This Week's Topic: Retirement Inflation Protection

Many people are getting so skittish about the stock market that they are considering moving entirely out of it or may have already done so. But where will they place their money? Money market funds are generally very safe and secure but yield a pittance. CDs will get you a little more and are generally very safe as well. Government backed securities are also very safe and longer term bonds will greatly enhance your yield, but at some interest rate risk because if you need to sell the bonds before maturity and interest rates have risen, then the value of the bonds will be less than when you purchased them. So do not be buying a lot of long term bonds if you will need the money before maturity.

The one buy-a-boo with fixed income securities is lack of inflation protection. Even low inflation can, in the long run, erodes your purchasing power. For example, if inflation runs at 3% per year, the purchasing power of you pension that pays $5000 month erodes to $3,700 in 10 years, which equates to a 26% reduction. If your experience inflation at 6%, it just takes 5 years for that same erosion in purchasing power. Additionally, recent experience is that health care costs rise much faster than the general inflation rate, so that retirees will experience a much greater impact than the normal working person who is presumably healthier because of their age. The price of drugs went up about 6% in 2000 and hospital services went up about 7%.

So you need a strategy to cope with inflation in retirement years without unduly subjecting yourself to market risk inherent in equities. One method is to purchase Treasury Inflation Protected Securities (TIPS). They come in 10 and 30 year maturities, and the interest rate is fixed, but each month the Treasury computes an inflation adjustment for the principal which is paid at maturity or when the bond is sold, but you must pay income taxes along the way on any inflation adjustments. Thus, owning them in a tax deferred account, like an IRA, would be best. Recently, the yield on TIPS was about 1.5% less than the non-inflation protected bond.

A recent study about the advantage of TIPS can be found at www.ibbotson.com/research.

Several mutual funds also invest in TIPS: Vanguard, American Century and Pimco.