How colleges and universities can guard against inflation
Monetary policy in the United States took a dramatic turn with the introduction of quantitative easing after the financial crisis of 2008.
Although it achieved its primary objective by forcing down long-term interest rates, it also increased the supply of money in the economy, which has contributed to inflationary pressures in the past.
While we are fortunate to have witnessed a lengthy and very low inflationary environment, as money supply increases, the probability of higher inflation also increases.
The U.S. Consumer Price Index (CPI) is the most common method of measuring inflation. CPI is a measure of the price changes in over 200 goods and services that an “average” American consumes. However, for colleges and universities, the Higher Education Price Index (HEPI) is more appropriate.
Compiled from data reported by government agencies and industry sources, HEPI measures the average relative level in the price of a fixed market basket of goods and services purchased by colleges and universities each year, excluding research.
From fiscal year 1993 to 2013, inflation as defined by HEPI averaged 3.3 percent while CPI averaged 2.5 percent. Both measures currently are significantly lower than their 50-year averages, which are 5 percent for HEPI and 4.2 percent for CPI.
Impact on invested assets
Universities and supporting foundations generally seek to maximize spending while minimizing distributions volatility. To promote intergenerational equity, they should also seek to grow principal in inflation-adjusted terms.
By growing principal, an organization can ensure that future generations benefit equally from the investment portfolio. Growth of principal in inflation-adjusted terms is necessary for an organization to continue its mission in perpetuity.
Even in the current environment, low inflation can rapidly decrease purchasing power of an investment portfolio. For example, during FY1993 to 2013, when HEPI was well below the 50-year average, $1 held at the end of June 1993 was worth less than $0.52 by the end of June 2013.
Protecting against inflation
Even during periods of low inflation, a portfolio that is not properly protected from the destructive properties of inflation will see purchasing power erode. As a result, universities should be aware of the threat inflation presents at all times and take appropriate steps to protect their investment portfolios throughout all market cycles.
One of the most efficient ways to approach this issue is to make a long-term strategic allocation to assets that typically benefit from inflation. This includes investment in liquid assets, such as commodities, real estate investment trusts (REITs) and Treasury inflation-protected securities (TIPS):
- Commodities are tangible assets that have historically performed well in a high inflation environment because many are included in the inflation calculation. From FY1984 to FY2013, commodities as measured by the S&P Goldman Sachs Commodity Index (GSCI) returned 23.32 percent when HEPI was above average, compared to -3.9 percent when HEPI ran below average.
- REITs are companies that act as investment agents and specialize in income-producing real estate. There are three distinctive types of REITs: equity, mortgage and hybrid. For purposes of providing inflation protection, equity REITs have considerable benefits to offer investors. From FY1984 to 2013, equity REITs generated returns in excess of inflation 73 percent of the time.
- TIPS are bonds issued by the Treasury Department and backed by the U.S. government. TIPS are similar to nominal or “normal” U.S. Treasury securities, but have the added benefit of interest payments that adjust to changes in the U.S. inflation rate. It is important to note that TIPS use CPI when calculating the inflation adjustment. However, HEPI and CPI have a 50-year correlation of 0.88, signaling that the two measures move in tandem a majority of the time.
Despite running at below-average levels for 20 years, inflation continues to harm university portfolios and slowly erode purchasing power. Akin to buying homeowners insurance before a house fire starts, the value of owning an inflation hedge is greatest before the price of the hedge goes up—that is, before an increase in the inflation rate.
William M. Courson is president of Lancaster Pollard Investment Advisory Group.
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