TIPS, otherwise known as Treasury Inflation Protected Securities, are a great idea that few investors understand.

Ditto their sister security, the I-Savings Bond.

First offered in January 1997, TIPS have been issued in 5-, 10-, and 30-year maturities and at real interest rates from 3.375 percent to 4.25 percent. Add the current rate of inflation and they are providing effective yields from about 6.4 percent to about 7.3 percent--- rates that compare favorably with traditional Treasury obligations. You can invest in these securities, when issued, in multiples of $1,000 through Treasury Direct, at no cost. You can also invest in them through mutual funds such as Vanguard Inflation Protected Securities fund (minimum investment $3,000) or in variable annuity form through CREF Inflation Linked Bond fund.

I-Savings Bonds currently offer a return that is 3.40 percent over the rate of inflation. Combine that with the official rate of inflation, and your effective yield is 6.49 percent. While the rate of inflation will vary, investors are guaranteed that they will receive a "real" return of 3.40 percent.

Not impressed?

I'm not surprised. After nearly two decades of incredible stock market returns, the idea of an inflation-adjusted return of 3.5 to 4.0 percent isn't very exciting.

Until you realize what it will do for you:
  • By historic standards it's a very high return. According to Ibbotson Associates data, the real return on both long and intermediate term government bonds has averaged 2.2 percent from 1926 to the present. So real returns of 3.4 to 4.0 percent being offered by the Treasury are a historic bargain.
  • Inflation index securities will cream the average managed bond fund. Since the average managed bond fund under performs a bond index and a bond index provides a lower real return than an inflation protected security, we can be quite confident that these securities will do much better than typical fixed income funds.
  • Whatever happens with inflation, investors now have a security that can be used to guarantee future purchasing power. If you buy $10,000 of inflation protected security today, you'll have $10,000 of real purchasing power when the security matures--- plus your real return.
This means you can estimate future needs and buy securities accordingly, knowing that the greatest single uncertain--- inflation--- has been neutralized. It means you can put together a sequence of securities that will deliver the cash you'll need in 2002, 2003, 2004, and so on, far into the future. It means that you can go through a year like this one without worries, knowing that your stocks or stock funds won't have to be sold because you've provided for cash far into the future.

As an extreme, you could design a portfolio that would provide necessary purchasing power beyond your life expectancy. According to an Excel spreadsheet I created to explore this idea, it would take $8,600 to fund $1,000 of inflation-adjusted yearly expenses for 10 years. To finance 17 years (the life expectancy of a 65-year old) you would need $13,700.

To fund $1,000 a year of constant purchasing power for the 25-year joint expectancy of a mid-sixties couple you would need $17,100. And you can maintain the purchasing power of $1,000 for 40 years--- the retirement equivalent of forever--- with $22,400. In other words, you would need 17 to 22 years of current purchasing power, invested in the safest security on earth to guarantee the investment side of a long retirement.

Add indexed stocks after 10 years and you can cut the multiple down to 13 to14 years. Add indexed stocks after 17 years and the multiple is 15 to16.

Want to learn more? Try these websites:

Bureau of Public Debt page on Treasury inflation indexed securities

Current earnings rate on I-Bonds

Questions and Answers about I-Savings Bonds

Vanguard Inflation Protected Securities fund

TIAA-CREF Inflation Linked Bond fund information (variable annuity)