TIPS and I bonds for military retirement?
Internet discussion boards have some perpetual topics. New members will constantly rediscover the same ground that has been trod by the older members, and occasionally a newbie will neglect to check the archives to see if the issue has already been beaten to death.
On retirement forums, two of those perpetual topics are inflation and investment portfolio management. Nearly every prospective retiree is aware that they have to plan for decades of inflation, and they’re usually interested in the various ways to optimize their asset allocation and their portfolio withdrawals to neutralize inflation’s corrosive effects. These methods can be fairly straightforward, but there are always a few economists and amateur academics who will manage to overcomplicate their portfolio management. I know this because I’m recovering from the syndrome.
Among those discussions, a new retiree will eventually have an epiphany: “Hey, why don’t I just invest my portfolio in TIPS and I bonds? I’ll always keep up with inflation and I’ll just live off the distributions!”
Of course every military veteran is immediately suspicious of this option because it just seems too easy. They’re right. It worked for Groucho Marx so it can eventually work for you. However there are several pitfalls that will make other asset allocations seem much more attractive.
The first issue is the withdrawal rate. When the Trinity Study first proposed a 4% safe withdrawal rate for a 30-year retirement, it assumed that the portfolio’s principal would eventually be consumed along with the returns. It’s the perfect “die broke” system, as long as the retiree cooperates by dying within the 30-year limit.
The Trinity Study’s results also depend on the portfolio’s asset allocation. This includes equities as well as other assets with lower volatility. Although equities are more volatile than other asset classes (sometimes catastrophically so) they also have the distinction of being the only asset class that has consistently beaten inflation over the long term. A few asset classes may keep up with inflation over 20-30 years, but only equities will beat it and enable the portfolio to support a higher withdrawal rate. This means that the Trinity Study’s 4% SWR will not work for a portfolio of only TIPS and I bonds.
Dividend investors don’t worry about the Trinity Study because they intend to live off their dividends without consuming their principal. This can be attempted for a portfolio of TIPS and I bonds (with a few other warnings below) but it instantly reduces your income to the dividend rates of those asset classes. In March 2011 it’s not pretty– only 2.19% for 30-year TIPS and 0.74% (!) for I bonds. Your portfolio is not eroded by inflation, but your dividend income doesn’t beat it either. The federal government has no incentive to raise the TIPS or I bond dividend rates (unlike a publicly-traded corporation) and you don’t want to live in an economy that forces the government to issue higher inflation adjustments. If you’ve been planning to gain financial independence on this much lower withdrawal rate then you’ll have to earn a higher income (good luck with that) or work longer to achieve the larger portfolio necessary for this lower rate. Even a 2% SWR requires nearly twice the portfolio of a 4% SWR (assuming principal is consumed), but if you’re planning to leave the principal untouched then you’ll need even a larger amount. If your dividend rate is only 1.5% then you’ll either have to have an extremely high income (like Groucho Marx) or work for a very long time.
Both TIPS and I bonds use the CPI to determine their inflation adjustment. However each security has significant administrative restrictions that limit their long-term inflation-fighting effectiveness. They’re good for short-term goals of 5-10 years but they won’t guard early retirees against 30-40 years of inflation.
Newly-issued Treasury Inflation-Protected Securities are sold by the government through public auctions, so their yields are determined by the bidders. Existing TIPS are also sold on the secondary market, again at discounts which make their yields attractive to the bidders. TIPS pay interest until maturity, but each year their principal value is also adjusted by the previous year’s rate of inflation. If inflation has risen by the CPI then the TIPS’ principal is also raised by the CPI. However that boost is considered taxable in the year in which it was earned, so investors could be required to pay taxes on gains that they have not actually realized. (The full value of the TIPS principal is not realized until the investor sells the TIPS or until it matures.) This unfortunate phenomenon is known as “phantom income”, and for this reason investors are usually advised to place their TIPS in a tax-deferred account like an IRA.
Although the IRA will defer the tax on the phantom income, the nature of an IRA makes it more difficult to tap that income. Investors who are younger than 59½ can withdraw contributions from their Roth IRAs at any time, and they can make limited withdrawals from a conventional IRA without penalty by using a legal rule called 72(t). This complicates what seemed to be an elegantly simple portfolio.
I bonds are a bit more flexible. They’re sold through the Treasury’s website and their base yield is adjusted every year to the CPI. They also pay an additional yield over the base which is set when they’re issued each April and November. The “problem” is that this secondary yield is set by demand, so as more investors clamor for I bonds then the secondary yield can go to zero (although the base rate will still be the CPI). Although the I bond will keep up with inflation until it matures, it may yield very little above that.
A second problem with both TIPS and I bonds is that they’re relatively new and still in demand. This means that the Treasury has no incentive to raise their yield. At one point the Treasury even temporarily canceled auctions of 30-year TIPS, which would make it extremely difficult for an investor to build a ladder of 30-year TIPS throughout their retirement. The Treasury recently restricted purchases of I bonds, which makes it nearly impossible to build the size of portfolio that an investor would require to live off their income.
A final problem for military retirees is that TIPS and I bonds are not necessary for asset allocation to their retirement portfolio. A military retiree’s pension is already equivalent to the income stream thrown off by a portfolio of I bonds, so adding more bonds to that portfolio would make it much too concentrated in one type of asset. A military retiree’s pension is already rock-steady income with no volatility, so it acts as a great anchor for additional equity assets. Even though equities can be quite volatile, the pension income reduces the portfolio’s overall volatility to an acceptable level that allows the owner to sleep at night.
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