On Retirement Income, Part 9: TIPS Q&A

“On Retirement Income” series:

In our last article, our fictional friends Bob and Fred began moving up the layers of Round Table’s Layer Cake retirement investment solution, learning how Treasury Inflation-Protected Securities (TIPS) can be used to:

Build an inflation-protected income “bridge” from the start of retirement to the commencement of Social Security retirement income, which we often recommend delaying to age 70 or at least full retirement age.
Build an additional stream of inflation-protected income in retirement, to fill any gap between what is provided by Social Security and what is needed to cover inflexible annual expenses.

Now we’re due for a Q&A article, and we know there must be questions, not least of which is probably…

Wow, this TIPS stuff may be the most complicated topic yet. Can you explain how it works in a little more detail?

We can! But not in this article. Here are some good places to start:

For a detailed explanation of TIPS themselves (as well as I-Bonds, another government-guaranteed inflation-protected instrument), see this article: I-Bonds vs. TIPS: Compare and Contrast.
For details[1] on how Round Table constructs a safe, secure stream of inflation-protected income, see the article descriptively but uncreatively titled How Round Table Uses TIPS to Target Inflation-Protected Income.
To learn how LifeX funds utilize mortality pooling to provide inflation-protected income for life (up to age 100), check out LifeX Funds Answer the Call. Side note: Some exciting LifeX product modifications are in the works as of this writing. Stay tuned!

Okay, I’ve read all that, so now a pricing question: TIPS interest rates are much higher than they were just a couple years ago, and that’s a good thing, right? Doesn’t that mean I should buy more TIPS now than I would have back then?

Those two question marks may seem to terminate variants of the same question, but that is not at all the case.

To the first question: Yes, buying TIPS at higher interest rates is unambiguously better than buying them at lower rates.

To the second question: This does not necessarily imply that you should buy more TIPS exposure just because rates are higher. In fact, a better view might be that higher TIPS rates enable you buy the same amount of income with fewer up-front dollars of TIPS exposure.

Remember, in the goals-based retirement framework for which Round Table is a steadfast advocate, you start by figuring out your goals. Some of those goals will be of the inflexible, gotta-have-it variety. TIPS-based strategies can help you have-it when you gotta! But the less money you have to spend (i.e., on TIPS) to cover gaps between Social Security’s payouts and your inflexible spending needs, the more money you have available to spend on other investments for other purposes! So, oddly enough, perhaps the best view is that the higher TIPS rates get, the more money you can spend on other investments instead.

But I’ve seen articles that ask questions like “Are TIPS rates now high enough to be worth an allocation?” or “Now that TIPS rates are high enough to compete with the 4% rule, should you consider them?” What gives?

We’ve seen those articles too. Our charitable response is that they are viewing the question through a different framework. Our pugilistic response is that their framework is flawed.

Charitable interpretation: At Round Table, we have no theoretical objection to a risk-averse investor purchasing additional safe, secure, inflation-adjusted income above what our goals-based modeling suggests is needed for inflexible expenses. In that case, basing the additional amount partly on “cost effectiveness” derived from real interest rates is not crazy. (Notably, the same can be said for purchasing guaranteed lifetime nominal income with an annuity, which we are also happy to help clients obtain, though see below.)

Less charitable interpretation: The assumption—implicit in the first quotation[2] above, explicit in the second—is that other investments, most especially equities, can ensure fixed minimal outcomes regardless of interest rate regime. Underlying this is a further assumption that stock returns are essentially independent of real interest rates. This is equivalent to saying that the equity risk premium conveniently increases/decreases so as to offset changes in the risk-free rate above which the premium accrues. Actually, it’s even worse, because it also implies that the premium is not really a risk premium at all, but more a certainty, at least if your retirement planning is constructed with a sufficiently long time horizon.

We very, very, very, very, very much beg to differ! The equity premium is a risk premium. You can’t get the premium without taking the risk. If you don’t want to take the risk, there is a risk-free alternative. TIPS interest rates set the going cost for that alternative, at any time horizon up to the max 30-year TIPS maturity. But no matter what TIPS are paying, any model that effectively assumes stocks can guarantee a better outcome is wrong.

You’re claiming TIPS are risk-free, but long-term TIPS sure seem volatile/risky!

The third “very” above (i.e., this article) goes into detail on this topic, but the simple answer is this: When investing, you can have safe income or safe asset value, but not both!

