TIPS for Retirement?
I have written about Treasury Inflation Protected Securities (TIPS) and I Bonds on several occasions over the years. In April, I wrote about how I use five year TIPS to construct a five year bond ladder which I use for personal cashflow needs. The article has links to several additional resources on TIPS. In June, I followed up with an article about using TIPS and I Bonds to hedge against inflation.
In recent months, the real yield of TIPS has increased substantially. At the time of my April article, the real yield on five year TIPS hovered around 1.25%. The real yield has since doubled to 2.5%. TIPS principal receives an inflation adjustment based on the CPI-U index with the bond’s coupon rate applied against inflation adjusted principal.
Current TIPS yields can be found on the Department of the Treasury website. As of October 4, TIPS yields were as follows:
- 5 Year: 2.54%
- 7 Year: 2.46%
- 10 Year: 2.40%
- 20 Year: 2.41%
- 30 Year: 2.44%
As we can see, the real yield curve is essentially flat, with longer maturities offering only slightly lower yields than the five year which offers the highest yield. Taking the 20 year TIPS as an example, the recent rise is best viewed as a return to market conditions that prevailed prior to the financial crisis.
In my opinion, the primary purpose of retirement savings is not to get rich but to avoid financial distress in old age. Within a tax advantaged vehicle such as an IRA, a thirty year TIPS could roughly double a retiree’s purchasing power, assuming reinvestment of coupons at the same rate. At first glance, this seems like an attractive deal for at least a portion of one’s retirement savings. While it is true that stocks should offer a higher real return, there is value in a “sure thing.”
But can we view the real yield on TIPS as a sure thing? As I wrote during the debt ceiling debate earlier this year, it is highly unlikely that the United States government will ever default on treasury securities. Regular treasuries are denominated in nominal dollars and the government will create whatever nominal dollars are needed to pay debt, even if the purchasing power for debt owners is substantially degraded.
When it comes to TIPS, the principal value is adjusted based on the CPI-U index, but the government controls the definition of the CPI-U and has repeatedly modified the calculation of the index in ways that reduce reported inflation. There’s plenty of debate over whether the modifications were warranted, but the point is that the government can “default” on TIPS in the sense that it controls CPI-U and there is very limited recourse for owners of debt who disagree with the government.
But let’s step back for a moment and consider whether the CPI-U is an accurate measure for what many retirees are trying to hedge against in old age. Medical costs represent a very significant component of potential costs in old age, particularly long-term care costs that are not covered by Medicare. The following exhibit published by Peterson-KFF is based on an analysis of components of the CPI published by the BLS. The green line represents medical costs while the blue line represents overall prices.
Many people, myself included, seek to have enough resources in old age to prevent themselves and others in their family from ending up in an institutional setting such as a nursing home or assisted living facility. Accomplishing this objective requires a significant amount of reserves given that in-home healthcare can cost over $30 per hour in many cities, amounting to over $250,000 per year for 24/7/365 care which would be in addition to the many other costs a person in such a situation would incur.
Using TIPS yielding ~2.4% plus CPI-U to self-insure for in-home nursing care in three decades seems very attractive but we have no way of knowing whether such costs will inflate at the rate of CPI-U. This raises a broader topic of one’s personal inflation rate.
Even if the government does nothing nefarious in its calculation of CPI-U in the future, the fact is that such an index will never measure an individual’s personal cost of living accurately since everyone consumes a different basket of goods and services. It is difficult for many people to anticipate their cost of living in retirement. Certain costs, such as commuting and purchasing clothing for work, will disappear while other costs, such as travel, may initially increase. Later in retirement, medical costs are unfortunately very likely to increase dramatically.
I’m personally undecided at this point regarding using longer term TIPS for retirement. At least investors have options today that were entirely lacking for many years when the real yield on TIPS was minuscule or even negative. With a real yield of between 2-3%, it seems like TIPS at least deserve consideration in a diversified retirement portfolio, especially if one believes that inflation will average more than the currently implied ~2.4% represented by the difference between the yield on the regular thirty year treasury bond and the thirty year TIPS.
This article represents the author’s opinions and is not meant to be investment advice. The author is not an investment advisor. Readers should consult their investment advisor before making any financial decisions.
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