Hedge Against Inflation – How to Protect Your Solo 401k

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Although it is a bit of a bumpy road, the economy is growing again and business activity is picking up. Interest rates remain at historical lows but there are signs of modest rate increases on the horizon. There is a mild fear that inflation may stunt the growth of the economy. If inflation kicks in, higher interest rates and lower stock prices could follow. Fortunately, investors with an understanding of alternative investments in Solo 401k accounts are well-positioned to hedge against inflation that strikes fear into stock market investors.

Inflation eats into stock values and reduces the buying power of assets in stock-based investment accounts. It can also be a concern for retirees with holdings of lower-return assets, such as cash and bonds. For example, if inflation rises 3% for many years, a retiree who has a $50,000 income this year would need just over $67,000 a year by 2031 and more than $90,000 per year by 2041 to fund the same lifestyle.

Inflation Might Have Legs

August 2021 saw consumer prices increase 5.3% compared to August 2020. That is an enormous jump from 1.5% in February of 2021 and more than twice the Federal Reserve’s expectation of 2.4% for 2021 with slowing to 2% in 2022 and 2023. Long-term, the Fed’s goal is for inflation to hover around 2%, which indicates a stable and healthy economy. The uncertainty is whether pent-up consumer demand from the pandemic will cause long-term supply-chain bottlenecks and product shortages or if shortages and demand will subside now that government stimulus checks have been spent. Some key metrics to watch are prices for gas, groceries, and used cars.

What we do know is that the prices suppliers charge businesses (producer prices) also rose in June at the fastest annual pace since 2010. Employers are also boosting worker pay amid a tight labor market. Another thing to watch for is rising interest rates, which is a secondary effect of inflation. The most current indications from the Fed indicate that rate hikes could come later this year or early next year, sooner than the 2024 date it forecast in March.

It all adds up to extraordinary uncertainty that Wall Street never likes. Solo 401k investors have better options. Most investors will be optimistically hoping for the best but pragmatic by hedging against inflation. Based on previous inflationary periods, the investments below have provided a hedge against a persistent period of rising prices.

Real Estate as a Hedge Against Inflation

Real estate has a well-established history of keeping pace with inflation. Both with increases in value and rents that go up with inflation. However, it’s an understatement to say that the pandemic has placed everything in uncharted territory. While residential real estate continues to be robust, the potential for pandemic-related lockdowns and social distancing leaves some commercial properties such as retail and offices more questionable.

Insulate against, both, recessions and inflation with a solid hedge asset. For inflation, these are investments providing goods and services that move in the same direction as rising prices without a dip in demand. Essential goods and services, products that consumers cannot live without, like housing, food, energy, etc. Luxury goods will be the first inflation casualties as consumers stick to the basics of survival. Specifically, affordable housing is one of the best inflation buffers because people always need shelter. Affordable housing also tends to be recession-resistant. This makes it a good hedge for either swing that the economy might take. During the low point of the pandemic in 2020, commercial real estate experienced vacancy increases and rent declines. At the same time, affordable housing such as apartments and mobile homes increased occupancy and rents.

Whether it is a recession from high unemployment or increasing prices from inflation, affordable housing has a reliable history as a hedge asset.

Is Cryptocurrency a Hedge Against Inflation?

Some investors are asking if cryptocurrency will replace gold as a hedge against inflation. Cryptocurrency has no record during a hyperinflation economy, which means there will be unknowns. The most compelling case for Bitcoin is its ability to store value — as gold has for thousands of years. Unlike the U.S. dollar, cryptocurrencies can’t be devalued by a government or a central bank, which is the exact purpose of an inflationary monetary policy.

Here is a beginning point for cryptocurrency investors. Many financial analysts find no correlation between inflation and cryptocurrency prices. According to some experts, the main reason Bitcoin is a hedge is because there’s a limited amount. The same reason that gold is a hedge. The government can’t just print more gold and the government can’t just print more Bitcoin.

Bitcoin Findings

The Fed’s easy money policies threaten to cause hyperinflation in the years to come because the central bank keeps swelling the money supply to spur economic growth. That practice is bound to create new dollars faster than the U.S. produces new products, hiking prices faster than salaries, and denting the purchasing power of America’s households.

During the 14 months before the pandemic, inflation was running almost exactly where the fed wanted it – between 1.6% and 2.3%. During the same time, Bitcoin staged a big rally, leaping from $3,700 to $10,200. This was probably a bull run on Bitcoin rather than a reaction to modestly rising prices. Still, inflation and Bitcoin moved in the same direction, though not nearly in the same proportions. During the first five months of the pandemic, inflation stalled at below 0.5%. During those same months, Bitcoin remained stable at about $11,000.

From September of 2020 through February of 2021, inflation, as measured by the CPI, remained very mild, at between 1.4% and 1.7%. Whether it was another bull rally or people seeking financial security, Bitcoin took another big jump from $10,000 to $47,000. The point is that Bitcoin isn’t dancing to the same tune as inflation.

