Why You Need TIPS in Your Retirement Account

With the dollar hitting a yearly low and the Federal Funds interest rate near zero percent, I think many people should be concerned about when inflation will creep back into the economy. Looking at the following two charts from the St. Louis Fed, one can see why inflation has been held in check for the past year. The money multiplier has fallen below one and has not moved much since the beginning of this financial crisis. At the same time, the monetary base has exploded as the Fed has injected lots of new money into the banking system through their open market operations. I do not think that the Federal Reserve will be able to accurately time the winding down of the monetary base to ward off future inflation, because there has not been much precedence of this before. Inflation and high inflation have been in existence since fiat monetary systems have been created.

You can protect yourself from inflation by buying Treasury Inflation-Protected Securities (TIPS). TIPS distribute coupons semi-annually like most other bonds. The difference is that TIPS pay a fixed percentage of the underlying principal. The principal is adjusted semi-annually by the percentage amount that the CPI has changed. Right now, the difference between a 10-year Treasury bond (3.46%) and 10-year TIPS (1.63%) is 1.83%. This means that investors roughly think that inflation will only average 1.83% over the next 10 years. The median rate of inflation has been around 2.5% over the past twenty years. The only drawback with TIPS is that the principal accrued through the inflation adjustments is not paid out annually, but these earnings are taxed by the government. Therefore, you are paying taxes on earnings that you have not yet received. This makes TIPS an extremely unattractive investment for investors in taxable accounts. This also means that the previous statement about inflation expectations is not completely accurate, because the differences in taxation do not make these securities completely comparable. However, if you are considering adding these to your retirement account, I would support this decision.

Besides being more attractive than other Treasury securities, TIPS can be a great compliment to a highly concentrated equity portfolio. Buying stocks to protect yourself against rising inflation may seem like a great idea at first glance, but history has told us that this is not actually the case. Looking at the line graph below, one can see that periods of extremely high inflation occurred while the stock market performed poorly. The most recent instance of this occurrence happened last year. Last August, high oil and commodities prices seemed to have everyone worried that inflation would spiral out of control. At the same time, the stock market was sluggish and was actually preparing itself for one of the worst declines in recent history. Holding TIPS from August 2007 to August 2008 would have allowed you to maintain some of your real wealth while reducing the riskiness of your portfolio.

Percentage Change from Previous Year

I believe inflation should be a current concern for investors and that the best choice to protect your wealth from inflation is by investing in TIPS. The fund that I recommend is Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX). According to Barclays Capital, the average duration for a 7-10 year Treasury fund is 7.5 years. The average maturity of this TIPS fund is 9 years but only has a duration of 3.4 years. This duration is comparable to a short-term corporate bond fund. Although the difference in yields between a TIPS bond fund and a short-term investment-grade bond fund is palpable, the real yields could end up differing greatly if inflation manifests itself in a greater force than many people think. Most importantly, TIPS are risk-free, because they are issued by the United States Government.

Disclosure: I do not hold any position in VIPSX

Comments

[VennData:]

You claim that you do not believe the Fed can buy in a bunch of cash with all the bonds they have? Why not?

They just go and buy the bonds. It's simple, really. They sold all the cash into the market. They are independent, why not buy it all back in?

The fact there there's more money is a simple problem of scale. But they have the bonds and the banks have most of this cash in reserves AT THE FED.

TIPs are an excellent counter weight to equities in your asset allocation, but the Fed can adjust the monetary base at will.

Sep 21 07:20 AM

[Aldebert:]

I agree with your post.
I am of the opinion that effectively the duration of the TIPs fund (and its underlying securities) is even shorter than usually stated because the principal amount of the securities is constantly adjusting with changes in the level of inflation. Unlike MBS, where "option-adjusted" duration is generally measured, I don't think that stated TIPs duration accounts for the constant principal adjustment. (Of course, my view is based on my belief that I can rely on a correlation between mid- to long-term interest rates and inflation rates.)

