Treasury inflation-protected securities can be a valuable tool for protecting retirement income against inflation.
TIPS offer a guaranteed real return that is adjusted for inflation, an uncommon feature among investment vehicles that aren’t manufactured and distributed by insurance companies. They also have the full faith and backing of the U.S. government.
Despite their virtues, TIPS are shunned by some stakeholders in the financial services industry. Skeptics often cite the nominal interest rates on TIPS being generally lower than other Treasury bonds of varying durations. They also dislike that interest earned on TIPS is subject to federal income tax, and any increase in principal due to inflation is also taxed in the year it occurs.
These are important factors for potential TIPS investors to understand, according to retirement researchers Wade Pfau and Alex Murguia. But they believe that to simply reject the potential utility of TIPS because of these issues is a mistake.
As the pair discuss on the latest episode of the Retire With Style podcast, the downsides of TIPS are much more acceptable when viewed through the lens of holistic retirement planning. They might not help investors maximize their nominal rate of return — but that isn’t the goal of most retirees.
Instead, Pfau and Murguia agreed, typical retirees prefer a higher degree of income protection and a guaranteed way to maintain their purchasing power during life after work. TIPS can help them do just that. In addition, the current inflationary environment means that TIPS are offering returns that are higher than they have been at many points since their introduction in 1997.
“That’s a nice thing to see, but we are never advocates for market timing,” Pfau said. “It might be an attractive time to get into TIPS right now, sure, but that misses the bigger point we’re trying to make. In a sense, it’s always the right time to get into TIPS if your goal is to build some inflation protection into your broader plan for retirement.”
Rate-of-Return Question
Pfau and Murguia find that it remains fairly common to come across even skilled financial advisors who seem to misunderstand the key features of TIPS — particularly the application of the inflation adjustment on top of the stated yield.
“If you don’t know the full story, you are going to get caught up on the fact that TIPS yields can look quite a lot lower than bonds with similar durations,” Murguia observed. “But you have to internalize the fact that the quoted yields are lower because inflation gets added on top of that. Otherwise, you’re going to be comparing apples and oranges, and you’ll pick the higher stated yield every time.”
Murguia further noted that downward inflation movements tend to cause spikes in TIPS skepticism — and that’s happening even as TIPS returns are attractive from a historical perspective. At various points, TIPS stated yields have even been negative.
“We all remember how high inflation was a few years ago and how much that sparked a conversation about TIPS being especially attractive,” he said. “Well, now you hear people saying TIPS must now be unattractive since inflation has moderated. As we said, that’s just not the right way to look at TIPS and build them into a financial plan — especially for retirees.”
Pfau agreed with that assessment.
“Retirees have an income liability that grows with inflation,” he said. “TIPS are an asset class that is providing you with inflation protection so that you can meet an expense that’s growing over time. It’s not about yield maximization. Strictly speaking, if inflation is low, TIPS will underperform relative to traditional Treasurys. But is that really a downside? I would say no, not necessarily. Low inflation is a winning scenario.”
On the flip side, the duo observed, TIPS can outperform bonds that have higher quoted yields in periods when inflation spikes.
“Again, it’s about setting the right expectations,” Pfau said. “If inflation is higher than expected, I could be in a lot of trouble as a retiree if I don’t have an inflation-protected asset. If inflation is lower than expected, I don't necessarily need all that much return on my assets, because the spending need is not going up so quickly.”
TIPS vs. TIPS Funds
There are some important considerations when it comes to investing in individual TIPS versus buying TIPS funds, Pfau and Murguia explained. Both options have clear virtues and potential drawbacks.
Buying individual TIPS and using them to build bond ladders, through which advisors can craft highly tailored TIPS portfolios that match their clients’ anticipated long-term income liability, works from a purely academic perspective, the experts agreed. But this technique also requires a substantial amount of effort by the advisor.
For that reason, some advisors rely on outsourced investment managers to build TIPS ladders within their clients’ separately managed accounts. This approach significantly lowers the amount of work involved, Murguia noted, but it also adds potentially significant costs that take away some of the advantages of inherent inflation protection.
Buying TIPS funds also has pros and cons, Pfau and Murguia said, and these resemble the issues involved in bond fund investing in general.
“Like other bond funds, TIPS fund values are going to move with real interest rates over time,” Pfau said. “If real TIPS yields go up, you’ll see capital losses on your TIPS funds. If real yields go down, you'll see capital gains on your TIPS funds. It’s a dynamic to consider versus buying and holding individual securities to maturity.”
Pictured: Wade Pfau
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