Treasury Inflation Protected Securities (TIPS) protect investors from inflation by automatically adjusting the original face value of the bond for inflation. What I have discovered is that this feature is used for different purposes by different people. I tend to use TIPS as a method of saving principal, but there are those who use TIPS as a “hedge” against inflation within a larger portfolio of riskier investments.
The Saver’s View
I discovered that the way that I look at TIPS is much different than the way investors tend to look at them. Since I look at TIPS as a way to save money for the future, I’m not very concerned about my returns. I’m just trying to preserve the returns that I have already received. I’m also trying to make sure that all of this money is available on a specific date. I also intend for that money to be adjusted for inflation.
The Investor’s View
When investors use TIPS, they are usually trying to make sure that if there is a downturn in other investments that are sensitive to inflation, that they own something that counteracts inflation. This allows their portfolio to lose less money or perhaps even gain money as a result.
Very Different Intentions
These two perspectives come from two very different intentions on the part of the bond holder. One person is trying to preserve and the other is seeking opportunity. This is why I recommend that you divide your money into two parts as I describe in the article: Stressed about Savings? Divide and Conquer!
The Investor’s Bond Market Focus
When we look at TIPS from the perspective of an investor, we are more concerned with counteracting inflation. This can be done by trading bonds that are sensitive to inflation. To TIPS traders, the current market value is more interesting than the adjusted principle. An investor is less likely to hold a TIPS to maturity. For TIPS investors, TIPS mutual funds or ETF’s may make sense. Trading TIPS on the secondary market may also be useful. Bond market traders are also very interested in Yield to Maturity (YTM). That’s because they are concerned with the return on investment. Without a good return, it isn’t a very good opportunity. This may not be a big deal in some investor’s minds because the inflation protection may be worth a loss in that part of their portfolio, however.
The Saver’s Inflation Protection Focus
When we look at TIPS from the preservation of savings point of view, we aren’t interested in the market value of TIPS. We are interested in the adjusted principle. Since we intend to be getting this principal someday when the bond matures, that’s all we really care about. We are more interested in seeing how well our savings is being protected, rather than seeing our yield to maturity. As preservers of principle, we are willing to pay some or even all of our yield to make sure that we have our money when we need it.
Taxes are a serious problem for both the investor and the saver. This is one place where the two views tend to come together. Taxes can make it difficult for an investor by taking money away during a successful time causing the money to not be there for a time when things aren’t so successful. This makes swings in income even worse.
For savers, taxes can actually cause us to lose money due to inflation as I explain in the article: “Inflation Protection and Taxes.” Since we don’t make much interest on a savings style investment, taxation can make our preservation costs unpredictable and threaten our attempts to preserve once again.
Be Careful Not to Mix Views
It can really cause you to become paralyzed as to what to do with your money if you flip back and forth between the investing and savings views of looking at TIPS. I find that it is wise to make a conscience effort to think one way or the other when choosing what to do. I tend to use them for savings preservation. I see very little help out there when it comes to looking at these bonds from this perspective. By viewing TIPS in a way that matches your needs, you will be able to make more confident decisions with them.
Trying to decide what to do with the money you have can be stressful. There are plenty of people willing to “help” you invest your money, but they rarely agree on how. Just leaving it the bank doesn’t seem right, but neither does losing it all in the market. I have found that dividing my money into two parts reduces the stress and gives me confidence.
Protection vs. Opportunity
There are two very different points-of-view when it comes to investing money. It’s possible to look at money as something to protect for some point in the future. It is also possible to look at it as an opportunity for gain. Both perspectives have benefits, but they require that we invest in different ways.
When we look at money from a protection point of view, we want to make sure that we don’t lose it. Our concern is not about future gains, but about having something at a specific time.
When we look at money from an opportunity point of view, we are willing to wait in order to get a big gain. We’re hoping to use money in order to get significantly more, but we can’t really control the timing of it.
These two points of view, are at odds with one another. Like the old saying goes, you can’t have your cake and eat it too. We can’t protect something and risk it at the same time. When we choose opportunity, we also choose to risk not having our money at a specific point in time.
