By Stan Luxenberg



) -- Will another bout of inflation appear? Plenty of economists worry that the

Federal Reserve's

efforts to flood the economy with cash will trigger inflation in coming years.

So far, consumer prices remain subdued, but managers of target-date retirement funds are preparing for harder times. The funds are adding commodities and inflation-protected bonds, assets that can hold their value during inflationary periods. Companies that are adjusting their portfolios include


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Principal Financial Group

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T. Rowe Price

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Target-date funds are designed for savers who plan to retire in a certain year such as 2010 or 2040. Popular offerings in 401(k) plans, the funds hold diversified portfolios that include mixes of stocks, bonds and other assets.

As part of its mix, AllianceBernstein has held global real estate investment trusts. Now to protect against inflation, the company is expanding its REIT component to include commodity futures, natural resource stocks and Treasury Inflation-Protected Securities, or TIPS. When the new inflation strategy is fully implemented in the next several months, investors in the

AllianceBernstein 2010 Retirement Strategy


will have 5% to 10% of assets in the inflation basket.

Before devising its new strategy, AllianceBernstein studied the impact of inflation on various asset classes. Researchers found that traditional hedges -- including gold and commodity futures -- typically rose in value during years when inflation was accelerating. But no single investment provided perfect protection. While commodities often climbed during times when demand was increasing and the economy was overheating, there were incidents when commodities fell because of oversupplies. Precious metals only climbed 49% of the time in inflationary periods. Even 10-year TIPS, among the most reliable hedges, only worked 84% of the time.

With data in hand, the fund company sought to build a diversified package of inflation hedges that would work in most environments. "Not every asset class will perform well in every environment, but you hope that the mix will perform well over long cycles," says Thomas Fontaine, head of defined contribution investments for AllianceBernstein.

Fontaine says that the inflation protection comes at a price. Because TIPS offer security, they cost more and deliver smaller returns. Investors who substitute TIPS for conventional Treasuries might sacrifice 0.25% in annual returns. "You are paying an insurance premium for the inflation protection," says Fontaine.

In July, T. Rowe Price began adding its Real Asset Fund to the company's target-date offerings. The inflation fund will account for 5% of the equity allocation of the funds. Besides holding stocks of metals and mining companies, the fund also owns REITs, which invest in commercial properties, such as offices and shopping malls. REITs don't necessarily rise and fall with inflation every month, but they tend to track consumer prices over long periods, says Wyatt Lee, associate portfolio manager of the T. Rowe Price retirement funds. "If you own an office building, you can't reset the rent tomorrow, but you can raise rents gradually along with inflation," he says.

In the past, T. Rowe Price included its Short-Term Income fund in the retirement portfolios. But now that fund will be converted into the Inflation Focused Bond Fund. At the retirement date, the target-date portfolio will have 10% of the assets in the inflation fund, which will hold TIPS and other securities. After the retirement date, the allocation to the inflation bond will gradually increase until it reaches 20% of assets. "Inflation protection is particularly important for someone who is retired and needs reliable income," says Lee.

In some of its target funds, ING is including two inflation funds,

ING BlackRock Inflation Protected Bond

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ING Goldman Sachs Commodity Strategy

. The two funds should complement each other because they are likely to excel at different times, says Paul Zemsky, ING's head of asset allocation. As inflation begins to accelerate, commodities can rise sharply for six or 12 months, Zemsky says. Then rising commodity prices tend to inadvertently slow economic growth. That puts a damper on further commodity increases. "Commodities do best during the early phases of inflation," says Zemsky. "TIPS rise steadily and can do well during a protracted period of inflation."

Principal Financial Group recently added Principal Diversified Real Asset Fund to the company's retirement-date offerings. The fund includes natural resources stocks and master limited partnerships, which own oil and gas pipelines. "There hasn't been significant inflation in two decades, but we are concerned that things could change," says Randy Welch, director of investment services for Principal.

Recall the late 1970s, when inflation plagued the markets. With prices rising at a 9% annual rate, the value of stocks and bonds eroded. Retirees living on fixed incomes watched helplessly while their purchasing power dropped.

By Stan Luxenberg

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.