There is a growing sense that the monetary and fiscal policies required to exit the great recession of 2008/2009 are laying the groundwork for future inflation. This sentiment alone can have an impact on asset returns and investor behavior, regardless of the future course of inflation. In light of that, we briefly examine the case for providing exposure to Treasury Inflation Protected Securities or “TIPS” in both pension plans and 401(k) plans.
TIPS provide investors protection against inflation while protecting against deflation. They are government issued bonds designed to provide a certain pre-tax real return when held to maturity. TIPS pay interest twice a year, at a fixed rate. The rate is applied to a principal value which is adjusted for accrued CPI inflation. Interest payments rise with inflation and fall with deflation. When a TIPS matures, investors are paid the greater of its adjusted principal or original principal, providing a hedge against both inflation and deflation.
The yield on a conventional Treasury bond that pays a fixed coupon must also include an expected inflation component to compensate the investor for future inflation. Its yield therefore includes a real rate of interest and an expected inflation component. With TIPS, the coupons and principal adjust relative to CPI so its yield is simply the real interest rate. The difference between the two yields reflects, among other things, expected inflation.
While the primary role of fixed income in many non ALM pension investment programs is to serve as a volatility hedge for stocks, it can also be constructed to offer inflation protection. The value of TIPS in a fixed income allocation, specifically as an inflation hedge, will be dependent on the nature of the plan’s liabilities.
Since the typical defined benefit plan has a set of liabilities that acts like a mix of nominal (retirees, term vested or frozen actives) and inflation linked (benefit accruing actives or inflation indexed retiree benefits) bonds, inflation can have varying impacts. Inflation protection may be less critical for pension plans that are mature, are not duration matching their liabilities and don’t have benefits that are linked to cost of living. Mature plans with a lower proportion of active participants may not be as exposed to salary inflation and might even benefit from the impact that inflation can have on devaluing plan liabilities. If a plan’s liabilities are not indexed to inflation, it benefits by paying nominal liabilities in inflated assets. Deflation represents a more considerable risk for these plans, so inflation protection may not be a primary objective.
Pension plans with a "COLA" liability based on their benefit formula can be negatively impacted by inflation. They would be natural holders of TIPS, along with other investors who want to match assets and liabilities in real terms. Financial assets, like nominal bonds, typically do poorly badly during periods of inflation, so a mix of TIPS and other inflation hedging assets such as commodities might be a good fit for these plans.
TIPS can also be used in pension plan portfolios as a diversifier since they behave differently than traditional fixed income securities in various market environments. Recent changes in pension accounting rules and the funding calculations of the Pension Protection Act of 2006 add to the diversification value of TIPS as either a strategic or tactical asset class.
401(k) plan sponsors have traditionally emphasized long term growth investments such as equity funds for their retirement investors. Equity tends to grow faster than bonds and has outpaced inflation in the long run. Traditional retirement portfolio planning suggests that as plan participants approach retirement they should increase their allocation to bonds to avoid the volatility of equity and other inflation hedging assets such as real estate or commodities. However, as their bond exposure grows, inflation replaces volatility as a primary risk. At a modest 3% inflation rate, prices can double over the life expectancy of the average retiree.
Plan participants often have only a few bond fund alternatives. The majority of 401(k) plans offer either a stable value fund or a money market fund and maybe a market value intermediate bond fund or two. None of these alternatives may not fully hedge inflation. Nominal bonds can perform poorly in the immediate wake of an inflation spike as yields increase. As yields and prices stabilize, nominal bond returns can ultimately predominate price declines, but the timing of this catch-up depends on the nature of the bond fund. Money market returns are likely to increase after an inflation spike, but their response is based on monetary policy and may have limitations. Stable value funds can adjust to inflation, perhaps better than money market funds, though the extent of the lag and the degree of their participation depends on their portfolio structure, duration and cash flows.
TIPS fully hedge inflation as measured by CPI and therefore could be a valuable addition for some investors in a 401(k) plan. There are also certain tax advantages to holding TIPs in a tax deferred account. Investors receive full inflation protection if TIPS are held in a tax deferred 401(k). According to Hewitt research, specialty bond funds, including TIPS funds, increased by 10% in 2009. Vanguard’s 2009 retirement plan survey data indicated 19% of its defined contribution plans offer a TIPS funds.
While TIPS are well suited for a role as an inflation hedge or fixed income portfolio diversifier in a 401(k) plan, other aspects should be considered in determining their suitability for particular plan populations.
While TIPS are relatively risk-free in the long run, they can be quite volatile in the short run. Naïve investors might assume that the inflation adjustment is the primary source of total returns for TIPS. However, the change in real interest rates, positively correlated with investors’ inflation expectations, has historically had a more significant impact on TIPS returns. TIPS can generate losses, even with rising inflation expectations, should real rates be rising faster or should heavy demand for TIPS drive yields down.
If TIPS notes are not held to maturity, investors loose their fixed real rate of return. Fluctuations in the yield on newly issued TIPS result in changes in the prices of existing securities, exposing investors to capital gains or losses. This market price exposure means that holding TIPS for short periods of time negates their inflation hedging capabilities and exposes investors to almost a similar level of price risk as nominal Treasuries.
Most 401(k) plans that offer TIPS use a TIPS fund rather than individual TIPS. TIPS funds have some advantages but do not allow investors to hedge date certain future liabilities. TIPS funds can be thought of as a rolling ladder of individual TIPS which have a specific duration. This structure exposes investors to some level of realized gains and losses as they draw down their investment through retirement. The financial impact of these hedging mismatches will be determined by the dollar weighted inflation component of pre retirement accumulations vs. post retirement distributions. For long term regularly scheduled accumulations and distributions, these impacts would theoretically average out.
TIPS investments can provide a conservative way for 401(k) plan participants to diversify their fixed income portfolios and hedge a slower growth, inflationary environment. However, like many fixed income sectors, they are somewhat complex and less well understood by participants, raising the potential for inappropriate expectation and utilization. Plan sponsors should consider a number of factors when determining whether a TIPS investment would be a suitable alternative for their plans:
· Demographic distribution of plan participants
· Range and characteristics of existing total plan and fixed income alternatives
· Retention of retirement accounts by post retirees
· Associated defined benefit pension plan benefits
· Ability to educate/inform participants about TIPS
· Utilization of advice facilities