You don't need an economics degree to know that inflation is a growing problem. Fueling up the car and buying groceries are sharp reminders of how hard-earned dollars are worth less when prices jump. Inflation affects everyone, but retirees are particularly vulnerable.
"The greatest risk retirees face is inflation, not short-term volatility of the stock market," says Tom Orecchio, national chair of the National Association of Personal Financial Advisors. "People focus on the market today as opposed to their purchasing power 25 years from now, and that's a mistake."
These investments can help retirees protect against it.
1. Treasury-Inflation Protected Securities (TIPS) How they work: TIPS are designed to protect investors from inflation by tying them to the Consumer Price Index, or CPI, the government's main gauge of inflation. Specifically, TIPS' principal rises with inflation and falls during deflation.
Consider: If someone buys $100,000 in TIPS and inflation increases by 3 percent, the TIPS principal will be worth $103,000 by the end of the year. (Adjustments are made every six months.) When TIPS mature, investors receive the original principal amount or one that's been adjusted, whichever is greater.
TIPS also pay interest on a semiannual basis. This coupon rate is constant, but the interest earnings will fluctuate because it's based on the inflation-adjusted principal. The interest every six months is computed by multiplying the principal by half of the coupon rate. So a $100,000 TIPS paying a 2 percent rate would pay $1,000 in interest every six months. (The principal's growth is not factored into this calculation.)
Cost: TIPS are sold directly from the U.S. Treasury Department in increments of $100 as of April 2008. That's down from a previous $1,000 minimum purchase price. Alternatively, you can purchase shares of mutual funds that primarily invest in TIPS, such as Harbor Real Return or Vanguard Inflation-Protected Securities. Minimum investment requirements and management fees vary from one fund to another.
Liquidity: TIPS are very liquid. You can sell them at any point in time, though there's no guarantee you'll make money. That's because if you sell before the TIPS maturity date, "you incur a risk of selling at a premium or discount of what you've paid for it," says Stephen Meyerhardt, spokesman for the U.S. Treasury's Bureau of the Public Debt. The current interest rate environment affects the value of TIPS as well as most other types of bonds.
Pros: Inflation protection.
Cons: Taxes. Investors must pay ordinary income tax rates, which can be as high as 35 percent, for the interest they receive as well as for any increase in value in the TIPS principal. They'll be taxed even if they continue to hold the TIPS. For that reason, experts recommend that TIPS be held in tax-sheltered accounts such as a 401(k) or an IRA.
Risk: In case of deflation, the value of the principal will go down. So if you sell it prior to maturity, you may get less than what you paid. You can avoid this risk by holding TIPS until they mature.
Lately, TIPS have been selling at a premium, due to consumer demand. That's driven yields lower. For example, five-year TIPS fell to negative yields in recent months. Experts advise buying TIPS through a mutual fund. "The (fund managers) can scoop up new TIPS when more attractive yields appear," says Paul Herbert, senior fund analyst at Morningstar.
Who they're good for: Retirees, and anyone else living on a fixed income are good candidates for TIPS. But since no one is immune from the corrosive effects of inflation, Herbert recommends them broadly to both workers and retirees alike.