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How Many TIPS Do You Need?

Christine Benz

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

How to position an in-retirement portfolio's asset allocation is a hugely important question, but it's one that retirees often struggle with.

Here to discuss that question with us is John Ameriks. He is head of Investment Counseling and Research at Vanguard.

John, thanks for being here.

John Ameriks: Thanks for having me, Christine.

Benz: So, John, I'd like to discuss one question that we've debated with users on Morningstar.com. This question of how much to hold in TIPS within a fixed-income portfolio. What's the right level of allocation for that asset class.

Ameriks: Sure. Well, it's a tough question. I mean TIPS are a very unique asset class and that actually, I think, was reflected. I know the Barclays committee just got together and talked about the aggregate and whether it would include TIPS. And I know, at this point, have made the decision that it won't be included in that aggregate.

But for an individual investor, you've got to think about what type of inflation protection do you really need. I think the higher your need for a CPI-linked sort of disaster protection in terms of inflation, the more you're going to want to look at TIPS as a part of the portfolio.

So, in our target-date funds in the retirement income portfolio--and that portfolio is 70% fixed income, 30% equities--20% of that portfolio is in TIPS. The remainder in a broad-based domestic fixed income.

So, that's what we're doing in the target-date fund exposure for, I would say, a default situation for somebody who is looking at spending from their portfolio gradually over time in retirement, but looking at spending that down. Their objective is to make it last as long as they do basically. They are not really looking to grow that portfolio. That type of an allocation might be something to consider.

Benz: So, how would I know if my need for inflation protection is greater than my neighbor's need for inflation protection in retirement?

Ameriks: Well, a lot of it may come down to different aspects of your financial situation. There are some folks who, matter of fact more than, I think, people expect, that are getting into retirement now, they do have a pension income that may come from a state or local government or from the federal government, that has literal inflation protection embedded in it, and for those people maybe the need for something like TIPS could be a little less than for someone else.

A lot of folks are getting some of their income from property, other sources that may have some inflation component built into it, maybe their need for TIPS allocation is a little less. So it really does come down to personal circumstances and thinking about, well, how will the rest of my income deal with an inflation surprise, and to the extent that you see a risk there and exposure there, TIPS may make some sense.

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Benz: So, another question I want to tackle with you, John, is how you see the retirement income landscape evolving? This is such a hot issue, and I think there is some discussion about whether the way 401(k) participants are treated, where they are sort of handed this basket of money at retirement is maybe not optimal--that you see people really struggling with what to do with that money and how to manage it. What are your thoughts on how this landscape will unfold?

Ameriks: Well, it absolutely is the hot topic these days, trying to think about what people are going to do with money that's in their retirement plans. And I think people have a lot of questions – I am not so sure that they are struggling so much. They do have a lot of questions. They are interested in getting a lot of different opinions, but at the end of the day, most retirees are pretty reasonable about how they proceed. They look to their portfolios for what income they generate. They are very prudent in terms of drawdown around when they are taking balances out.

I think the notion that there is one way that this is going to evolve and that is going to focus on income solutions and that those people who get to retirement really just want to flip a switch and turn the income on, I don't think that's related to real-world behavior.

I mean, let's look at what's happening with pension plans. Right now, increasingly over the last 10 to 20 years, pensions have added the options for people to get lump sums rather than annuity payments. And when those options are offered, overwhelmingly, people will choose to take a lump sum payment rather than the income from a guaranteed pension. So it's the retirement landscape, and we talk about it as financing retirement rather than retirement income. I think it's a mistake to focus overwhelmingly on income.

Absolutely, people need to replace their paychecks and they need to think about how they are going to pay their bills. But that's not the only thing that's on their mind. They are also worried about unexpected events that could occur in retirement. Those can be good or bad. And they need to have the financial resources to be able to deal with those. If it's a medical expense, they may need to go to a specialist that isn't covered at the same rate that other doctors are, or they may have an unexpected grandchild and want to pay for that ritzy college that they get into. So they need to preserve their assets to have that flexibility.

Benz: So a related question, though, is the challenging fixed-income environment. So we're in a period where yields are about as low as they can go and the prospect of higher interest rates is looming large. So that arguably compounds the challenge for today's crop of retirees.

Ameriks: It does. And we really need to be careful as we talk to them about strategies that you have to be very careful and think about total return on a portfolio and what your return expectations are long term. We do worry a little bit about retirees that get attracted to what are essentially riskier instruments, something like high yield, because they are interested in that higher yield, and we just need to be very, very careful.

When you've got a portfolio that's built around income-generating sectors in the economy, you are going to lose some diversification benefit. That can happen in bonds, with high yield. That can happen in equities as people are still stinging from some of this, given what happened in 2008 and 2009, because a lot of the companies that were generating high dividends were in the financial-services sector that got hit so hard.

So people need to think broad diversification, pay attention to the overall portfolio, and I think focus on the long term when you are setting a withdrawal strategy.

Benz: So one last question related to fixed income is the fact that the next couple of decades in fixed income may not be as hospitable as the past few have been, and how do retirees think about that question when managing their fixed income portfolios? And does it call for a lower fixed income weighting than may have been the case for, let's say, our parents or grandparents?

Ameriks: I think it all comes back to risk and return again and thinking about diversification very broadly. Retirees, most of them are old enough to know and have been through enough to know that things change and you don't always and  even what the market expects may not be what materializes.

You need to understand that you need a broad portfolio; you're going to need both growth and some income going forward, and finding a balanced portfolio is going to be the right approach for most people.

Benz: Okay. Well, thank you, John. Thanks for sharing your insights.

Ameriks: You're welcome. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.