Wednesday, March 14, 2012

How do TIPS help retirees to meet their goals?

Dear Dr. Pfau,
  I am a reader of your blog.  I find it very helpful as I navigate retirement in these very unsettling times.
  I've read Risk Less and Prosper and it was interesting to find its thesis presented in Monday's Wall St. Journal.
  My question is this:  We have many illustrations showing how investments in the stock market have fared in the past.   However, I do not see any illustrations showing how investments in TIPS over the last 10-20 years might have helped retirees reach their goals.
  Can you provide an example of how an investment in TIPS would have benefited the average investor/retiree?
  Thank you for all you do......Glory, West Bloomfield, Michigan

A writer from my birthplace (I lived in West Bloomfield until I was 15) has asked an important question.

How do TIPS help investors or retirees (to reach their goals)?

First of all, tracking the performance of a TIPS mutual fund such as VIPSX as one would do with a stock or other bond funds is not the best way to look at this issue. TIPS mutual funds have actually done quite well because the yield on TIPS have generally been decreasing since their introduction in 1997. That makes older TIPS more attractive... newer TIPS offer lower coupon payments and so investors bid up the price for the older TIPS with higher coupon payments. That increases the market value of the older TIPS, which increases the asset value of TIPS mutual funds and boosts their total returns. But if TIPS yields start increasing, that is bad news for TIPS mutual funds. No one wants to own older TIPS because they can buy new TIPS with higher coupon payments. The value of the older TIPS decrease, hurting the value of the mutual fund assets.

Zvi Bodie suggests that retirees ignore all of these market value fluctuations I was just describing though. Forget about that last paragraph. TIPS should be held to their maturity date. It doesn't matter how their price fluctuates in the mean time. At the maturity date the owner receives the full principal value plus adjustments for inflation. For example, if I buy $10,000 of TIPS maturing in 10 years, I know that I will receive $10,000 worth of real purchasing power since I will get this amount plus an amount that adjusts for all of the inflation. This keeps my spending power constant in real terms.

Bodie's suggestion is to create a ladder of TIPS bonds with some TIPS maturing each year to provide you with enough income to meet your essential spending needs in that year. In real life, making this ladder is a bit complicated because TIPS maturing at different dates have different yields (coming from both different coupon rates and different prices that they are selling for in the market), TIPS pay coupon payments which must be considered when figuring out how much to allocate to TIPS with different maturity dates, and there are a few years where no TIPS mature. Perhaps a trusted financial planner who charges an hourly fee could help put together a TIPS ladder if this is what you decide to do.

And so how do TIPS help retirees?  By providing a safe way to ensure you get a desired amount of income in each year of retirement that will be adjusted for inflation to maintain its real purchasing power. To explain this a bit more, let me give an example which simplifies some of the complications I just mentioned about creating a TIPS ladder. 

Suppose I am trying to get $20,000 of safe income for year 12 in retirement. I see a TIPS for sale that doesn't make any coupon payments and matures in 12 years and has a face value of $20,000. Suppose its yield is 1.2%. Since it does not have coupon payments, the way that yield is expressed is that the price it sells for is discounted by an amount that would allow it to grow to be $20,000 in 12 years. Suppose interest is compounded annually.  Then this TIPS would sell for 
20,000 / (1 + 1.2/100 )^12 = $17,333

If I pay $17,333 today for that TIPS, I can be assured with a US government guarantee that I will have $20,000 of real inflation-adjusted spending power for year 12 of my retirement.

And I repeat that sort of calculation for each year of retirement and build a floor of safe income. 

If you invest your retirement funds in stocks, on average you can expect the stocks to grow larger than the TIPS growth, but stocks are much more volatile and there is a decent chance that you may end up finding the portfolio value of your stocks to be insufficient to meet that $20,000 spending need.  This is the idea behind "risk less."

