How Much Should Retirees Stake in TIPS?

Retirees and pre-retirees have been challenged by the investing environment during the past several years, to put it mildly. In addition to contending with the epic bear market from 2007 through early 2009, many retirees are complaining that it's next to impossible to generate a livable income stream from their portfolios given ultralow bond yields. To cover their day-to-day expenses, retirees are having to choose between tapping their principal or venturing into higher-yielding, but also riskier, securities such as preferred stocks. Neither is an especially appealing prospect. Others, meanwhile, are concerned about what could happen to their bond portfolios if interest rates were to jump up, which has been happening recently.

And while inflation currently appears to be in line with historical norms, retirees are also rightfully worried about the potential for rising inflation to gobble up their portfolios' future purchasing power. I usually recommend inflation-linked securities like Treasury Inflation-Protected Securities as the most direct way to hedge against inflation. But even investors who are convinced that TIPS are a good place to be long term still have questions about implementation. How much of a retiree's fixed-income portfolio should go toward TIPS or other inflation-linked bonds? And what about timing? If you buy TIPS at an inflated level (pardon the pun) and the bonds' prices sink shortly thereafter, do you erode any long-term benefit you hoped to gain from them?

The Importance of Being Inflation-Protected
I'll discuss these questions in a minute, but first it's worth fleshing out why a dose of inflation protection is so important for retiree portfolios. In large part, it's because retired folks miss out on some of the inflation protection that working people normally enjoy.

Paychecks will generally trend upward to keep pace with rising prices (maybe not right away and not for everyone, but over long periods of time and on average), but retirees don't have that safety net. True, Social Security payments are adjusted upward in an effort to keep pace with rising prices. But to the extent that a retiree is living off a portfolio anchored in fixed-rate investments, the payout from that sleeve of the portfolio will be just that--fixed. If prices go up, the purchasing power of that portfolio--and in turn the retiree's standard of living--goes down.

That's why inflation-indexed securities like TIPS, whose principal values adjust upward to keep pace with inflation, make so much sense as part of a retiree's fixed-income portfolio.

How Much Is Enough?
So assuming you've decided you'd like to include inflation-protected investments in your portfolio, what's the right amount? At first blush it might appear that you'd want all of your fixed-income portfolio in TIPS; that's the tack embraced by some academics and other investment theorists. After all, if there's a bond investment that helps offset the corrosive effects of inflation, why would you want to forgo it for one that doesn't offer that protection?

The key reason is diversification. Although some corporate, foreign, and municipal bonds carry inflation protection, TIPS are the most widely available and liquid type of inflation-linked bonds, and most inflation-protected bond funds skew heavily or even entirely toward TIPS. That means an investor in search of an all-inflation-protected fixed-income portfolio would have to go out of his way to avoid a heavy emphasis on government bonds; at the same time, he'd hold relatively less in corporate, asset-backed, and other bond types, which will outperform Treasuries and other government-backed bonds at various points in time.

So the answer to the question about how much retirees should hold in TIPS falls somewhere between zero and 100%. But where?

A survey of various target-date mutual funds geared toward investors in retirement shows that the major financial-service providers have not come to a clear consensus on this topic. Some income-oriented target-date funds have staked nothing in dedicated TIPS investments (possibly because the sponsoring firms lack an in-house TIPS investment?), while others have relatively robust weightings. For example,  Vanguard's Target Retirement Income (VTINX) has about one third of its fixed-income portfolio in a TIPS fund.

One starting point for determining an appropriate allocation to TIPS is to take a look at Morningstar's Lifetime Allocation Indexes, which were developed in conjunction with Ibbotson Associates. (Here's a document discussing how Ibbotson has allocated the assets for these indexes; in short, Ibbotson creates optimal portfolios based on the historical behavior of various asset classes.) The indexes geared toward investors of retirement age all make room for a healthy slice of TIPS--anywhere from 20% to nearly 40% of their fixed-income weightings. And the larger the bond stake overall, the larger the percentage of that fixed-income weighting that lands in TIPS. For example, the allocation for a conservative investor who retired in 2000 includes a 68% fixed-income weighting, 22 percentage points (or 32%) of which is in TIPS. By contrast, the aggressive allocation for a new retiree has a 33% overall fixed-income weighting, 8 percentage points (or 24%) of which is in TIPS. This document includes TIPS allocations for various age bands.

Must Have Been the Right Place, Must Have Been the Wrong Time
So far I've been discussing TIPS allocations in the context of strategic allocation--namely, long-term and hands-off strategies. But there are occasions when an asset class that makes perfect sense from a long-term strategic perspective becomes unattractive from a valuation standpoint. If you've decided your portfolio needs TIPS, does it make sense to barrel in there regardless of the current market environment?

Clearly, TIPS are far from the screaming buy they were in late 2008 and early 2009, when these securities were priced as though inflation would never rear its head again. TIPS went on to enjoy a tremendous runup for the rest of 2009 and skyrocketed again in 2011, eventually resulting in negative real yields for TIPS. There's also the issue of how rising interest rates would affect TIPS. Although they wouldn't likely be as adversely affected as nominal Treasuries, they wouldn't be immune to a sharp upward spike in interest rates.

Given that backdrop, TIPS investors might be inclined to take a more tactical approach, adding to TIPS when they appear cheap and lightening up when they're dear, or moving assets among TIPS of various maturity ranges. Given that most investors would prefer to be more hands-off, however, I'd advise a simpler approach to mitigate the risk of buying TIPS at a high point. If you've determined that your portfolio is light on TIPS now, consider dollar-cost averaging into a high-quality, low-cost TIPS fund during a period of a year or longer. Harbor Real Return and Vanguard Inflation-Protected Securities (VIPSX) are two of our analysts' favorite actively managed funds;  iShares Barclays TIPS Bond (TIP) is a worthwhile exchange-traded fund choice. 

A version of this article appeared Nov. 15, 2011.

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