Allan Roth: I Love TIPS—Just Don’t Go All-In

The single biggest discovery I’ve found over the past two decades of financial planning is using individual Treasury Inflation Protected Securities (TIPS) to secure a safe withdrawal rate and grant dysfunctional savers like me a license to spend. 

I’ve challenged the financial services industry to solve the safe withdrawal rate as a 30-year TIPS ladder now produces a 4.5% inflation-adjusted cash flow. iShares and LifeX have made progress. Fees are falling and Nate Conrad, head of LifeX, told me the expense ratio of LifeX’s Longevity Income ETFs will be cut by half to 0.25% beginning on Feb. 19.

For now, any ultra-low-cost, long-term-level TIPS ladder must be built manually. TipsLadder.com makes it a whole lot easier than when I first built my own. 

While I think TIPS and TIPS ladders are great, I also tell people not to put more than 25% of their fixed income in TIPS. Though buying TIPS and holding until maturity is the least risky asset on the planet (inflation-adjusted and backed by the US Treasury), I can think of at least three ways it could go wrong.

A TIPS Ladder Is Volatile in the Long-Term 

The duration of a 30-year TIPS ladder is about 13.5 years. This means a one percentage point increase in real interest rates would equate to about a 13.5% decline in value. And, of course, those longer-term TIPS really get hammered if real rates rise. Rates are 30 bps higher than when I built my million-dollar TIPS ladder 18 months ago. While I’m going to get back exactly what I bargained for, in hindsight I should have waited. No one can predict rates though. 

I advise clients and readers that after they build the TIPS ladder, it’s critical to do nothing. This isn’t as easy as it seems: The value of the TIPS can be seen in real-time, so the same behavioral instincts make it painful to see a loss. Ironically, insurance annuities are pain-free as you don’t see the market value, yet these products expose people to extreme inflation risk rather than help solve the issue. 

TIPS and Political Risk 

I’m not terribly worried that the US Treasury will completely default, as I suspect just about every asset class would tank with it. Still, there are other risks such as: 

• The government changes the measure of inflation in a way that lowers the crediting. For example, the chained CPI is lower than the currently used CPI. And who is to say that someone couldn’t come up with an even lower calculation. I’m not one to say the current CPI is an intentionally misleading measure but everyone’s inflation is different.
• Another risk is that laws could change such as scrapping current laws that make interest from TIPS (and all Treasury bonds) state-tax exempt.
• And there could always be some draconian measures such as the government declaring a three-month period where interest will not be credited. Of course, there’s always the possibility that the debt limit isn’t raised and there is a default that lasts more than a few days. 

TIPS and Inflation Risk 

While TIPS helps solve the risk of high inflation, they are far from the perfect solution. That’s because TIPS provides real inflation-adjusted returns while the IRS taxes us based on nominal returns. I encourage clients to “get real,” as in after-tax inflation-adjusted returns.

Let’s look at an extreme example. Say we put $100,000 in a 10-year TIPS with a 2.5% real yield. If we hold until maturity, we are guaranteed to be paid 2.5% above inflation. Now assume that our national debt catches up with us and inflation turns out to be 20% and we are in the 32% marginal tax rate. All things being equal, the coupon payment plus the increased value of the TIPS will be $22,500 which is what the IRS taxes us on. At that tax bracket, $7,200 goes to taxes, leaving us with $15,300 or a 15.3% return. The obvious conclusion is that the after-tax return of 15.3% was 4.7 percentage points below the 20% inflation.

I’m not too concerned about the phantom income tax as one could sell enough of those bonds to pay the taxes or even hold within an IRA account. Holding TIPS in a traditional or Roth IRA solves this problem but, if you live in a state with high taxes, you lose out on the state tax exemption. 

The one consolation is that a 20-year nominal bond would likely do far worse because, unlike the TIPS, the nominal bond would not be increasing the payment or crediting. I wouldn’t recommend going that far out on the yield curve for nominal bonds as they have too much inflation risk. 

Ironically, TIPS are better if inflation is low. If inflation is zero, the bond in the example produces the full 2.5% above inflation. Deflation, while very unlikely, produces an even better after-tax real return.

Conclusion 

TIPS are a really good basket and the safest investment on the planet. They guarantee a pretax return higher than inflation. But as good of a basket as it is, I tell people never to put all of their eggs in any one basket.