My latest journey down the rabbit hole of creating a "good-enough to get 'er done" retirement portfolio reads like a biblical recounting of who begat whom.
I started with William Bernstein's Ages of the Investor, which inspired me to read one the books he referenced: Michael Zwecher's Retirement Portfolios: Theory, Construction and Management. Zwecher strongly argues for the use of Treasury Inflation Protected Securities (TIPS) as a tool to establish a dependable retirement floor.
Curious to learn more about TIPS, I purchased the aptly titled Explore TIPS by author Harry Sit, who blogs over at The Finance Buff. It was outstanding, easy to read and helpful in demystifying a complex financial product.
I've been reading Harry's blog on and off for years, and one of the highlights of attending WCI Con 2020 just before the pandemic shut down the world was finding myself seated next to him for Physician on Fire's lecture on philanthropy.
It was akin to a 12 year old girl meeting Justin Bieber - in my nerdy way, I expressed my fanboy enthusiasm for his writing, and thanked one of my blogging heroes for his public service. Harry was gracious, a bit tickled by the unexpected fame, and a genuinely nice guy. But back to TIPS.
Intrigued why they aren't more widely used in construction of investment portfolios, I reached out to a friend who is a high-powered bond trader at a hedge fund to get his take. He sent me an article premised on the fact that TIPS make for lousy long-term investments compared to higher yielding alternatives.
Following is my reply to the article he sent, which reflects my evolving understanding of the proper role for TIPS in a retirement portfolio:
The basic problem is that TIPS are seen by the author as a poor investment compared to other fixed income investments, when in fact they represent insurance against catastrophe (runaway inflation reducing real purchasing power leading to delayed retirement/downward adjustment to lifestyle).
In the same way I wouldn't call homeowner's insurance a bad investment if my house never catches fire, nor consider disability insurance a poor investment if I have a full working career without making a claim, TIPS are insurance against one of Bernstein's four sources of deep risk: inflation (the others are deflation, confiscation and devastation).
I'm willing to sacrifice potential upside for an insurance policy that secures a threshold level of flooring to my retirement lifestyle. I can shift added risk to a different bucket containing my risk portfolio (real estate syndicates, equities, with some bond fund to provide dry powder for rebalancing). If that risk portfolio performs as expected, I can draw on it to raise my lifestyle flooring and leave bequests or an inheritance.
This works if you use a liability-driven investment plan where you create your own TIPS ladder in a tax-deferred account and hold each to maturity, where it provides the income to be spent in the year it matures.
Those who don't want to sacrifice upside (they are always more numerous after a historic bull market) prefer to keep everything in an investment portfolio using a probabilistic retirement plan (does my current allocation have a high probability of success based on Monte Carlo simulations using historical returns in meeting my retirement goals?). Which works except when it doesn't.
As a risk averse guy, I want certainty for my retirement flooring. TIPS is not a bad way to go, and certain advocates of life cycle investing (namely Zvi Bodie at BU) think it should have a place in most retirement portfolios. I'm not a fan of annuities (SPIA would be an even more conservative approach), but TIPS I can wrap my head around.
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I agree CD,
I have been a fan of I-bonds and TIPS ever since they were created. It nearly eliminated the biggest risk of bond investing – loss of purchase price.
I will have to check out that book.
I’m glad to see smart people like Bill Bernstein, Kotlikoff, Bodie etc encourage such “ultra-conservative” investments.
Protecting against downside is key.
Along with diversification.
Author
WD,
In the blogger world where boasting of upside wins is all the rage, you are one of my risk-averse companions in trying not to die poor.
My views always feel more legitimate when I find that you share them as well.
Fondly,
CD
TIPS have associated a practical “efficiency component” which is often overlooked in the theoretical discussion. This means your investments insurance quality is entirely dependent on “what is inflation”. The government notion of “inflation” is notoriously narrow and contrived and underestimates true inflation. Yet it’s true inflation that consumes your purchasing power. Real inflation may run at 5% while TIP inflation is “declared” to be 3% and so your insurance includes a 40% shortfall. This is what I call the efficiency component or maybe better put the inefficiency component. The real thing that assures retirement portfolio longevity is overfunding beyond all the sequence of return risks of which inflation is one. If you look at Bernstein’s work that is the bottom line. This is not to say owning TIPS in the face of inflation won’t provide some insurance, it’s just to say at 60% efficiency if may not provide the bang you anticipate.
If you look at Bernstein’s work he has a concept called Human Capital, which is the driving force of how your retirement is funded. Human Capital begins on the day you are born, is modified by education and career choice, work history, work longevity and ends on the day you quit and begin drawing down your pile. In the main Human Capital is how you actually fund your post work retirement. Compounding from investment is generally a multiplier of your Human Capital, but in Bernstein’s analysis Human Capital is the dog and compounding is the tail. In most FIRE literature HC is the tail and compounding is the dog. The entire FIRE notion is based on the idea that you can pay for 30 years of life using 25 years of money at a 4% fixed withdrawal saved over 40 years of work and then extrapolating that to 40 and 50 years of retirement. The problem is a 40 year retirement means you only accumulate for 25 years, and then rely on leverage to get you through 40 years. It flips dog and tail. Certainly TIPS can help mitigate in an inflationary environment in a growing economy, but what if the economy is not growing? From 1879 to 1989 a measure of productivity averaged 2.2%. From 1989 to yesterday the average was 1.2%. William Bengen did his 4% rule analysis in the years before 1994 and was published in 1994. Trinity was published in 1998. When I look at this economy given the world wide demographics it makes me wonder if we can even get “inflation”.
