Wade Pfau, Ph.D., CFA

The TIPS You May Need – Treasure Inflation-Protected Securities (TIPS) – Part 2

This article is part of a series; click here to read part 1.

In 2003, Zvi Bodie and Michael J. Clowes published the book Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, in which they argued that typical retirement-oriented investors should rely primarily on TIPS for their retirement savings. Of course, other financial assets should be included in retirement portfolios, but, they said, only once you have enough savings (after accounting for any income expected from Social Security and other defined-benefit pensions) to cover your planned retirement expenditures without these riskier assets. In an interview in the February 2010 issue of Journal of Financial Planning, Bodie confirmed his continued endorsement of this strategy. He also indicated that his personal retirement portfolio is 100 percent in TIPS.

TIPS tend to be the preferred choice in academic approaches to retirement income, assuming that spending needs grow with inflation. But not everyone agrees. First, there are issues to consider related to how TIPS provide adjustments for the Consumer Price Index for All Urban Consumers (CPI-U). The CPI-U does not match the actual inflation experience of any individual household purchasing a different basket of goods. The Bureau of Labor Statistics has also created an experimental CPI for the elderly that suggests their consumption basket cost may grow at a faster overall rate. It is also safe to assume that the spending of many households will not keep pace with inflation in retirement as their consumption basket changes over time. TIPS are presented by some as the perfect hedge for the retirement spending liability, but that is only true if a retiree’s spending grows at the same rate as the CPI-U.

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Another reason TIPS are not universally adored is that while they are exempt from state and local taxes (like all treasuries), the inflation adjustments provided for their coupon payments and principal are taxable at the federal level. This tax will need to be paid on an ongoing basis for the inflation adjustments on the accrued principal, even though you won’t see a penny of it until the maturity date. Calculating taxes for this “phantom income” can be especially complex, so many retirees prefer to hold their TIPS in qualified retirement accounts.

Another negative is that TIPS tend to have a higher duration than traditional treasuries because of their lower real coupon rates and because the cash flows received from TIPS will weigh more heavily toward payments with bigger inflation adjustments made closer to the maturity date.

Michael Zwecher suggests in his 2010 book Retirement Portfolios that he is not dogmatic about seeking inflation protection. He views the higher yield on traditional bonds as a premium for writing a call option on inflation. As indicated, traditional bonds lose out when inflation is unexpectedly high. Some retirees may be willing to accept this risk in return for the higher yield that traditional bonds provide otherwise. This could be especially true of households who are not as exposed to this inflation risk either because their spending will not keep pace with inflation or because they have inflation protection from other assets like Social Security.

Overall, there is no single answer to the choice of TIPS versus traditional treasuries. I tend to lean toward TIPS as a default choice, but individual circumstances could certainly warrant a more mixed approach. Individuals who can live comfortably on their inflation-adjusted Social Security benefit, for instance, may have little need for TIPS.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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