Sep 21 08:56 AM

[mdpath:]

What's your thoughts about the i shares Lehman (TIP) fund as compared to VIPSX.

Sep 21 09:30 AM

[PLONG:]

I agree that TIPs are critical especially in retirement planning / investing. I would also look at adding TVE and/or TVC to a portfolio for yield protection.

Sep 21 04:18 PM

[Fund Insider:]

There are very few bonds issued, so security selection isn't really much of an issue for fund managers. Performance is similar :

finance.yahoo.com/echa...;range=20040913,200909...

I'd pick based on whether you are using a brokerage acct where it's cheaper to trade TIP, or if you have an acct at Vanguard and can move in/out of VIPSX at no cost. Expense ratios are almost identical.

On Sep 21 09:30 AM mdpath wrote:

> What's your thoughts about the i shares Lehman (seekingalpha.com/symbo...)
> fund as compared to VIPSX.

Sep 21 04:28 PM

[Old Trader:]

Given all of the reasons that its in the government's interest to "game the system", when it comes to computing the rate of inflation, I wouldn't be terribly comfortable pinning all of my inflation "protection" on a slug of TIPs in my portfolio.

Sep 21 08:24 PM

[Robert Zingale:]

That is what everyone thought Greenspan would do when he sent the Fed Funds rate to 1%, but in hindsight, it seems that he left rates too low for too long. I lean toward a monetarist view of the economic cycle. I do not believe that the Federal Reserve has perfect foresight into how to set interest rates and the monetary base. Your idea that it is that easy to unwind that much money is too simplistic. If unemployment and the general economy remain sluggish, they will not have an incentive to sell back the Treasuries that they previously bought. Maybe they will time it exactly right, and inflation will not be that bad. However, if you are wrong about your beliefs about the abilities of the Federal Reserve, then you stand the possibility of losing much more than I do if I am wrong.


On Sep 21 07:20 AM VennData wrote:

> You claim that you do not believe the Fed can buy in a bunch of cash
> with all the bonds they have? Why not?
>
> They just go and buy the bonds. It's simple, really. They sold
> all the cash into the market. They are independent, why not buy
> it all back in?
>
> The fact there there's more money is a simple problem of scale.
> But they have the bonds and the banks have most of this cash in reserves
> AT THE FED.
>
> TIPs are an excellent counter weight to equities in your asset allocation,
> but the Fed can adjust the monetary base at will.

Sep 21 10:37 PM

[Robert Zingale:]

Old Trader, your point is well taken. However, the most gaming by the government is done in the housing category. They like to use renters equivalent in the CPI index instead of a broad housing price index like the Case-Shiller Index. I do not think that the excess money will be pumped back into housing this time, so I think the effects of inflation will be felt in the CPI index. You are exactly right about the gaming. If you replace the renters equivalent measurement with the Case-Shiller index, inflation would have averaged around 1% more each year since 2003. I had the exact number and graph, but my other computer crashed. The calculation can easily been done if you are interested in doing it yourself. I do think the government does game CPI with the renters equivalent and hedonic pricing measures that they use. At the same time, TIPS are an efficient way of protecting your money. You don't have to put all of your money in them of course.


On Sep 21 08:24 PM Old Trader wrote:

> Given all of the reasons that its in the government's interest to
> "game the system", when it comes to computing the rate of inflation,
> I wouldn't be terribly comfortable pinning all of my inflation "protection"
> on a slug of TIPs in my portfolio.

Sep 21 10:47 PM

[claudio.lan...:]

Tell me why anyone would want to buy TIPs? Paid semi annually, and taxed which automatically put you behind the curve. The dollar weak and getting weaker. If someone wanted protection from inflation why wouldn't they invest in countries with commodity export base and low debt. Seems those currency would do far better. Plus the companies or country ETFs at least have a dividend which is taxed at the lower rate. I doubt if the smart money is going into TIPs

Sep 22 11:52 PM