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By Christine Benz | 10-18-2012 04:00 PM

Inflation Protection: When TIPS Aren't Enough

The government reported CPI rate, which TIPS are linked to, might not be relevant for everyone in every stage of their life, says Vanguard's Chris Philips.

Christine Benz: Hi, I'm Christine Benz for

With the Federal Reserve's latest round of quantitative easing, some investors have grown concern that inflation could spike. I recently sat down with Chris Philips, who is a senior analyst in Vanguard's Investment Strategy Group, to discuss the best ways to inflation-protect a portfolio.

Chris, thank you so much for being here.

Chris Philips: My pleasure.

Benz: One hot topic recently, especially with QE3 under way, is this question of inflation and how big a bite it could take out of portfolio returns.

First, one question I'd like to tackle is, you have said that inflation should be sort of a customized target based on my own spending basket. Let's talk a little bit about that, and how I should think about that question.

Philips: I think the challenge we all face is that we see inflation-linked vehicles out there--TIPS are the most popular vehicle out there. But the government reported CPI rate, which TIPS are linked to, might not be relevant for everyone in every stage of their life, and yet that's what the inflation-fighting vehicles are measured against.

So, if you are a retiree, for example, you might have health-care costs that at least for the last memorable history, have been increasing much faster than CPI. If you have a disproportionate amount of your expenses in food or energy, which tend to be very volatile, they can be much greater than CPI, they can be much less than CPI. These are factors that we would want to consider when thinking about the impact of inflation on us as citizens, but also our investment portfolio and our ability to meet future obligations, whether it's education, health-care costs, or just the cost of living.

Benz: You mentioned health care and education. Those are two areas that have been running hotter than the general inflation rate. If those are big shares of my overall expenditures, how do I think about actually getting a higher rate of inflation protection? Where do I go for that?

Philips: So, this … gets down to time horizon. So … if someone is starting a 529 plan, for example, and they have a one-, two-, or three-year-old child, and the 529 is out for 18, 19, 20 years in the future, then we would actually look at equities as probably your best vehicle for giving you positive real returns, giving you returns above inflation over that time period. If we were to, say, put all that money into TIPS, yes it's going to track CPI over time, but you might not actually get enough money to fund a child's education because of the low returns you get in a traditional sense.

So, we actually do view equities as being a vehicle where investors that have longer time horizons can hope to pick up that inflation premium, if you will, over the CPI rate.

Benz: And the higher inflation that retirees can expect mainly because they may have higher health-care outlays, you would also say argues for holding equities in a retiree's portfolio.

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