding a loss after the first year. Because mutual funds and ETFs buy, sell, and redeem TIPS continuously, they are vulnerable to such miscalculations. They can lose money when their inflation bets are too high. 

For some evidence, consider the chart below. It shows the real (inflation-adjusted) returns since late 2009 for two funds: STPZ, the PIMCO ETF for short-term TIPS; and VSGBX, a Vanguard fund for short-term bonds from the Treasury Department and other federal agencies. The PIMCO fund holds TIPS exclusively; the Vanguard fund holds no TIPS at all. Over the six-year period, both funds virtually matched inflation, with a terminal value near $1.00 for every dollar originally invested. But the TIPS fund was more volatile, rising or falling as its inflation bets came out winners or losers.

It would be nice to know if the long-term trend will resemble the short history shown in this chart. Alas, six years is the longest history available for a short-term TIPS fund as of September 2015. Pending additional evidence, a rational investor could use a short-term TIPS fund, instead of short-term Treasuries, but the outcome might not be any better, and the ride may be less smooth. An educated guess is that short-term TIPS may do better when inflation is rising, while short-term Treasuries might excel when deflation and recession are lurking.

Academic studies and historical data imply that near-term protection against inflation (and deflation) can be secured by either of these strategies:

• Hold a year's worth of anticipated expenses in 3-month T-Bills, redeeming and re-investing every three months. Virtually as good, use a savings or money-market fund if it is safe, very liquid, and pays interest at or above the rate of T-Bills.
• Or, hold two years of anticipated expenses in a fund of short-term U.S. government bonds. Withdraw expenses for a year, and replenish with anticipated expenses for the next year, keeping any surplus on reserve. A fund of short-term TIPS may be reasonable, but other U.S. government bonds are likely to offer more consistent performance.

In the next and final post in this series, we'll look at long-run inflation and the best strategies to mitigate its effects on your portfolio.

* In the chart, an outlier that goes against the trend is the solitary point in the lower right quadrant. It's for 1921 when, after World War I brought inflation that exceeded 15% annually, the economy sank sharply into recession. Within the year, high inflation switched to extreme deflation. It's the only such whipsaw in the past century. In fact, it's an exception that proves the rule because the preceding inflationary trend persisted for four years, and the subsequent deflation lasted for two, followed by several years of low inflation and the booming economy of the Roaring Twenties.

Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds and stocks may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.

An annuity that gives you guaranteed payments, for the rest of your life, may seem attractive. But it likely comes with fees and restrictions that may be hard to decipher. Furthermore, the net benefit to you may be less than you think, and more expensive than other options. Still, for some, certain annuities make sense. The key questions are:

• What's an annuity, and do you need one?
• How can you find the best annuities from the best companies?
• What annuities should be avoided, because better alternatives are available?

For answers, click here to read our article on annuities, which is located on the Retirement tab. Or, for detailed examples based on our research, continue reading the post below.

Here are some examples of Single-Premium Immediate Annuities (SPIAs) and other options. They are based on actual quotes and real products, for a hypothetical married couple in their late 60's, seeking to invest $100,000 from an existing retirement account, with 100% benefits to be paid as long as either spouse lives. Although the quotes and products are genuine, I've made the companies anonymous because they may not operate in the state where you live, your age and other variables may differ, and the companies may impose contractual stipulations that depart from the quotes and website-data available to me. These examples should not be construed as recommendations to buy any particular security or insurance product. Rather, they are intended to illustrate how you might examine and evaluate annuity options applicable in your circumstances.

• SPIA-3%. This immediate income annuity raises its payments by 3% each year. The first year's payment is $4544, a 4.54% rate on the $100,000 deposit. With a COMDEX rank of 96, the insurer is among the top 30.
• SPIA-CPI. Also an immediate income annuity, this one increases its payments by the same percentage as the previous year's increase in the Consumer Price Index. Its first year payment is $4349, or 4.34%. The insurance company's COMDEX rank is 90, which puts it solidly in the top 100.
• Rider. This variable annuity is a partnership between a well established, highly regarded investment firm and an insurance company with a COMDEX rank of 92 (the top 60). Underlying the annuity is a mutual fund invested 60% in domestic and international stocks, and 40% in domestic and international bonds. The mutual fund, if purchased by itself, would have fees under 0.2%. Purchased as a variable annuity, it has additional fees of 0.29%. A guaranteed income rider adds 1.2% more. The total fees are pro-rated as 0.127% deducted automatically every month. In year one, for a $100,000 purchase, the annuity pays you $4500 (4.5%). Net, every month that year, the insurer deducts $501.67 from your account, paying $375.00 to you and $126.67 to itself. These values may change, depending on the performance of the mutual fund. It's possible for the annuity fees to increase while the payments to you remain flat. On the other hand, a legal rider to the annuity contract guarantees that payments to you will never decrease, and stipulates a formula by which they will increase if the underlying investments rise above their value at the time of purchase.
• Self-CPI. This option is not an annuity. It's a direct investment in the same mutual fund that underlies the Rider option. But the fees are lower, under $16 monthly, because none of the annuity fees apply, and the fund is held in an IRA account with no employer-related fees. It's a self-managed plan, where the investor uses the "collared inflation" method described here and implemented in our retirement income calculator. This method starts with an initial payment of $4020 (4.02%) because of the age of the hypothetical couple. It increases the payment each year by the smaller of (a) 6.7% or (b) last year's change in the Consumer Price Index. The limit of 6.7% is a "collar" which, historically, has been necessary to protect against depleting the fund in the worst case of 40+ years in retirement with inflation initially at extreme levels.

