Although they haven’t yet seen the kind of inflation that plagued the U.S. economy in the 1970s, TIPS exchange traded funds (ETFs) are still seen as a great way to hedge rising prices. But do they work as well for those of you in retirement?
Charlie Farrell for MoneyWatch says that retirees he speaks to often bring up inflation as one of their prime concerns. [Watch Tom Talk Inflation-Protection on CNBC.]
TIPS, also known as Treasury Inflation-Protected Securities, are designed to hedge inflation by linking the principal to the Consumer Price Index (CPI). Farrell gives this example:
Assume the CPI climbs to 5% a few years from now. If you own a TIP bond, the principal value of the bond will increase by 5% that year. And the interest payment you receive on the bond will be applied to that larger principal value. That means you have an asset that has gone up in value with the CPI and you received an increase in your income equal to the increase in the CPI. It’s similar to getting an inflation adjusted raise at work.
The main thing to keep in mind with TIPS is that the bond principal value will go up if the CPI increases, but you don’t have access to that increase until you receive your adjusted principal value at maturity. Essentially, the CPI increase is added to the value of the bond, and when it matures, the U.S. Treasury pays you that increase. [TIPS ETFs Give ‘Em Some Time.]
But here, Farrel says, are why TIPS may not necessarily be the best option for retirees:
- The increase in the CPI adjustment each year is taxable to you, even though you don’t really get the money. If you hold TIPS outside of an IRA or qualified retirement plan, you will owe tax on “phantom” income.
- TIPS are a great hedge in a portfolio over a period of at least 10 years. If an income stream is what you need for retirement, there may be better options out there, such as other fixed-income securities and dividend ETFs.
Either way, right now, the U.S. economy isn’t in an inflationary environment, which means it’s not a favorable environment to own TIPS. Once inflation does appear, however, you’ll find a number of ETFs available to play it, including:
- iShares Barclays TIPS (NYSEArca: TIP)
- PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
- Schwab U.S. TIPS (NYSEArca: SCHP)
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.