Timing is Everything

Then came the big inflation surges. First in April at 4.2%, again in May at 5.0%, and followed by 5.4% in June. Some serious analysts believe Bitcoin surged in value to a record of almost $65,000 in mid-April as an unprecedented hedge against inflation. If that is true, those investors may have been late to the party. Based on this brief Bitcoin history, investors took strong notice that the value of Bitcoin soon dropped from its precipitously high back to $32,500 by mid-July. If that is your measure, Bitcoin is not a good hedge against inflation for you.

But timing is everything. If you had the foresight to buy Bitcoin a year earlier (or in 2017 thru 2019) the rise in value would make you a financial genius. It was only the Johnny-come-lately that relied on it as an instant hedge against inflation and has seen his value evaporate. Those who see cryptocurrencies as a long-term store of value are in much better financial shape today than when it stabilized at about $11,000 during the first days of the pandemic. Again, Bitcoin may not be dancing to the same tune as inflation, but it is still a good store of value. Otherwise, your alternative might be gold as a hedge against inflation.

Commodities as a Hedge Against Inflation

If you are averse to stock markets, the thought of commodities as an inflation hedge might not make your list. Although typically traded on exchanges, commodities are very different from stocks. One of the differences between stocks and commodities is that the average person won’t be directly impacted by the rise or fall of any company’s stock. On the other hand, a rise in the price of commodities such as electricity or potatoes will be directly felt through reduced purchasing power. The direct relationship with consumers is also the tie to inflation.

Commodities represent physical products, while stocks represent ownership as a part of the future cash flows of a company. Commodities are traded and held for a short duration, while stocks can be held for countless years. Another way to think about commodities is that they don’t ‘do’ anything, while stocks do things. Your gold won’t grow over time from 100 to 200 ounces nor will your bushels of rice double in quantity.

Why Commodities

What relates commodities to inflation is that prices for raw materials like oil, metals, and agricultural products usually increase along with inflation, so they can be a good hedge. But you need to invest in the right commodities that increase with inflation. The price of commodities depends on supply and demand. That means that prices for essentials and staples are likely to rise with inflation while luxury-based commodities like caviar are at a much higher risk.

Be wary of commodity-related equities and managed commodity futures accounts. These investment strategies may not capture the potential diversification and other benefits of commodity exposure in a portfolio. For example, commodity-related equities will not necessarily reflect changes in the price of commodities. If an oil producer has already sold its supply on a forward basis, the producer’s stock price may not fully benefit from a rise in the price of oil. Commodity-related equity returns can also be affected by the issuer’s financial structure.

It’s possible to own the physical commodities directly – hogs, cattle, and oil come to mind. If that isn’t practical, precious metals can be purchased as bullion from online dealers and pawn shops. Be sure you are paying close to spot market prices and not for collector value.

Leveraged Loans

Leveraged loans pay high rates of interest but can be risky because these are made to companies that have high levels of debt or a low credit score. There should be underlying collateral that secures the loan, and you want to receive payments on a regular schedule. The loan should have a floating interest rate that makes them a good hedge against inflation.

Control Taxable Income through Solo 401k Accounts

You can increase your purchasing power during inflationary times by reducing your taxes and at the same time enhancing your retirement account. By making choices between traditional or Roth Solo 401k contributions, you can make your taxable income higher or lower. If you want a higher adjusted gross income (AGI), you make Roth contributions. If you want a lower AGI, you make traditional Solo 401k contributions. Not only can you control your spendable income for the year, but you may also be able to control which tax bracket you fall into for the year. And of course, you’re funding your retirement in both cases.

Spend from Cash Accounts

To keep up with inflation, as much of your money as possible should remain in income-producing accounts. If you are drawing from retirement accounts, you want to have as little as possible in checking, some in a savings account, with the remainder in higher-paying investments.

Use a Retirement Withdrawal Strategy

This strategy is quite common and intended to keep pace with inflation. The first year, you simply withdraw 4% of the value of your Solo 401k. In the following years, you withdraw the same amount and add in the amount needed to keep pace with inflation (typically an additional 2%). With an example $1 million account, you begin the first year by withdrawing $40,000. In the second year you withdraw $40,800 and in the third year $41,616 (the previous year’s amount, plus 2%). This is simple to follow and gives you an inflation adjusted income each year. However, if your remaining investments don’t keep up with inflation, you could run the risk of running out of money during your lifetime.

Hope for the Best, Prepare for the Worst

You may be hearing a lot about hyperinflation just because consumer prices have taken a few big jumps. The effects of the pandemic may just cut this short. A different theory says this is actually “reflation.” Prices are recovering from losses suffered during the pandemic lockdowns. Once supply lines are reestablished and business cash flow returns, price spikes will retreat. But we live in a world of uncertainty. Until that happens, we need to hope for the best and prepare for the worst.

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