Insure Against Catastrophic Inflation With TIPS

crispydocUncategorized

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.