Inflation should always be a concern of investors and especially for those who are retired or are about to retire and live on a fixed income. According to the Bureau of Labor Statistics, which issues the Consumer Price Index or CPI, over the last several years inflation has been low and otherwise in check.

The CPI is simply a measure of the price variance of a market basket of various consumer goods from one period to the next. So what’s the concern, if inflation has been in check for the last several years? Inflation has not always been so moderate and, indeed, with the recent economic stimulus plan and other unprecedented government spending inflation or even hyper-inflation is a real and significant possibility.  

So how does an investor combat inflation or the erosion of purchasing power? Certainly, holding equities is a simple and often effective approach to ameliorating inflation’s effect. Also, using options or futures contracts would do. Sounds good, except that the typical retiree holds or should hold a moderate proportion of his or her investment portfolio in equities, so adding more equities to combat inflation would be contraindicated. And, for the vast majority of retirees, the use of options or futures contracts is far beyond the risk that the typical investor should take.

So is there another approach suitable for most investors? The answer is yes and that approach is to use Treasury Inflation Protected Securities (or TIPS) as a certain percentage of the fixed income component of an investment portfolio.

What are Treasury Inflation Protected Securities (TIPS)?

TIPS provide inflation protection and are issued and guaranteed by the United States government. They are marketable securities which principal balance is tied directly to the CPI. Therefore, TIPS have an advantage over most bonds in both credit quality risk and inflation risk.  

What’s the downside to holding TIPS?

The trade-off to using TIPS is often a lower current income due to an adjusted principal balance indexed to the CPI. TIPS pay a fixed interest rate on this adjusted principal balance.

Therefore, in the event of deflation, the interest payment decreases. At maturity, investors receive either the adjusted principal or the original principal, whichever is greater, thus providing some protection against deflation. Of course, this deflation protection is not as advantageous as the inflation protection for which purpose TIPS are designed.

Currently, do the current rates between TIPS differ substantially from conventional Treasury bonds?

No. The bond market has held a low inflation expectation for the last several years (but this is likely to change soon) and, as a result, the current rates are substantially similar between TIPS and conventional Treasury bonds.

What if inflation rises significantly over the next few years and what if it doesn’t?

If inflation rises significantly over the next few years, the TIPS will most likely outperform conventional Treasury bonds. Of course, if such inflation does not occur, then conventional Treasury bonds are likely to outperform TIPS. Yet, this negative correlative relationship between TIPS and conventional Treasury bonds is precisely what experts in investment diversification seek to accomplish—one asset class or investment vehicle complementing another.

What are the tax implications of TIPS?

All semiannual interest payments and any increases in principal value of the TIPS are taxed as regular income at the federal level. TIPS are exempt from state and local taxation. Therefore, the tax implications of TIPS are substantially similar to conventional Treasury bonds. As such, we recommend that TIPS be held, if possible, in tax-deferred accounts.  

For further exploration of the taxable implications of an investment portfolio we recommend a review of our article titled “Ask an Expert: Tax Engineering Your Investments” in the November 2006 issue of The Greater Lansing Business Monthly.

The big question: What percentage of the fixed-income portion of an investment portfolio should include TIPS?

The answer is the old law school refrain, “it depends…” It depends on how your portfolio is constructed and optimized in relation to other asset classes. The decision to use TIPS is fairly evident. Deciding on the percentage of your fixed-income portfolio that should include TIPS is not as simple, as it involves some complexity and sophistication. We highly recommend the use of TIPS but only in consultation with your fee-only, fiduciary financial adviser preferably trained as an accountant with adequate experience in both using TIPS and in creating optimal and efficient investment portfolios based upon academic, data-driven research principles found in the scholarly literature in the field.

		Stephen L. Hicks, JD, MS, CPA, and Roger L. Millbrook, JD, CPA/PFS, are fee-only fiduciary investment advisers and principals at Siena Capital Management, LLC., in Grand Ledge working exclusively with high-net worth individuals, families and businesses.  Both are accountants and hold law degrees as well as other advanced degrees and designations in the area of financial services.