Many of the professionals in the financial world are more focused on opportunity than they are on protection. It’s good to keep that in mind when you seek help. If your intention is to protect, you probably won’t need professional help. With a little education, you should do just fine on your own.
Insurance vs. Investments
Those who intend to preserve their money are better off thinking about it like they would insurance. That’s because when you preserve, you are saving what you’ve already earned. You’re just making sure that it’s there for you when you need it. A preservation mentality is helpful when you are saving for specific things. Those things might include maintaining or buying a car. Other things include buying a house, paying for college or for paying for retirement. Preservation is good for those things that you already know that you will probably need.
When you want to use your money to take advantage of growth opportunities, insurance doesn’t really make sense. That’s because you’ve accepted the risk that your money won’t necessarily be there at a specific point in time.
Promise vs. Potential
When we make a decision about where we put our money, we need to decide whether we care more about having a promise that our money will be available, or that we have the potential to gain when opportunity arises.
These kinds of financial arrangements are at odds with each other but they both have their place. If there was no potential for gain, there wouldn’t be a way to have something to preserve. If there was no place to save your money, how could you keep what you have gained for a time that you need it?
Determine Your Timing Related Risk Capacity
When I say “timing related risk,” I mean the kind of risk you expose yourself to by not having money when you need to use it. Considering your timing related risk capacity is a good way to decide whether you should preserve or speculate.
source: nattanan23 (Pixabay)
If you don’t have any savings at all, then you are at risk whenever something doesn’t go right. You really don’t have any capacity for timing risk. If you have no extra money and your car’s transmission fails, you would immediately be in financial trouble. It’s important to have emergency savings and not having it definitely qualifies a timing related risk.
There are other timing related risks you may have. Retirement is an important one. You can calculate the amount of time that remains before you plan to retire and the amount of money you might need for the rest of your life from that point. These projections expose a risk. If your retirement money isn’t there when you need it, you will probably suffer. Other things have timing related risk too, like buying a house, paying for college or paying for family vacations.
When we think about risk, we need to consider what we would feel like if our money wasn’t there when we need it. If the money you are thinking about isn’t going to be needed for a particular time in the future, then opportunity investing is probably a good idea for you. If you know what the money is intended for, then preservation investing would probably be a better idea.
A Helpful Separation
I have found it helpful to separate my money into two distinct parts. One is the part I intend to preserve as savings. That part includes my emergency savings, the part of my retirement savings that would pay for my basic retirement needs and any other amount of money that I would rather preserve than take risks with. These may include funds I intend to use as an inheritance or a donation.
The other part is for investments that I believe will eventually be profitable. For these investments, I accept that I don’t know when they will be profitable and I am willing wait.
By taking your savings and setting it aside as something you intend to preserve, you don’t have to worry about how much money it makes. As long as it keeps up with inflation, it will still be there for you. The rest you can use to do some investing. That’s the part you may want to have an investment professional help you with. If things don’t go quite as well you expected them to go, you can rest assured that your savings is still intact.
Professor Zvi Bodie of Boston University said something that really shaped my thinking about retirement savings. He said that we should think about retirement savings more like we think about insurance. When I tried that, I realized that it caused me to challenge the advice about retirement that I often hear and read about. It exposed something that I was seeing that I knew didn’t seem right as I was planning for retirement.
Assurances are not Guarantees
Fund managers want you to invest in their products, but they don’t give guarantees. They are careful to have disclaimers so that we understand that we could actually lose our money. That’s worth taking time to consider. Professor Bodie says that these management companies are in a far better position to understand risk management than the common person, yet they refuse to guarantee that you will even have your retirement savings when you need it. They give assurances, but they refuse to give a guarantee. Professor Bodie says that the reason they don’t give a guarantee, is that they can’t. Instead, they leave the risk of the investment with the person who is least knowledgeable about what they are doing.
A good thing to ask ourselves is: “Why can’t they give a guarantee when they are managing the money?” The answer is: “Because the investments they use are risky and they know it.”
Professor Zvi Bodie does a great job of explaining the problem here in his video:
Is it really Savings?
