“Changing expectations of inflation may have your advisor recommending TIPS. But you should know they don’t work like conventional bonds and may carry more risk.” Lyle Boss
What exactly are TIPS?
Treasury inflation-protected securities (TIPS) are a security issued by the U.S. Treasury. TIPS are indexed to inflation to offer investors protection against a decline in the purchasing power of their dollars. When inflation rises, TIPS will adjust in price to maintain its value.
Although Treasury Inflation-Protected Securities, or TIPS, work similarly to conventional bonds, they are missing one essential component in the form of guarantees. TIPS are not guaranteed investments. Because they are not guaranteed, even though they index to inflation, they may not go up in value during an inflationary period.
As with other equities, TIPS moves more with investor expectations than inflationary reality. Relying mainly on expectations means that TIPS are more likely to outperform regular bonds if the actual inflation rate turns out to be higher than expected. If inflation proves to be lower than expected, TIPS may underperform conventional bonds.
Some people turn to TIPS and mutual funds that invest in TIPS for portfolio protection. They can be a good choice when inflation runs high since they offer stability and relatively low market risk while other securities may not. Investing in TIPS is often seen as more of a short-term strategy.
What are the pros and cons of TIPS?
TIPS have two primary benefits:
- TIPS offers low market risk: Because they are Treasuries backed by the U.S. government, TIPS offers somewhat lower investment risk than other types of investments.
- TIPS has a low inflation risk. Since they are indexed for inflation, TIPS have nearly no inflation risk as long as an investor’s ‘personal rate of inflation” is close to the Consumer Price Index. (CPI)
TIPS are not without risks, though. The most critical of these are:
- There is a possibility of price fluctuation: TIPS are low-risk investments, so their market prices may shift substantially when actual interest rates change. Thus, the share price of a mutual fund investing in TIPS can vary significantly over the short term.
- There is deflation risk: Deflation is the risk of a general decline in prices deflation. It is the opposite of inflation. In a long period of deflation, TIPS could potentially lose some value.
Could annuities be a better option than TIPS?
Both annuities and bonds are part of the “fixed income” asset class. Since bonds trade on the market, investors traditionally have used them more often when creating the “safe money” part of their retirement portfolios.
However, several retirement planners have recently begun nudging their clients away from bonds and into income annuities. A growing body of data, including papers produced by prominent retirement researcher Dr. Wade Pfau, indicates that the most efficient retirement portfolios have stocks and income annuities but no bonds. According to Pfau, this mixture best addresses retirees’ primary retirement goals: not running out of money and leaving a legacy to loved ones. Pfau believes that because income annuities offer “mortality credits,” they will outperform bonds and bond funds in the long term. Dr. Pfau’s research also points to potentially having more significant liquid financial assets later in retirement by putting some of your money into annuities.
TIPS or TIPS funds may be a wise addition to a diversified portfolio for some pre-retirees and retirees. But, even though TIPS are a type of fixed-income investment, you should be aware that they do not work the same way as corporate bonds. Annuities are another possibility, especially if you are concerned about having enough money to last your retirement or want to create a legacy. Talk to a Certified Financial Fiduciary (CFF) about all your fixed income options before making any decisions.