Traditional bonds are priced around the objective of getting a return that exceeds expected inflation. If inflation is unexpectedly high, then the real return on nominal bonds is less.
TIPS, on the other hand, keep pace with higher inflation, because it triggers a higher nominal return above their underlying real interest rate. Essentially, TIPS provide protection from unexpected inflation. They outperform Treasuries when inflation exceeds the implied breakeven inflation rate.
This is a valuable attribute when spending for your retirement income plan is expected to grow with inflation. Traditional bonds outperform if inflation is unexpectedly low.
Although low inflation also makes it easier to meet retirement spending goals, this outcome is actually less desirable. Retirees generally get more use from insurance that protects from high inflation, making TIPS a more natural candidate for retirement portfolios.
In short, TIPS provide retirees with reliable, inflation-adjusted income that will maintain its real purchasing power.
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% 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). But the CPI-U often doesn’t 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. As we have already explored, it’s safe to assume that the spending of many households will not keep pace with inflation.
Another reason TIPS are not universally adored is that 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.
TIPS are presented by some as the perfect hedge for retirement spending liability, but that is only true if a retiree’s spending grows at the same rate as the CPI-U.
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 they have inflation protection from other sources on the household balance sheet.
Overall, there is no single answer to the choice of TIPS vs. traditional Treasuries.
I tend to lean toward TIPS as a default choice, but individual circumstances could certainly warrant a more mixed approach. An individual who can live comfortably on their inflation-adjusted Social Security benefit, for instance, may have little need for TIPS.
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