I think that there is terminology that retirement fund salespeople should not be using. They often refer to the money that we put into mutual funds or the stock market and other volatile investments, as our “retirement savings.” In my opinion, the money we are putting into those kinds of investments are actually “retirement ventures.” Since no one is committed to maintaining a specific amount of money in those accounts, I don’t think that it can legitimately be called: “savings.”
When we use the word “savings” we naturally think of money in a piggy bank or money in a banking institution. In those places, our money is insured in some way. Our piggy bank is locked in our house and our bank accounts even have deposit insurance from the federal government. We naturally expect that when we return to our bank, we will find the same amount or more than we left in it, but that’s not how most “retirement savings” accounts work in my experience.
Unfortunately, we need to be on guard when money managers use the term: “savings.”
Guaranteeing our Savings
There are ways to guarantee savings, and some of them come at a cost. We know that insurance has a cost because many of us have insurance for other things like healthcare, our cars or a house. Insurance costs something because someone else is bearing a risk for us. When we think of something as important as our retirement, doesn’t it make sense to insure that it will meet our basic needs? Sure there are things in retirement, like golf or fancy vacations, that we don’t really need. I’m not talking about that necessarily, but what about food and medical needs? What about the power bill or visiting family for Christmas? Do we want to become a burden on our adult children when it can be avoided?
Zvi Bodie brings up an interesting point in another place. He suggests that we consider the fact that we are willing to pay $1000 for fire insurance for our house even though it is very unlikely that our house will burn down. The chances are very small, yet we still pay for it. That’s because we believe that the seriousness of not having a house outweighs the fact that it is unlikely to happen. What good a house if I am unable to live in it in because my retirement savings has disappeared? It doesn’t really make sense to protect the house and not protect my income.
Two Categories of Retirement Funds
Thinking about retirement in this way leads to dividing our retirement funds into two parts. One part is the part you reasonably believe you can’t do without in your old age. The other part is for things that you hope for, but that are not critical to your survival. When we divide it up like this, and get insurance for the critical part, it can lead to peace of mind knowing that our critical retirement needs are guaranteed to be there for us.
Guaranteed Retirement Options
When it comes to ways to guarantee the critical part of your retirement, you might be imagining a large piggy bank or perhaps a bank CD. If you have been reading my blog, however, you know what I think about that. Both piggy banks and CD’s are not usually inflation protected, which means that they are not a guarantee. They fail to be a guarantee because you don’t know what the contents of your piggy bank will buy in 30 years when you need it.
There have been CD’s that were “inflation-linked” in the past but I have not seen any in the last few years. Hopefully, demand for them will increase and they will be offered again in the future.
One obvious form of retirement insurance is Social Security. It is inflation protected and it’s definitely something to consider when thinking about your critical retirement savings. Social Security is likely to go through some changes in the future, but I expect that something very similar to it will be available for a long time to come. There’s more about this investment in the article: Possibly the Most Popular Inflation Protected Investment.
Company or Government Pensions
If you happen to have a job that offers a pension that adjusts your payments for inflation, you are in a good position. When I say pension, I mean the old fashioned kind that doesn’t require that you manage the money and that does provide a written guarantee. Pensions that don’t adjust for inflation, are helpful but they don’t guarantee that you won’t run out of money to pay your expenses in the distant future.
Be Careful With Insurance Annuities
Other insurance products are provided by insurance companies by way of inflation adjusted annuities. I would just make sure that the inflation adjustments are connected to actual inflation and not a flat percentage increase each year. It’s important to understand how much you are paying for that insurance up front too. Beware: Insurance companies use the word “guarantee” in a similar way that fund managers use the word “savings.” Make sure you know what they are actually guaranteeing. Guaranteed percentages are not the whole story. You also need to know the exact amount of principal the percentage is calculated against. If the principle goes down with something other than inflation, it’s not much of a guarantee. Also remember that if the guarantee isn’t in writing, it’s still not a guarantee. Insurance companies do and have gone out of business. Zvi Bodie recommends splitting up your funds between companies.
The Equity in our homes really is a form of inflation protection. Because a house is a physical thing that represents one of our important needs, it’s automatically inflation protected. Its value goes up with inflation because a house is still a house no matter what the value of money is. Just having your home paid off is big part of insuring your retirement.