I like the idea of building a TIPS ladder in this way, but I still have trouble being completely convinced that this the best general approach for everyone.  Some of my concerns include:

-The TIPS ladder doesn't protect you if you live longer than the end date for your TIPS ladder. I discussed some research about a TIPS ladder plus a deferred annuity. Another alternative is an inflation-adjusted single premium immediate annuity (SPIA). But when getting into this issue of annuities, you have to be careful and make sure the advisor selling the annuity is someone you can trust to have your best interests at heart.

-Building a TIPS ladder is quite expensive when TIPS yields are low. I discussed these costs recently as well. Some examples I discussed there regard building a TIPS ladder for 30 years. With a TIPS yield of 1%, even a 3.5% withdrawal rate is pushing the limits of feasibility, requiring 91% of your portfolio to do it. With a TIPS yield of 0%, a 3% withdrawal rate is about the best that can be hoped for, as it costs 90% of your wealth. The reason you shouldn't spend all your wealth on the TIPS ladder is you need something for emergencies and also you need to worry about if you live longer than 30 years. What these numbers mean is that with TIPS yields of 1%, you can only guarantee $3,500 of annual income for each $100,000 saved. It is $3,000 with a TIPS yield of 0%. Not that we should ever expect to see this again, but with TIPS yields of 4% you could get about $5,000 of annual income for 30 years at a cost of $90,000 (90% of a $100,000 portfolio).

There is nothing that can be done about the current low TIPS yields. They are low and may stay that way or get even lower. Or they could go up. It is hard to know. I've wondered about the book name, Risk Less and Prosper, as it is really more about Riss Less and Ensure Your Basic Needs will be Met. For this reason, some people may decide to take their chances by holding some stocks with the hopes that this will support a higher spending amount. But anyone doing that must realize that stocks are risky, even over the long run, and this creates a small but real possibility that your spending power will fall even below the level that TIPS could provide.

So that's how TIPS help retirees meet their goals. Though costly, TIPS do provide a way to safely lock-in desired spending amounts for throughout one's retirement without the risk of bad market conditions further eating away at one's wealth.

Postscript: Risk Less and Prosper talks about TIPS in somewhat general terms. Anyone actually serious about investing in TIPS could benefit from reading the Finance Buff's Explore TIPS.


  1. I believe zeros are calculated with semi-annual implied coupons

    20,000 x (1 + 1.2/2/100 )^-24 = $17,325.21

    1. Yes, you are right. I was trying to make my simple example as simple as possible. Funny that it only amounts to an $8 difference.

  2. I've been a believer in a small scale use of I-Bonds. Every month, we purchase $400 of I-Bonds. Our current food expenses are about $500/mo. But if we needed to, we could cut back on some meat, etc, and make do on $400. So, no matter how our investments perform, we should be able to eat. (Our house is paid off.) This represents a very small fraction of our savings - but one that allows us to know that we may not eat well, but we won't be eating dog food.

    1. Thanks for sharing. It sounds like you are doing a form of the floor/upside or essentials/discretionary approach. You are making sure your basic needs will be met, and then you have more flexibility with the rest of your portfolio.

  3. Hi! Wade,

    First of all, thank you for your meaningful contributions to the retirement planning literature. Our firm has benefitted greatly from your work.

    I wanted to share that a book edited by John Brynjolfsson and Frank Fabozzi (Handbook of Inflation Indexed Bonds) was very helpful to me over a decade ago when we began to incorporate 'Linkers' (inflation-indexed bonds) in our client portfolios. It may be a bit dated at this point (I have not looked for revised/updated editions) but likely still very useful.

    Bill Gross wrote the forward and among the contributing authors were Ray Dalio and Laurence Siegel. Worth a look if you have not already seen it.

    best regards,
    stephen barnes, cfa, cfp(r)
    barnes investment advisory, inc.

  4. Stephen,

    Thank you very much for the comments and the book suggestion. I've added it to my Amazon shopping cart.

    Best wishes, Wade