Interest rates essentially create a ladder from present value to future value. As rates rise/fall, the ladder gets taller/shorter, which means the dollar value for a given safe/stable/risk-free future income goes down/up in price today. The further into the future is the income, the taller the ladder and the bigger the swings in present value. (See this section of an old article for as simple an explanation of this concept as we can offer.) Note that a stream of future income is nothing more than a series of future values strung together.

Consequently, if you want to have risk-free, inflation-protected future income, TIPS can provide that for you, but on the dollars so allocated, it is necessary to accept volatility in the present value. For safe, secure present-dollar value, we recommend the creation of an emergency fund, which will be discussed in a future article in this series.

I’ve seen articles by other retirement researchers suggesting that annuities are the best way to generate secure income for retirement. Why do you use TIPS instead?

We’ve seen many of the same articles and we have great respect for many of their authors. And annuities do have a major advantage: mortality pooling. I.e., when many investors pool their resources, they can collectively ensure lifetime income in a manner that one investor cannot do alone.

The problem with annuities in the U.S. at present is that they do not provide true inflation protection. The vast majority of lifetime income guarantees on annuity products provide a level nominal income. But this in effect ensures the policyholder a guarantee that they can spend less every year. Recall this chart from the previous article:

Inflation's effect on nominal income. — **Source: Round Table Investment Strategies**

Except in the unlikely event of long-term 0% (or less) inflation, a level nominal income stream guarantees declining annual spending power. In the event of sustained above-expectation inflation, the decline can be devastating. We ask our readers to re-read what we wrote about the “money illusion” in that article.

So then doesn’t the debate between TIPS and annuities effectively mean choosing between inflation protection and longevity protection?

On its own, yes it does. But there are, at present, two ways to get both.[3] The first is to create a TIPS ladder for some number of years and purchase a deferred income annuity (DIA) that will pick up after the ladder expires. This is not ideal, as it reintroduces inflation risk in the very years (i.e., far-future years) when the cumulative effects of inflation are at their worst. But this beats a stand-alone TIPS approach by offering some degree of longevity protection, and it beats a nominal annuity payment[4] by offering inflation protection during the ladder years and the same annuitized nominal income thereafter.

LifeX funds are the one product in the U.S. of which we are currently aware that offers both inflation and longevity protection, making them a great addition to the available toolbox! However, for various structural reasons too complicated to get into here, we will not abandon our call for the annuity industry to bring back CPI-linked annuity products (but at a sensible price relative to nominal guarantees). That would truly be the best of both worlds.

Just to play devil’s advocate, doesn’t retiree spending decline over time anyway? I mean, what about David Blanchett’s “spending smile” research? Can’t we just think of inflation that way?

The “spending smile” research is well-documented and comports with typical experience: Retiree spending does tend to decline as activities wane throughout retirement, unless/until medical and long-term care expenses ramp up in old age. (We’ll get to that issue when we examine a higher level on the Layer Cake.) But the notion that inflation eating away at nominal income can aptly mimic this process suffers from multiple problems:

Blanchett’s research found an average yearly decrease in real (i.e., inflation-adjusted) spending of about 1%/year, but inflation is projected to be, and has historically been, significantly higher. Again, breakeven rates are currently between 2% and 2.5%/year, and the Fed’s 2% target inflation rate is twice the spending smile-implied reduction. Consequently, level nominal income is still projected to fall well short of smile-adjusted spending.
We recommend supplemental inflation-protected income (“Layer 2” of our Layer Cake model) to meet inflexible expenses. By definition, inflexible expenses are purchases of stuff the amount of which does not decline from year to year! For meeting such expenses, a non-declining inflation-protected income stream is ideal.[5]
1%/year is the average, but nobody is average. An old professor of mine used to say, “If my head is in a blast furnace and my feet are in a vat of liquid nitrogen, on average I’m doing fine!” Admittedly this is more relevant to the planning process than to the means of generating secure income (e.g., nominal vs. real), but exactly how similar the 1%/year decline may be to a specific retiree’s target spending path can vary substantially. So too can the degree of flexibility in spending plans, a topic we will cover in Layer 3 of the Layer Cake.
Inflation can be worse than projected! If even projected inflation of 2.5% more than laps the spending smile reduction, how much uglier are the effects of unexpectedly high inflation?!