Author
Gasem,
You are far from alone in critiquing whether the CPI-U is a relevant proxy for inflation, but if you are willing to grant that it’s one of several measures that it’s at least a reasonable attempt to measure it, then TIPS can be a useful tool in the toolkit. As with any type of build, you can’t construct a complete and comprehensive shelter with a single tool.
Overfunding is a far more powerful tool, and used in combination with TIPS, ups the odds of not dying poor considerably. Add in the superpowers of parsimony and flexibility, and you’ve got the tools to construct a very solid retirement portfolio that is likely to withstand most storms.
Appreciate your insights as always,
CD
I share Gasem’s concern about what the inflation adjustment tips is based on reflects the true inflation that is occurring.
A lot of the things that is used to calculate CPI is manipulated. The basket of goods currently being used is different from what was included in the 90s.
The government is disincentivized to reveal a high inflation amount.
So what do you consider a safe investment? If T-bills & TIPS aren’t then what is the alternative?
Author
Xray,
I’ll grant you the imperfection of the CPI-U. It’s not ideal, but it gives a decent enough approximation that TIPS can still be useful as part of a multi-pronged strategy.
Owning TIPS is all about locking in your retirement flooring with as little risk as is possible. It’s a limit downside/don’t lose what you can’t afford to lose strategy.
Owning equities and real estate is about maximizing upside strategy. The cost is potentially ill-timed volatility; you must be prepared to lose significant amounts of the portfolio over time. Lose it when you need it to draw down (sequence of returns risk) you are hosed.
Having different buckets is one solution. The flooring bucket ought to cover your minimum retirement lifestyle in instruments and adjust for inflation. I bonds are ideal but purchase limits of 10k per year make them inadequate to build flooring out of, hence TIPS make more sense and can be bought in large quantities on the secondary market via most brokerage accounts.
Anything above and beyond your minimum lifestyle bucket can go into your upside bucket, because you can afford to lose it or leave it untouched in hopes of a recovery in bear markets. Some folks (Zwecher) make a case that periodically rebalancing when the upside portfolio does well to raise the minimum flooring bucket is the way to raise lifestyle as you go.
The closer I get to my number, the more jealously I want to guard my leprechaun pot and the less comfortable I am leaving it in higher risk instruments. So TIPS, with all their imperfections, sound like reasonable options to secure my flooring.
Sure, they aren’t perfect, but I try not to let the perfect be the enemy of the good enough.
Fondly,
CD
Hi CD,
How much of your portfolio would you feel comfortable allocating to TIPS as an insurance?
I am very curious because I see Gasem and Xray’s point of TIPS not keeping up with the true cost of inflation.
Personally, I probably will not be investing any portion of my portfolio to TIPS. But everybody’s situation is different. My wife and I will likely retire with generous pension plans that serve as the “insurance policy that secures a threshold level of flooring to my retirement lifestyle” that you speak of.
Cheers,
DMF
Author
Hey DMF,
I’m currently at 20% TIPS and 20% total bond fund (VBTLX), as per our revised asset allocation.
I currently have that amount in a couple of TIPS funds as a placeholder until I feel competent to build a TIPS ladder, and have been reading threads on the Bogleheads forum to help me get there:
https://www.bogleheads.org/forum/viewtopic.php?t=208540
https://www.bogleheads.org/forum/viewtopic.php?t=280867
https://www.bogleheads.org/forum/viewtopic.php?t=224016
https://www.bogleheads.org/forum/viewtopic.php?t=136125
https://www.bogleheads.org/forum/viewtopic.php?t=240325
https://www.bogleheads.org/forum/viewtopic.php?t=124218
It’s been a lot of deep dive reading.
I’ve also enjoyed Harry Sit’s book, Explore TIPS, which is far easier to follow than some of the more complex threads on the Bogleheads forum.
You are fortunate to be able to count on those pensions. My wife and I will have to create our own, likely using a TIPS ladder.
Fondly,
CD
Thanks so much for providing these resources. I am always looking to learning more about different ways to invest.
Folks may have some interest in the IVOL ETF. It seeks to somewhat immunize TIPS from interest rate manipulation and volatility by the FED through hedging. It’s also extremely uncorrelated. Both of these reduce volatility in the overall portfolio. I own it. I talked to the manager and the fund hedges about 30% and the average duration of the TIPS in the fund is about 6 years. If you’re into a totally passive approach, this fund has active management.
Author
Knee jerk reflex is that the expense ratio a bit high at .99%, but intriguing concept – I’ll investigate further and appreciate the suggestion.
Thanks Gasem!