Tax planning for the use of TIPS at retirement.

• Author: Toolson, Richard B.
• Position: Treasury inflation-protected securities

EXECUTIVE SUMMARY

* TIPS are Treasury bonds adjusted daily based on the consumer price index.

* The income from newly issued TIPS may be accounted for under either the coupon bond method or the discount bond method.

* TIPS may be purchased directly from Treasury or on the secondary market from a broker.

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For some retirees, Treasury inflation-protected securities (TIPS), the principal of which rises or falls as the consumer price index increases or decreases, may be a valuable source of retirement income. This article discusses the mechanics of TIPS, how they are taxed, and whether they should be held in taxable or retirement accounts.

A retiree needs to have an income stream that is sufficient to meet living expenses for the rest of his or her life and that increases with inflation. The most common sources of inflation-protected income for retirees are Social Security and defined-benefit pension plans. Social Security benefits provide a lifetime income stream to beneficiaries that increases as the cost of living increases. (1) While the vast majority of retirees are eligible to receive Social Security payments, for most of them the payments are insufficient to meet day-to-day living expenses. For 2006, the estimated average monthly benefit was only $1,011 for all retired workers and $1,658 for a couple when both were receiving benefits. (2) These amounts are clearly not adequate to allow for a comfortable retirement for most retirees.

Defined-benefit pension plans normally will provide a lifetime income stream and may include a cost-of-living adjustment (COLA) provision. Almost all full-time local and state employees are offered a defined-benefit plan, the majority of which include at least a partial COLA. Currently, however, only about 21% of private-sector employees are offered a defined-benefit plan, and these plans usually do not have a COLA. Moreover, the trend is clearly away from defined-benefit plans in the private sector. In 1985, there were 112,000 private pension plans insured by the Pension Benefit Guaranty Corporation; in 2005 there were fewer than 30,000. (3)

Given the inadequacy of Social Security and the limited availability of defined-benefit plans, particularly plans with a COLA, most retirees will need to have other investments that mimic these sources of retirement income. Investments that can provide lifetime income streams for retirees that increase. over time with inflation include immediate annuities, equity-based dividends, and Treasury inflation-protected securities (TIPS). In addition to providing a potential lifetime rising income source, TIPS (as well as dividend-paying equities) give retirees the opportunity to pass on their assets to heirs. This article addresses how to efficiently use TIPS as a source of retirement income. (4)

Mechanics of TIPS

TIPS are Treasury bonds, the principal of which rises or falls in direct proportion to increases or decreases in the consumer price index for all urban consumers (CPIU). Daily adjustments are made to the principal of the bonds using an index ratio based on changes in the CPI-U over that period. Specifically, the index ratio is computed by multiplying the reference CPI for the current date by the reference CPI on the date the bond was issued.

Example 1: TIPS, with a 10-year term and a stated interest rate of 3.375%, are issued on February 6,1997. At the time of their issuance, the reference CPI is 158.43548 and on June 30, 2006, it is 201.44. On the latter date, the index ratio for these TIPS is 1.271 (201.44 / 158.43548), and the adjusted principal for each $1,000 of original issuance is $1,271 ($1,000 x 1.271).

Interest on TIPS is paid semiannually based on the adjusted principal multiplied by half of the coupon or stated interest rate. TIPS are a unique asset because, as Treasury bonds, they are not subject to default risk and the income they generate represents a real rate of return, because the original principal preserves its original purchasing power due to the adjustments.

TIPS are currently offered with maturity lengths of 5, 10, or 20 years and are offered in denominations of $1,000. At maturity, the bondholder is paid the adjusted principal amount. (5)

Example 2: On April 15, J purchases five-year $1,000 TIPS with an annual stated interest rate of 2.375%. During the next six months, the CPI-U increases by 1.5%. Consequently, the $1,000 principal is adjusted upward by 1.5% to $1,015 ($1,000 x 101.5%) by the end of six months. At this time, J receives an interest payment of $12.05 ($1,015 x (2.375% / 2)) to compensate him for six months of earned interest. During the next six months, the CPIU increases by another 2%, so after one year it has increased by a total of 3.5%. The $1,000 principal is adjusted upward by 3.5% to $1,035 ($1,000 x 103.5%) during this period. J would receive another interest payment of $12.29 ($1,035 x (2.375% + 2)) to cover the interest earned for the next six months. The interest payment in the second six-month period is slightly higher than in the first six-month period because of the higher adjusted principal. If J holds the TIPS until maturity, he will receive an adjusted principal that reflects the total increase in the CPI-U over the term of the bond.

As long as the retiree spends only the after-tax real return amount, he or she will preserve the purchasing power of the original investment. If the bond is purchased in the secondary market after the issuance date, the price paid for the bond will be higher (lower) than the adjusted principal if market interest rates have decreased (increased) since the bond was issued. The real return or yield of the bond will therefore be higher (lower) than the coupon or stated interest rate if the purchase price is lower (higher) than the adjusted principal. In this case, the amount that the retiree may withdraw without reducing the bond's purchasing power is the real yield and not the stated rate (assuming the bond is purchased above or below the adjusted principal amount).

Obviously, the ability of the retiree to spend only the real return from the TIPS depends on both the retiree's spending requirements and the real return of the retiree's TIPS, which is set when the TIPS are purchased. TIPS were initially offered in 1997. Since that time the annual stated interest rates for 10- and 20-year TIPS have ranged from 1.625% to 4.25%.

Currently, longer-term TIPS are priced to yield an annual real return of 2.1-2.3% and regular Treasury bonds are priced to yield a nominal return of 4.5-4.7%, depending on their maturity date. (6) The difference between the real return of TIPS and the nominal return of a regular Treasury bond with the same maturity represents the annual expected inflation rate over the remaining life of the TIPS. If, for example, TIPS are currently yielding 2.2% and a regular Treasury bond with the same maturity is yielding 4.7%, the annual expected inflation rate is 2.5%. If the inflation rate turns out to be greater than 2.5%, the holder is better off owning TIPS because the real yield plus the inflation adjustment to principal will exceed 4.7%. Conversely, if the annual inflation rate is less than 2.5%, the owner is better off holding regular Treasury bonds.

TIPS may be purchased outright or through mutual funds. If they are purchased outright, the retiree can avoid the ongoing expense charges imposed by the mutual funds. Also, because a TIPS mutual fund will normally not have a portfolio consisting exclusively of 20-year term TIPS, the retiree can only lock in a predetermined real rate for a longer period of time by purchasing the bonds outright. If the retiree does choose the mutual fund route, it is critical that he or she choose a fund with a low expense ratio because the expense charges directly reduce the real return to the retiree. (7)

Diversification Benefits

Even during retirement, it is important that the retiree maintain a balanced portfolio, which normally...