This presents an option for those who have no heirs or have no other choice. Many of us spend our lives paying the bank to own a house. The tables can be turned. It is possible to sell the equity to the bank and have them pay you to live in your own house. That’s what is called a reverse mortgage.
Once again caution is needed. Make sure to read everything in any contract to make sure that the bank isn’t taking too much for themselves in the deal. They may woo you with assurances that the remaining equity will go to your heirs, but I am told that this is often not the case because of high fees. Again, there’s no guarantee.
Another thing to consider is selling your house to your heirs, with permission to continue living in the house as long as you can. Working a deal with your loved ones could be a practical option and it can be a win-win situation with them.
Inflation Protected Bonds
My favorite option is to use Treasury Inflation Protected Securities and I Bonds for savings that I want to insure. I do have to do a bit more work myself, but fees are low or non existent. These are just boring government bonds that usually don’t make a whole lot of interest, but they do one thing very well: they protect long-term savings from inflation and that’s what I’m looking for when it comes to protecting the critical part of my retirement savings.
How to Buy an I Bond
If you are ready to get some I Bonds right now and protect some of your savings, I’ve made some step-by-step instructions to help you set up your Treasury Direct account and purchase your first I bond.
So, you are at the point where you have decided to stay out of the market and all you really want to do is save what you have for later. The problem is, you haven’t found a way to save money for longer than a year or so, without feeling the effects of inflation. A simple look at the inflation rates reveal that you would have to get an interest rate of somewhere around 2% just to break even! With 5 year CD rates at 1.5%, you realize that you would be paying the bank half a percent to keep your money from you! If you were an irresponsible spender, that might make sense, but you are serious about saving. Now, am I the only one who thinks this is crazy? Why are more people not upset about this?
Running Toward Risk
One reason might be that people have been placated by the possibility that they could make money using the stock market. It’s hard for me to believe that this was not the intent of denying us the right to save our money. I believe it is dishonest for any government to act like money is money if it can’t be saved for more than a few months. It would also be pretty hypocritical for a government to complain about the number of people without savings, if they haven’t even provided a way to save this so-called money. Well, I’m happy to inform you that they actually have provided a way to save. There must be a few godly people in the government because they gave us a way to save money that can actually avoid much of the exposure to inflation. In the United States, there are actually two ways. They aren’t perfect, but they do appear to be a step in a good direction. This information is so little known, and so important, that I really wanted to share it.
The Old Way
I’m going to assume that you are familiar with how a savings account accrues interest. It’s important that you also understand how CDs or Certificates of Deposit work at the bank too. A typical CD is a special account in which you give the bank your money for a dedicated amount of time with the promise from them to pay you interest. If you take your money out early, there is a penalty. The interest is calculated on the amount of money you initially put into the account, plus any interest accrued. Now if that interest rate is less than the rate of inflation, you are actually losing money. That’s because what you can actually buy with the money has become less over time, while at the same time, the interest didn’t increase fast enough to give you the same purchasing power your money had when you earned it. So what did the United States Government do to help us in this situation?
The New Way
In 1997 the United States Treasury provided a new way of saving by issuing something called: “I Bonds. ” In order to understand what those are, you kind of need to understand what a normal “bond” is. Stocks and bonds are really different even though they are often spoken of together. When you “buy” a bond, you are actually loaning your money to someone. Pretty confusing right? It sounds like you are purchasing something when, in reality, you are loaning someone else your money! Well, no matter what it seems like, that’s what it is. When you buy a bond, you become the bank. You can loan money to companies by buying corporate bonds. You can also loan money to a government by buying government bonds. That’s one way that United States Treasury finances their needs and they allow individuals or institutions to buy bonds. One institution that does this is, … surprise…. your bank. In fact, those CDs you get are often backed by government bonds. I tell you this to help you understand that that these I Bonds are not really a new risk to you. You are accessing the same United States Treasury only in a different way. Let’s look at how a typical bond earns money for you.
