Smart Ways to Inflationproof Your Retirement Portfolio

Prudent hedges keep rising prices from gnawing at your nest egg.

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It's been a rough year for retirees—and those eyeing retirement. Crashing stocks have slammed retirement account values. Falling house prices are shuttering dreams of selling the big family home, buying a less expensive pad, and pocketing the excess to shore up savings.

Now rising inflation is threatening to exact its own insidious toll. Runaway inflation? Not quite, but consumer prices have jumped 5 percent in the past year, according to the Labor Department. That's far above the 2.7 percent average over the past decade.

You don't have to be a financial whiz to know that rising living costs ravage your savings. Inflation touches everything from the cost of your groceries and gas to medical expenses. When the dollars you pull from your retirement accounts are worth less, you feel it fast. Consider this: In 20 years, at 3.5 percent inflation, your purchasing power would be cut in half.

That's a worry for one and all, but the risk for retirees is considerable. In the good old days, many pension payouts were indexed for inflation, as Social Security is, but with retirees depending more on 401(k) accounts and IRAs, there's no automatic adjustment. What's more, people nearing retirement often switch to investments like certificates of deposit and bonds that have a tough time keeping pace with rising prices.

Defending yourself against inflation means finding investments that earn a healthy rate of return without feeling you're taking too much risk. "A well-diversified portfolio that offers a blend of investments will have plenty of buffering built in," says certified financial planner Deena Katz, an associate professor of personal financial planning at Texas Tech University.

Individual needs vary, so it's best to consult a financial adviser to help divvy up your portfolio in a balance suited to your life stage and risk tolerance. That said, here are five ways to keep inflation from gnawing away at your portfolio.

1. Dividend-paying stocks. "Investing in equities is still your best bet against moderate to high inflation," Katz says. Even if a roller-coaster market makes you queasy, you can't afford to dump stocks in an inflationary environment. Many retirees' portfolios are skewed to bonds and cash with minimal exposure to stocks. History shows, however, that of these three asset classes, only stocks have provided strong growth after accounting for inflation.

You don't have to shoot for the moon by buying individual shares in untested companies. "Keep it plain vanilla, a diversified mutual fund such as the Standard & Poor's 500 index fund, for example, and stay there," advises Katz.

There's an added bonus hedge in doing so. Nearly 80 percent of the S&P 500's stocks are well-established, large companies that pay dividends. Unlike fixed-income investments, these stocks offer a double dip. First, they provide income by paying cash dividends (the S&P 500's dividend yield is 2.3 percent). Plus, they have the potential for steady capital growth. That's because their size and industry dominance can allow them to pass along rising costs to their customers and keep profits rolling in.

"Index funds aren't sexy and are hard to feel excited about, but they are what most retirees should seek out," says Katz, who advises keeping at least half of your portfolio holdings in equities. Exchange-traded funds that track the S&P 500 can offer rock-bottom expenses. The iShares S&P 500 Index levies fees of 0.09 percent. Yet the ETF hasn't escaped this year's stock swoon: It is down about 14 percent so far but has averaged a roughly 7 percent annual return over the past five years.

2. Treasury inflation-protected securities. TIPS aim to shield investors from inflation by tying their return to the consumer price index. TIPS' principal rises with inflation. Everyone living on a fixed income should have some exposure to TIPS in a tax-deferred account, says financial adviser Ron Rogé of Bohemia, N.Y.

Here's how it works: If you buy $100,000 in TIPS and annual inflation is 3 percent, your principal will be worth $103,000 by the end of a year. When TIPS mature, investors receive the original principal amount or one that's been adjusted—whichever is greater. TIPS pay interest every six months that is exempt from state and local taxes but subject to federal tax.