How Vanguard TDFs combat inflation

July 16, 2018

A/AText size:AAA
Michael Palazzi

Michael Palazzi

Plan sponsors and their participants are increasingly concerned that inflationary pressures may be building in the U.S. economy. Such concern is understandable. Unemployment rates are at multidecade lows and there is little sign of slack in the economy. What's more, rising prices for what producers have to pay for goods are leading investors to question the impact of inflation on their portfolios.

Against this backdrop, we sat down with Michael Palazzi, a senior investment strategist in Vanguard Defined Contribution Advisory Services, to discuss how Vanguard considers the impact of inflation in the construction of its target-date funds (TDFs).

Inflation certainly isn't a new topic, but it's taken on more significance in recent months. Why is that?

Michael: Since 2008, inflation has been a concern at various points in time. Think about when the Federal Reserve implemented its multiyear quantitative easing program, the European Central Bank followed suit several years later, and the Japanese Central Bank intervened in the bond markets. These events all led to concerns over inflationary pressure. Yet despite this unprecedented monetary stimulus, inflation has been stubbornly low, with central bankers unable to achieve even modest inflationary targets.

But the conversations are beginning to change as unemployment rates are at multidecade lows, interest rates are rising, and oil prices are experiencing a comeback. Clients are starting to ask whether TDFs are constructed to withstand higher rates of inflation.

Is inflation a risk today?

Michael: In the Vanguard Economic and Market Outlook for 2018: Rising Risks to the Status Quo, our Investment Strategy Group commented that one of the more pronounced risks coming into this year was a continually tightening labor market, which could lead to a higher-than-expected bounce in wage inflation. That could then lead the markets to reprice, signaling a more aggressive path for monetary policy normalization.

While the strength in the labor market may point to a cyclical uptick in inflation in the short term, we continue to believe that structural forces—in the form of technological disruption, and shifting demographic trends—will help keep a lid on inflation over the medium to long term.

Given the recent headlines about increasing inflationary pressures, how should clients view TDF design and construction now?

Michael: In designing the Vanguard Target Retirement Funds, our Strategic Asset Allocation Committee focuses on the long term. Investors saving for retirement often have multidecade time horizons. This is why our Target Retirement Funds maintain significant commitments to stocks throughout an investor's working career (ranging from 90% at the beginning of a career to 50% at age 65), and even well into retirement (30% for investors in retirement). We're trying to provide investors long-term growth in excess of inflation.

When most investors think of inflation-hedging asset classes, stocks are not necessarily the first thing that comes to mind. However, while equities have very little correlation to inflation over the short term, they have served as a great inflation hedge for investors over the long term. For instance, the S&P 500 has returned 10.52% annually from January 1, 1970 through December 31, 2017, on average. Inflation, on the other hand, represented by the consumer price index, grew at an average 4.10% annually during the same time period.

Inflation and S&P 500 Returns


Data are based on rolling monthly average observations from the Bureau of Labor Statistics Consumer Price Index for All Urban Consumers and the S&P 500 Total Return Index, Morningstar, from January 1, 1970 through December 31, 2017

Could you talk a little bit about how commodities might act as an inflation hedge?

Michael: In the ongoing evaluation of our Target Retirement Funds, we look at a number of alternative asset classes to assess their potential role in long-term portfolios. Commodities are often cited for their inflation-hedging properties. Our research indicates that commodities, in general, have exhibited a high correlation to unexpected inflationary shocks. What is less clear, however, is their long-term sensitivity and correlation to the broader rate of inflation (see the chart below).

The long-term risks investors face from inflationary pressure are real, and they are more acute for investors living in and nearing retirement, as their portfolios are generally more heavily invested in bonds. This is where explicit inflation-hedging allocations can make sense.

In our Target Retirement Funds, we include an allocation to short-term Treasury Inflation-Protected Securities (better known as TIPS)—through Vanguard Short-Term Inflation-Protected Securities Index Fund—to provide investors with an age-appropriate level of inflation protection. Over the 21 years since TIPS were introduced in the United States, they have exhibited a stronger correlation to short-term changes in inflation, coupled with significantly less volatility than commodities.

Correlation of asset returns with unexpected and expected inflation, 1970–2017

Correlation of asset returns

Data are based on rolling monthly observations. We use the following indexes as asset class proxies: cash equivalents—Ibbotson U.S. 30-Day Treasury Bill from 1970 through 1977 and Citigroup 3-Month U.S. Treasury Bill from 1978 through 2017; TIPS—Barclays Capital U.S. Treasury Inflation Protected Securities from April 1997 through 2017; commodity futures—S&P GSCI Excess Return from 1970 through 2017; mining and energy stocks—Fama-French industry returns from 1970 through 2017; REITs—FTSE NAREIT Equity REIT from 1972 through 2017; international stocks—MSCI World ex US (USD); U.S. stocks—Standard & Poor's 500 from 1970 through 1974; Dow Jones Wilshire 5000 Composite from 1975 through April 22, 2005; and MSCI US Broad Market thereafter through 2017; U.S. bonds—Citigroup High Grade from 1970 through 1972; Lehman Brothers Long-Term AA Corporate from 1973 through 1975; and Bloomberg Barclays U.S. Aggregate Bond from 1976 through 2017.

We define unexpected inflation as the difference between the 1-year annualized Consumer Price Index for All Urban Consumers and the Federal Reserve Bank of Atlanta Sticky CPI. We define expected inflation as the difference between the CPI and unexpected inflation.

Sources: Vanguard and

Beyond inflation, what are some of the risks we try to manage when building our Target Retirement Funds?

Michael: As we design portfolios that we believe can stand the test of time, we seek to balance a number of risks investors face. Market risk, longevity risk, and inflation risk are all weighed in the process of designing, and continually vetting, our Target Retirement Fund construction.

This is why it's so important to focus on the enduring investment principles that we believe will serve investors well over the long term. We strive to build portfolios that will help investors reach their goals through a globally diversified, transparent, and low-cost approach.


  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • Diversification does not ensure a profit or protect against a loss.
  • All investing is subject to risk, including possible loss of principal.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.
  • The Vanguard Short-Term Inflation-Protected Securities Index Fund invests in bonds that are backed by the full faith and credit of the federal government and whose principal is adjusted periodically based on inflation. The fund is subject to interest rate risk because although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. The fund's quarterly income distributions are likely to fluctuate considerably more than the income distributions of a typical bond fund. Income fluctuations associated with changes in interest rates are expected to be low; however, income fluctuations associated with changes in inflation are expected to be high. Overall, investors can expect income fluctuations to be high for the fund
  • Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.