2 Ways Long-Term Investors Can Benefit From Buying TIPS

TIPS are issued by the U.S. Treasury and are indexed to inflation. They protect investors from a decline in the purchasing power of their money. The principal will be adjusted for inflation each year as measured by the Consumer Price Index for All Urban Consumers (CPI-U), and TIPS also pay a small coupon semiannually in cash. 

Unfortunately, the IRS taxes both the inflation adjustment (not paid in cash) and the coupon payment. This phantom income isn’t nearly as bad as it sounds. It’s a timing issue in that taxes are paid sooner but not more in total. I consider it an annoyance rather than a deal breaker. But TIPS are also exempt from state and local income taxes so they could make sense to hold in a taxable account if the client lives in a state with high income taxes. You can read more on TIPS taxation in this Wall Street Journal article.  

TIPS are hot now because of the surge in real interest rates. In the beginning of 2022, TIPS yielded inflation minus about 1% annually—not very appealing. You could lock in an investment guaranteed to lose spending power. Now the yield on TIPS has surged by 3.3 percentage points to inflation plus about 2.3%. This allows us to lock in a guaranteed increase in spending power, at least before taxes. To get these returns, however, one must buy the individual securities and hold to maturity rather than a TIPS fund that rolls over to new TIPS.

Though clients tend to think in nominal terms, I advise them to “get real,” as in think about real returns, after the impact of inflation. It’s the increase in spending power that matters. We are in uncharted territory with record high debt and deficit spending and no one knows what long-run inflation will be. TIPS help protect investors from this potentially devastating unknown.

Consider these two strategies. Both can can offer protection for investors in different life stages.

Wealth without risk. If I asked you if you want a good part of the return of the stock market without risk, you might think I’m trying to sell a fixed indexed annuity (FIA). I’m not, as those have high fees and aren’t guaranteed to beat inflation. How about an investment guaranteed to beat inflation with an expected annualized return of 4.4%? Mark Hulbert recently wrote about this virtually riskless wealth building strategy in MarketWatch. 

Using $100,000 and a long investment horizon of just over 26 years, one buys a 2050 maturity TIPS yielding 2.338% with $54,492 and puts the other $45,508 in a low-cost stock index fund or two. Assuming you let the semiannual coupons accrete, that TIPS will mature with $100,000 of spending power in today’s dollars (that’s the principal, which will be adjusted for the actual rate of inflation). If stocks match their long-term historical real annualized return of 6.05% since 1793 (according to Edward McQuarrie, an emeritus professor at California’s Santa Clara University), one will best inflation by 4.4% annually or nearly triple their spending power, before taxes. For maximum tax efficiency, the equities could be held in a taxable account while the TIPS could be in an IRA. 

The longer the period one can hold the TIPS, the greater the proportion that can go into equities. But this can work for shorter periods as well with a greater proportion in TIPS so there will be less of the return coming from equities, which hopefully will outperform. 

TIPS ladder—a license to spend. The prior strategy is for accumulators but what about during the drawdown stage in retirement? What’s a safe spend rate, increasing annually with inflation? Some think it’s as low as 1.9% annually over 30 years. Morningstar’s latest annual research shows it at 4.0% but that assumes no fees and disciplined rebalancing. Even that has only a 90% chance of success and a 10% chance of failure, in this case, running out of money before the 10-year period is over.

But a 30 year-TIPS ladder can support a 4.56% safe withdrawal rate as of Nov. 18, 2023 with 100% certainty. And one could get a 4% safe spend rate by putting roughly 86% in the TIPS ladder and the other 14% in equities. I first constructed a $100,000d TIPS ladder for myself and quickly increased to $one million. I describe it in detail here and now often do the same thing for clients. You can use TIPSladder.com to quickly construct a ladder and see the real yields and cash flows.

I’m not suggesting anyone have the majority of their assets in this TIPS ladder but, for my clients and me, the TIPS ladder and Social Security provide a floor of inflation-adjusted cash flow for the next 30 years. So in a worst-case scenario, which savers tend to worry about, the client feels comfortable they could live on this cash flow. Retirement researchers David Blanchett and Michael Finke call a predictable cash flow like the TIPS ladder a license to spend.

How long will these strategies be attractive? Neither of these strategies would have worked well when TIPS yields were negative. No one knows how long real rates will be this attractive or whether they will go even higher. That said, consider using TIPS and holding to maturity to lock in growth of spending power for the future. 

Allan Roth is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He is a licensed CPA and CFP, and has an M.B.A. from Northwestern University (Kellogg), but still claims he can keep investing simple.