Why You Need TIPS in Your Retirement Account

| About: iShares TIPS (TIP)

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