A good old-fashioned bond used to be printed on paper, kind of like a dollar bill. On the face of this bill, it had a value, like $100. If you were to buy this bond at its face value you would loan the government $100 and they would give you this bill. In those days, part of your loan agreement was that every six months or so, the government would pay you by sending you a coupon in the mail for all the interest they owed you on that money so far. You could then go cash the coupon and use the money. That was your interest for allowing the government to use your $100. Another thing about your bill is that it would have a term associated with it that was recorded in a book somewhere. That’s the amount of time you agreed to allow the government to use your $100. When time is up, you can cash in your bill to get your $100 back. As long as they are using your $100, they promise to keep sending you your interest as coupons in the mail. Well, it’s pretty obvious that computers were bound to change this process a bit.
Buying Treasury Bonds Today
Now days, we use the same terms, but the paper is almost gone. You still can buy a bond, but the coupon never gets sent to you, it just accumulates in an account. In fact, the Treasury is willing to compound the interest now just like a CD. Not only that, you can go to the Treasury’s web site and open an account online, just like using online banking. Anyone with a Social Security Number is eligible. Their website even has a clever name:
Yes, you have your very own online bank account waiting for you, but wait, there’s more. Let’s go back to talking about I Bonds. I Bonds, or more accurately Series I Savings Bonds, are what the Treasury calls “Inflation Adjusted Bonds”. That’s right. They’re bonds whose interest is tied to inflation. That means that when inflation goes up, the interest rate on these bonds go up too. Part of the interest calculation is connected to an index that follows the cost of goods in the United States called the CPI-U. The CPI-U is a good topic for another article. It’s good to know, for now, that your interest rate will go up when inflation goes up. It’s also important to understand that what goes up, must also come down. If inflation goes down (yes that would be deflation) the rate goes down, but the Treasury decided that they would not allow your bonds to ever go below your original amount. That means you could actually make money in a deflationary time as well. If you want to buy an I Bond, I have step-by-step instructions available at this website.
The Tax Problem
Now let’s say that you are convinced and you’re ready to put some of your savings into one of these I Bonds. First, let’s talk about the down side. I Bonds, unfortunately, are not protected from taxation by the IRS. The United States Tax Code, for some reason, doesn’t recognize the fact that you already earned this money once. Evidently, our congress believed that simply recovering your money’s lost value to inflation is a taxable event and that we owe money for that. This means that you aren’t completely protected from inflation. You will have to treat your interest on an I Bond as “income” and report it. That’s the bad news. This same bad news spans all investments including your bank account. That’s not much comfort, but there are two tax advantages that you also need to consider as well.
First, we are allowed to defer reporting our interest to the IRS. You can choose to not report your interest until you need to use the money. The reason that this is significant is that you can wait to use the money for a rainy day, such as, a year when you don’t have much income. For many of us, that will probably be during retirement. At that time, you may not even be taxed, depending on what other income you have. The other advantage is that these bonds are not taxable by state or local governments, like your bank account is. So, even though taxes make things less than perfect when trying to shelter yourself from inflation, these I Bonds are one of the best things we have.
If you are interested in learning more about the effects of taxes on our inflation-protected savings, make sure to check out my post: Inflation Protection and Taxes.
Some Important Details
Now for some important details about I Bonds: You can buy an I Bond for $25 or more at Treasury Direct, but you can’t buy more than $10,000 in any given year. For many of us, that’s not an issue, but there are some who would like to save more than that. Well, there is another trick… You can use your tax return to buy about $5000 more and guess what, you will get the paper certificates! They are pretty cool, I have to admit. There are more pictures of them at Treasury Direct.
Also, I Bonds are a long-term investment. They act kind of like a CD in that there are restrictions about when you can take the money out. You can’t cash them in for the first full year. Also, you are penalized if you cash out before a 5 year term, but the penalty is not very bad. You would have to give up the previous three months of interest, but that’s it. Since you probably want to save anyway so that’s not a big deal. The good thing is that you can keep your money in this bond for 30 years! Yes you read that right. Anywhere from 5 to 30 years, the government is willing to keep growing your interest rate with inflation and allow you cash out any time. After 30 years the interest stops so it’s a good idea to cash it in and get a new one so you keep earning interest.