The Three-Headed Investment Bandit

Retirement, Social Security, Strategies

There is a three-headed investment bandit lurking in the weeds looking to steal your wealth. Savvy investors must deal with them – all at the same time.

First up is the safety bandit. If you invest in stocks and bonds, they can default or go down in value, robbing wealth from your nest egg.

Second is the income bandit. Retirees need income to pay the bills. If the income bandit robs you of income, you must withdraw principle to pay the bills and your wealth decreases.

Even if you invest safely, and earn good income, the biggest bandit is the inflation bandit. It’s a stealth robber, operating in the background, hoping not to be noticed. If your income and asset appreciation does not beat inflation, your wealth has been stolen – and probably lost forever.

During the Carter years, the inflation bandit came out in the open. For the five-year period 1977-1981, accumulated inflation was 60%. If an investor bought a five-year 6% FDIC insured CD, the inflation bandit still robbed around 40% of the investor’s wealth. I saw this happen to my parents. They handled the income and safety bandit while inflation clobbered them.

Investors are continually making calculated risks and trade-offs. In order to earn safe income, you may buy long term bonds or CDs. You risk being robbed by the inflation bandit. If you seek higher yield, lower rated bonds or investing in stocks increases your risk being robbed by the safety bandit. If you buy gold, the ultimate inflation hedge, it pays no income. Is there such a thing as a candle with three ends?

Over the last several weeks we have looked at gold, bonds, foreign currency, stocks, and gold stocks; discussing the pros and cons of each in relation to the three-headed bandit looking to confiscate your wealth.

Readers asked about Treasury Inflation Protected Securities (TIPS). They are issued by the federal government and offer some inflation protection. How do they combat the safety, income and inflation bandits?

Treasury Direct tells us:

“TIPS are marketable Treasury securities whose principal amount is adjusted for inflation. They were first auctioned in January 1997 after the market expressed a strong interest in the inflation-indexed asset class. …. Treasury now offers 5-year, 10-year, and 30-year TIPS.”

Investopedia adds: (my emphasis)

“TIPS are…considered a low-risk investment because the U.S. government backs them. …. The key feature of TIPS is the inflation adjustment. As inflation rises, as measured by the Consumer Price Index (CPI), the par value or face value of the bonds also rises.

TIPS pay interest every six months based on a fixed rate determined at the bond’s auction. However, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond. If the principal amount is adjusted higher over time due to rising prices, the interest rate will be multiplied by the increased principal amount. As a result, investors receive higher interest or coupon payments as inflation rises. Conversely, investors will receive lower coupon payments if deflation occurs.

…. When TIPS mature, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater.”

Isn’t it interesting that the inflation bandit (the government), offers inflation insurance? Pundits speculated the reason TIPS were developed was the government did not want money moving away from US debt instruments into gold. Moving out of dollars into other asset classes raises inflation even higher.

With TIPS, your principal is protected and will rise with inflation. If inflation drops you will receive your original principal. You will not lose your money. Investors know the Federal Reserve has publicly targeted a 2% annual inflation rate.

Investors understand they are lending money to the inflation bandit. Your income and final payout are based on the CPI. The inflation bandit is the scorekeeper and has a history of adjusting the index to suit their needs. Just saying…

A case study

This Bloomberg site provides “United States Rates & Bonds”. Currently, 5-year TIPS yield .41% interest. A 5-year CD pays 2.75% interest. Assuming no inflation, a $10,000 investment in TIPS would pay $41 interest annually. The comparable CD would pay $275.

Let’s look at what happens if the Fed reaches it’s 2% annual inflation target in a straight line with their semiannual payouts.

At the end of 6 months, the inflation-adjusted value of your TIPS would increase by 1% to $10,100. Your 6 months interest would be $20.71. ($10,100 x .0041 ÷ 2 = $20.71).

Assuming the same compounded 2% straight line annual inflation for five years, your TIPS would yield $216.62 in interest and return $11,046 in principal. Your net return would be $1,262.62.

Your 5-year CD would pay $1,375 in interest and return $10,000.

Using our 2% assumption, TIPS come up a bit short as compared to the CD – however, TIPS would have a good deal of upside in a high inflationary period. In times of low inflation, or deflation, your interest payments would be lower. TIPS address the three-headed monster by protecting your original investment, offering a low yield and providing some inflation protection.

The market value of TIPS is set at auction. Buyers factor in the guaranteed interest rate, plus anticipated inflation over the life of the bond. TIPS buyers are betting on inflation being higher than anticipated at the time of auction.

What TIPS are not

I’ve asked many financial planners what they use to protect their client’s portfolio against inflation. The most common answer is TIPS. When I ask about gold or foreign currency, they normally look down their nose and mention risk.

TIPS, by design, only protect your amount invested in them against inflation. During the Carter years, gold, some stocks, and currencies rose ahead of inflation helping to offset inflation losses in other areas of your portfolio. TIPS have zero umbrella effect.

If you have a $1 million portfolio, $50,000 invested in TIPS will not help the remaining $950,000. While past performance is no guarantee of the future, you have the possibility of investing in other assets that may grow ahead of inflation providing an umbrella effect. TIPS are guaranteed not to do that.

I fear many planners are creating the illusion of protecting the portfolio against inflation when they are really protecting only the single investment. The goal of many a “retirement specialist” in the mutual fund houses is to capture as much of your money as possible in their fee-based funds. If you invest in foreign currency or gold, they are unlikely to earn fees on that investment.

At a dinner with a highly respected Certified Financial Planner (CFP), I pressed him about TIPS. I understood they worked well for the amount you invest in them. What about the rest of the portfolio?

He looked around, almost as though he was checking to be sure no one was listening, dropped his voice and said, “There are some times we have to listen to our lawyers. TIPS are safe.”

Wow! That was an eye-opener. The entire financial community is taught to invest in TIPS because they are deemed safe? If a client sued them, they can point to the guidelines, say everyone is doing it…and probably would be OK. If they invested in gold or other items considered risky, they would be vulnerable.

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What about taxes?

Unless you own TIPS in a (non-taxable) Roth IRA, they will not cover the entire loss of buying power. The income and increase in principal are subject to federal income tax but exempt from state and local income taxes.

How can you buy TIPS?

I contacted my online broker and was told there are two ways to buy TIPS. I could call their bond department directly, or there are ETF’s that specialize in them. Were I to buy them, my plan would be to hold them to maturity. I’d prefer to build my own fixed income ladder.

My personal conclusion

Investors need to protect themselves. We are continually dealing with the three-headed monster trying to weigh the risk against the reward.

When it comes to the inflation bandit, gold is the ultimate hedge, yet it provides no income. Investors, looking to supplement their core gold holdings and add more inflation protection must balance all three risks.

I’m glad readers pressed me to look into TIPS, they are not as bad as I thought. While I don’t own any TIPS, I feel they have some value. Some pundits recommend using TIPS as part of a bond ladder and that could make sense – as long as investors realize their limitations. Others suggest using them in a young person’s college fund.

Over the last few weeks, we have interviewed several experts looking at various alternatives dealing with all facets of the three-headed investment bandit. Government debt and spending are out of control and eventually, the inflation bandit will raise its head like the Carter years.

Diversification and moderation appears to be the conservative approach to protecting the value of your life savings. If you buy TIPS, know what you are buying and why. Be sure you are also protecting the rest of your portfolio against the inflation bandit as best you can.

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