TIPS for Retirees: A Guide to Inflation-Protected Securities

Let’s talk about TIPS. And not the kind you leave after a meal. I’m referring to Treasury Inflation Protected Securities – a bond investment that adjusts for inflation.

Throughout a majority of my career, TIPS have not been a very exciting investment to own. But after years of negative and low real returns, they are starting to become more attractive again in certain situations.

What are TIPS?

At their core, TIPS are fixed-income securities that have two components – an interest rate that is stated on the note and a principal amount that adjusts with inflation based on the Consumer Price Index (CPI). Both the interest and principal adjustments occur every six months until the bond matures. Think of them as US Treasury bonds that adjust for inflation.

Are there any risks for purchasing TIPS?

TIPS are backed by the full faith and credit of the US federal government, making their risk of default low. Just like other bond investments, the value of TIPS can decrease when interest rates rise. This is called an inverse relationship to interest rates, and is not as important if you hold the TIPS to maturity, but would potentially impact the price if you needed to sell it early and/or like to view the value of your investments on a regular basis.

TIPS can also lose value if there is deflation, or a decrease in the Consumer Price Index. And finally, if you purchase TIPS in a taxable account, you need to have sufficient resources to pay taxes on any increases in value over time. See “How are TIPS taxed?” below.

How are TIPS taxed?

There are two components of taxation for TIPS – the interest paid and the increase or decrease in principle each year from the inflation adjustment.

Just like traditional US Treasuries, the interest paid on TIPS is taxable at the federal level, but not at the state or local level.

An increase in the principal value due to inflation adjustments is also taxable at the federal level each year, but not at the state or local level. Note this is often referred to as “phantom income” because it generates a tax liability without distributing any income to help pay the taxes.

Any decrease in the principal value due to deflation adjustments can be used to offset taxable interest income on the TIPS.

How can you purchase TIPS?

There are a number of ways to purchase TIPS. You can buy them:

• Directly from the US government via https://www.treasurydirect.gov/. Note that if you go this route, you may have trouble if you need to sell them before maturity. In that case, you can transfer them to a brokerage firm, which from my experience may take up to 13 weeks from submitting paperwork to Treasury Direct.
• Indirectly from a brokerage company or bank, either at auction or through the secondary market
• Indirectly through a mutual fund or ETF

Note that if you purchase them at auction, TIPS are only available with terms of 5, 10 or 30 years with different action dates for each term. This means if you want to build out a ladder with TIPS maturing each year, it can take years to do so unless you also consider the secondary market.

Are there limits to purchasing TIPS, like with iBonds?

Unlike iBonds, TIPS have a MUCH higher purchasing limit. You can purchase up to $10 million or 35% of an offering amount at auction, depending on your bid type. And you can purchase even more on the secondary market, assuming they are available for your desired maturity date.

How do I cash in TIPS?

If you need to sell TIPS before they mature, you’ll need to first transfer them to a bank, broker or dealer. Note that this can take several months, so if there is a chance you’ll need to sell it early, it is best to plan ahead.

Should I purchase TIPS outright or through an ETF or mutual fund?

While everyone’s situation is different, the main reason to consider purchasing TIPS directly instead of through an exchange-traded fund (ETF) or mutual fund is because most (not all) bond funds have what is called a “rolling yield.” This means the duration of the fund tends to stay constant. You therefore can experience a little more interest rate risk when investing in TIPS funds instead of individual TIPS themselves if your plan is to spend the TIPS proceeds as each bond matures. If you don’t plan to spend the TIPS as they mature and instead continually roll them forward, your investment experience likely won’t be much different than using a TIPS fund, assuming a similar overall duration, other than incurring an investment management fee when using the fund.

Note that there are newer investment products which attempt to help investors create their own TIPS bond ladder with targeted maturity dates, such as the iShares iBonds TIPS ETF series.

Are there any alternatives to TIPS?

The closest alternatives to TIPS would likely be iBonds, or just outright US Treasuries if the inflation adjustments are not needed. As mentioned above, iBonds are limited purchases of up to $10,000 per individual per year (plus an additional $5,000 if purchased through a tax refund). There are a few ways to purchase more through gifting strategies, using trusts, and/or business accounts, but the annual limit is still greatly limited compared to the TIPS limit of up to $10 million per auction.

iBonds also cannot be sold for at least 12 months, carry a three-month interest penalty if cashed in during the first five years after purchase, and need to be held and redeemed through Treasury Direct.

For a comparison of the two, visit https://www.treasurydirect.gov/research-center/history-of-savings-bond/comparing-tips-to-i/.

Who should consider TIPS?

Anyone who is looking for a bond-like investment with a hedge against inflation could consider investing in TIPS. Given the more limited availability and terms, it’s important to have a good understanding of when you may need the funds and how TIPS work.

Retirees may find them attractive, especially in the early years of retirement to help protect your spending power against a potentially higher than expected inflationary environment. Depending on your goals and objectives you may not necessarily want to build out a TIPS ladder for your full retirement, but doing so for the initial retirement years may help provide some additional peace of mind as you transition from the accumulation to decumulation stage.

Sources:

https://www.treasurydirect.gov/marketable-securities/tips/