Wait, if inflexible spending declines by 0% and overall spending declines by 1%/year, might not flexible spending decline by something more closely resembling 2.5%/year?

Very clever! This is true, and for this reason, we are relatively comfortable with the idea of placing clients in level-nominal annuitized income to cover (a portion of) their flexible expenses, albeit after carefully explaining the nature of the single risk,[6] inflation, that they are not mitigating thereby.

A different way of viewing this is that flexible expenses can be met with:

A risk asset portfolio (i.e., stocks and bonds), which can produce the highest stream of real income in expectation and over most time horizons in exchange for a willingness to reduce spending if the risk shows up but the risk premium does not.

…or…

Annuitized nominal income, which will produce a lower long-run real income stream in expectation,[7] but requires only the flexibility to reduce consumption at the rate of inflation, since it is otherwise guaranteed for life.

Here again, a better option is theoretically possible! Given sub-2.5% breakevens (and the availability of inflation swaps, as discussed in footnote 6 of this article), the following two options would, in theory, provide the same year-1 income for the same up-front premium:

An annuity with a level nominal income stream.
An annuity where real income declines by 2.5%/year.

The second option is manifestly better! If inflation comes in at precisely 2.5% each year, the two incomes streams will be equivalent. If inflation comes in lower, nominal income in option 2 will decline, but that’s okay because inflation was low. If inflation comes in higher—no matter how much higher—option 2 will grow by an amount sufficient to keep up with the pre-programmed 2.5%/year decline in real income.

In other words, with option 2, you could know in advance just how much annually spending “flexibility” will be required of you. Plus, it would overcome the money illusion by offering the same year-1 income as would a nominal annuity! Why does this product not exist?! C’mon annuity industry!

Are you feeling better now that you got that out?

Yup, rant over. And article over too.

[1] So you’re not disappointed, be aware that we don’t give away all our secrets! (Actually, even in a highly detailed article like that one, we couldn’t provide exhaustive details on the mechanics of TIPS ladders and duration-matched TIPS portfolios. It’s complicated stuff!)

[2] These are not genuine quotations, but they are thematically consonant with articles that we’ve seen but will not link to here. Whether we omit such links due to a kindly wish to avoid personalized accusations or an uncompassionate desire to avoid boosting their visibility is a question we leave to the musings of the reader.

[3] The prior article in this series provides a detailed breakdown of each option. See these bullet points for a quick summary of pros and cons.

[4] Whether it beats a nominal annuity after accounting for cost differential is a very complicated question…a question that could be eliminated by the introduction of a cost-effective CPI-adjusted annuity!

[5] Technically, a non-declining income stream whose annual adjustments match the weighted average change in price of the actual stuff you are buying is truly ideal. Good luck finding that! In its absence, we fall back on the general observation that if your inflation is low/high, CPI inflation will almost certainly be low/high as well.

[6] Actually, there is also default risk, which is low for highly rated insurers but certainly nonzero. As of yet, I confess I have devised neither a great way to model nor a great way to defend against this risk. This is an advantage of direct TIPS exposure and of LifeX funds (given their direct TIPS exposure).

[7] This awkward phrasing is brought to you by our old friend, the money illusion. Year-1 spending with an annuity might be somewhat higher than year-1 spending from a “Layer 2” risk asset portfolio. But that is because the latter can produce at least some degree of inflation-fighting pay increases (in expectation, not with certainty), as well as nonzero expected terminal value.

DISCLOSURES: All content is provided solely for informational purposes and should not be considered an offer, or a solicitation of an offer, to buy or sell any particular security, product, or service. Round Table Investment Strategies (Round Table) does not offer specific investment recommendations in this presentation. This article should not be considered a comprehensive review or analysis of the topics discussed in the article. Investing involves risks, including possible loss of principal. Despite efforts to be accurate and current, this article may contain out-of-date information; Round Table will not be under an obligation to advise of any subsequent changes related to the topics discussed in this article. Round Table is not an attorney or accountant and does not provide legal, tax or accounting advice. This article is impersonal and does not take into account individual circumstances. An individual should not make personal financial or investment decisions based solely upon this article. This article is not a substitute for or the same as a consultation with an investment adviser in a one-on-one context whereby all the facts of the individual’s situation can be considered in their entirety and the investment adviser can provide individualized investment advice or a customized financial plan.

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Annuities, Income, Inflation, TIPS