TIPS Ladder Funds Don’t Yet Exist, but They Should

A Bright Idea

The world needs another fund like I need a hole in my head. By Morningstar’s reckoning, the globe contains 118,159 distinct mutual funds and exchange-traded funds, 10,289 of which operate in the United States. Most charge premium fees for a commodity service. If they disappeared tomorrow, they could be replaced immediately.

Nor have the industry’s more-idiosyncratic creations excelled. In recent months, I have highlighted the failings of tactical asset allocation funds, option-income funds, and thematic investing. At least those categories still exist. At various times in the industry’s past, “government plus” funds, 130/30 funds, and short-term multimarket funds were marketing triumphs. They now sleep with the dinosaurs.

Recently, though, financial planner (and author) Allan Roth suggested a truly useful fund innovation: a portfolio that holds a ladder of Treasury Inflation-Protected Securities. No such funds currently exist. But they should. Such a creation would be triply attractive.

Three Advantages

First, TIPS ladders are unique. No current fund behaves similarly. In a fund world dominated by me-too products, being different is valuable.

Second, TIPS ladders aren’t just distinctive—they’re distinctive and useful. True inflation hedges are rare. With enough time, stocks usually do the job, but as 2022 demonstrated, they offer no guarantees. Nor did most other presumed inflation hedges prosper last year, aside from commodities. Gold was flat, cryptocurrencies were worse than flat, and TIPS outside of ladders were disappointing. But TIPS ladders delivered on their promises.

Third, TIPS ladders are laborious for retail investors to construct. Although publicly available software eases the process, building a TIPS ladder nevertheless requires as many as 30 separate purchases. The endeavor is not only time-consuming, but imprecise for those without large budgets. For such tasks were professionally managed funds created.

TIPS Ladders

TIPS ladders, of course, are subsets of bond ladders, which exist to mitigate the risk of investing at a poor time, thereby receiving a paltry return. For example, the yield on a 10-year Treasury note in June 2020 was a miserly 0.70%. Those who invested with a bond ladder are now receiving principal repayments that may be reinvested at much higher rates, while those who did not remain trapped.

TIPS ladders take the concept of bond ladders a giant leap further. Whereas traditional ladders merely reduce investment risk, TIPS ladders eliminate the possibility entirely. In that they are unique. Conventional Treasuries face no conceivable credit risk, but they certainly court inflation risk. A Treasury bond that pays 4% when inflation is 6% is a loser, in real terms. The same holds for corporate bonds and annuities, no matter how creditworthy their issuer.

In contrast, every inflation-adjusted penny from a TIPS ladder is known in advance. The current available annual payout for a 30-year TIPS ladder is 4.27%. The first year that investors own such a ladder, they will receive $4,270 on a $100,000 purchase. The next year they will receive that same $4,270, multiplied by the previous year’s inflation rate. The same holds for all 30 years.

No other investments can make such a claim. Social Security receipts and some pensions are inflation-adjusted, but unlike TIPS ladders they cease upon the recipient’s death. The same caveat holds for the relatively few lifetime annuities that are sold with cost-of-living adjustments. Not so for TIPS ladders. Because they consist of marketable securities, their owners’ health is immaterial. Should the investor in a TIPS ladder perish, the asset will pass untouched to a beneficiary.

A Fixed Lifespan

TIPS ladders do possess one major deficiency: They self-liquidate. Their payments consist both of true income, earned by the underlying TIPS, and by return of the investor’s capital. Thus, when the specified term of the TIPS ladder expires, so too do its assets. They are exhausted by the investment process.

That drawback may seem a step too far. Why accept 4.27% from an immolating investment when one can buy a lifetime annuity that currently pays more, and which carries no expiration date? Two reasons. First, as already mentioned, the annuity’s lifetime feature cuts both ways. Second, if inflation is substantial the real value of a nominal distribution, as made by annuities and conventional bonds, shrivels. Twelve years of 6% annual inflation halves purchasing power.

The Second Rung

A TIPS ladder fund would be a specialized investment. The concept is unsuited for workers, as they attempt to grow their assets rather than spend them. What’s more, most retirees receive inflation-adjusted income from the Social Security Administration. However, to the extent that Social Security payments fail to meet a retiree’s fixed expenses, a TIPS ladder fund would fill the gap—more neatly, I think, than any conceivable competitor.

This would place TIPS ladder funds on the second rung of the industry’s hierarchy. The first rung consists of funds that can be held extensively by many investors—broadly diversified (and cheap) stock and bond market funds, target-date funds, and balanced funds. The second rung holds funds that also appeal widely but should be held in smaller amounts. The third rung contains funds that some investors might reasonably consider. The fourth and final rung consists of funds that nobody should want. It, regrettably, is the largest category.

In that light, second rung out of four isn’t bad!

Conclusion

There is an operational question. Could a TIPS ladder fund exist as an ETF, or would the cash flow fluctuations that occur with ETFs unduly disrupt the ladder’s ability to make its promised distributions? Roth believes the former, while I lean toward the latter. But surely the ingenious fund-industry product managers who devised not only ETFs but also stable-value and interval funds can sort that out.

Retirees need simple, effective methods for protecting their portfolios against inflation’s ravages. A TIPS ladder fund would expand their current options. It’s time for this idea to arrive.