I was able to obtain market data since 1972 for the domestic stock, international stock, and domestic bond indices underlying the Rider and Self-CPI options (but not for the international bond index, which was added to the mutual fund only very recently). This data was used to simulate what would have happened if an investor had begun each of the options above under three scenarios:

• From January 1972 to December 2014, a 43-year retirement with wide variation in markets and inflation.
• A 21-year retirement starting in 1973, when stocks crashed then rose, and inflation started very high.
• A 21-year retirement starting in 1994, when stocks and bonds both rose and fell, but inflation was low.

The simulations are necessarily conjectures. The annuities being simulated were not available to be purchased during these time-periods, and had they been, their prices, interest rates, and contractual terms might have been different from what is sold today. Thus, the analyses reported below must be viewed as suppositions about what might happen if today's annuity products were to experience future markets for stocks, bonds, and interest rates resembling markets of the past.

First, the good news. All four options provided payments every year for 43 years. Even better, the Self-CPI option had a residual value of $209,650, adjusted for inflation, in 2014. Yes, you read that right. With the money left in 2014, the investor's heirs would have had twice the buying power of the couple's original $100,00 investment in 1972. The annuities, as annuities, had no residual value. Instead, any profits went to the insurers.

However, because 43 years is a long time, because inflation was high in the 1970's, and because the period included multiple large swings in the values of stocks and bonds, the four options paid out very different amounts from year to year. The chart below shows how they differed, over time. It's important to note that in the chart, all values are inflation-adjusted to show constant buying power, pegged to January 1972.

Viewed in terms of buying power, the SPIA-CPI option was the clear winner. When adjusting for last year's inflation, it sometimes lost a bit of buying power if current-year inflation was high. But over the long term, it guaranteed constant income, in real, inflation-adjusted dollars. 

The SPIA-3% option underestimated the high inflation of the 1970's and never caught up. Had this annuity been purchased with a 4% annual increase instead of 3%, the initial payment would have been a bit smaller, but the decline during high inflation would have been more limited. Eventually the initial buying power would have been nearly restored, as the compound rate of inflation for the entire 43-year period was 4.14%.

The Self-CPI option, because of its 6.7% cap on annual increases, fell behind inflation in the 1970's, but leveled out from 1980 onward. In effect, this method made a trade-off. It kept a large bequest as a result of cautious withdrawals.

The Rider option, when adjusted for inflation, fell short on its promise that payments would never decrease. Yes, in nominal dollars, the same amount was paid every year throughout the 1970's, but within a decade, inflation cut the buying power of those dollars in half. When huge bull markets in stocks and bonds began in 1982, the Rider option swiftly recovered, only to lose ground again after the dot-com bubble burst in 2000. Of all four options, this one had the least consistent payouts, adjusted for inflation.

The foregoing analysis comes with a big caveat. It's for a very long retirement in a unique historical period. Your experience in retirement will almost certainly be different. Consider, then, two other examples, both 21 years in length, one from January 1973 to December 1993; the other, from January 1994 to December 2014.

During these two periods, the underlying mutual fund of the Rider and Self-CPI options had compound, inflation-adjusted returns a bit higher than 5% per year. In this respect, the stock and bond markets were, overall, about average during both periods, despite some dramatic swings along the way.

At 21 years, both periods were also average in another sense. They fit the joint life-expectancy of a couple in their late 60's.

A key difference, however, is that in the first period, 1973-1993, inflation was abnormally high (6.05%), while in the second, 1994-2014, inflation was much lower (2.30%). Because of inflation, the SPIA-CPI option did the best job of maintaining payments at constant buying power in the 1973-1993 period; the other methods lost about 25%, falling close to $3000, inflation-adjusted. In the low-inflation period from 1994 to 2014, however, all the options preserved buying power, and the SPIA-3% and Rider payments actually bettered inflation. The chart below displays the average payments, after adjusting for inflation.

As shown in the next chart, only SPIA-CPI generated annual increases that kept pace with the 6% rate of inflation in the first period, while all the options matched or beat the tame 2.3% rate of inflation in the second period.

Finally, as with the 43-year analysis, the Self-CPI option was unique in preserving a bequest. Adjusted for inflation to reflect constant buying power, Self-CPI preserved principal approximately equal to the initial investment, in both 21-year periods: $90,756 at the end of 1972-1993, and $144,631 at the end of 1994-2014. The three annuities, by design, left nothing.

The examples presented here are for selected options and time periods. As such, they cannot be taken as guarantees of future performance or as definitive recommendations of certain products. Your results may differ, and will, as with any investment, entail a risk of loss. With those important cautions in mind, consider the following key insights from these examples:

• If one's goal were to guarantee constant buying power, SPIA-CPI would have been the best of the options examined above. A SPIA with a 4% or 5% annual increase might have performed comparably for periods of high inflation, but would have been more than necessary under normal levels of inflation.
• If one's goals were to preserve constant buying power and also leave a bequest, Self-CPI would have been the best of the options studied here. However, it would require active management by the investor (or by a paid adviser), which sets it apart from the annuity options.