Balkinization: Investment Tips for Retirees Worried About Inflation

Investment Tips for Retirees Worried About Inflation

Ian Ayres

Crosspost from Freakonomics:

As I was getting coffee in the faculty lounge, I started talking to a senior colleague who is nearing retirement. He said that he avoided a lot of the market pain of the last year because he had only about 25 percent of his savings in stock. (Now with the market drop, he has an even smaller percentage!) But his current concern is inflation.

As this killer graph from Paul Krugman shows, Ben Bernanke has been incredibly aggressive in expanding the money supply.

It is quite reasonable to be worried that the Fed will not be nimble enough to suck up this cash as the economy recovers. The banks and others are currently hoarding cash. But when they start to spend or invest it, the Fed will need to remove it by buying back assets (such as Treasury bonds), or we will have substantial inflation.

So here’s a puzzle: What should you do if you are retired or close to retirement and you are scared about the risk of inflation?

Holding stocks is often a way to hedge inflation — because dividends and stock prices rise with inflation. But at this stage in your life, you don’t want the risk of holding stock. Where should you invest at least some of your money to hedge the inflation risk?

This is not a hard puzzler; but if you’re having trouble, here’s a hint: Larry Summers.

A less obscure hint is the title of this post.

I’d love to hear your suggestions (let me say in advance that speculating on gold is not a great answer).

But the most simple response is to buy TIPS. TIPS stands for Treasury Inflation Protected Securities:

TIPS are treasury notes which offer guaranteed payments — interests in every six months and principal on security maturing. In every six months, the value of TIPS is automatically recalculated with respect to the inflation rate (measured based on Consumer Price Index, CPI). That is, when the inflation rate is up, the value of TIPS is also increased automatically.

I mentioned Larry Summers because Summers championed their creation when he was Deputy Treasury Secretary in the 1990’s. I think of TIPS as Summers’s gift to the world, giving us a low-risk way to hedge inflation risk.

The brilliant Andy Tobias also points out that TIPS hedge not only against inflation, they also provide a hedge against deflation — because in comparison to stocks they will keep their value, even if there is a decline in the Consumer Price Index.

Posted 2:20 PM by Ian Ayres [link]

Comments:

But who will protect the taxpayers from the interest from TIPS bonds during a government created inflation?

# posted by

Bart DePalma : 2:27 PM

"Bart" ImASmartInvestorBarackWonBuyGoldNow:

But who will protect the taxpayers from the interest from TIPS bonds during a government created inflation?

Why do you think the "taxpayers" are paying the interest? It's (by definition) an inflationary period, and at such times the money supply is expanding.

Any issues with inflation here are borne by the taxpayers whether or not such securities exist.

Cheers,

# posted by

Arne Langsetmo : 4:03 PM

The banks and others are currently hoarding cash. But when they start to spend or invest it, the Fed will need to remove it by buying back assets (such as Treasury bonds), or we will have substantial inflation.

Doesn't the Fed remove money from the economy by selling assets such as Treasuries? Buying them would involve putting more cash into the economy!

# posted by

marcel : 4:08 PM

A fair number of analysts consider CPI to underestimate inflation -- and that's for the population at large. For the elderly, whose costs are disproportionately in things which may be under-represented in the CPI, an older person may actually need investments which exceed the official inflation rate.

# posted by

C2H50H : 5:54 PM

Doesn't the Fed remove money from the economy by selling assets such as Treasuries? Buying them would involve putting more cash into the economy!

My question exactly!

And as a corollary, does it matter for inflation if the Fed is buying/selling assets overseas, ie, China?

# posted by

mattski : 6:50 PM

Arne:

Inflation without TIPS obligations robs wealth from everyone who holds currency.

TIPS obligations impose a double hit on taxpayers who are not only being robbed of wealth, but will also be on the hook for greater government interest costs.

# posted by

Bart DePalma : 7:01 PM

"Bart" DeClueless:

Inflation without TIPS obligations robs wealth from everyone who holds currency.

True. I think I said that. What does that have to do with the price of tea in Sri Lanka?

TIPS obligations impose a double hit on taxpayers who are not only being robbed of wealth, but will also be on the hook for greater government interest costs.

Why? How so? What TIPS are is an instrument that is buffered against currency value changes. They're no different than other such investments (and there's other ways of constructing them ... or if you prefer, just invest in some other country's currency or securities).

As such, their value reflects this structure, and that should be reflected in the buying price (or alternatively, in the return rate compared to teh buying price).

Why you think this puts taxpayers on the hook is beyond me....

Cheers,

# posted by

Arne Langsetmo : 7:42 PM

In re deflation, ask the Treasury: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm#deflation

"What happens to TIPS if deflation occurs?

The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal."

So TIPS interest adjusts down with deflation, as does principal, but you are always guaranteed the original principal. That's some help, but not much.

Bart, you really, really need to get a life.

# posted by

wcw : 1:48 AM

Arne:

The TIPS bonds are being pitched because they pay more interest as inflation rises.

If not the tax payers, who precisely do you believe will pay the increased interest on these TIPS bonds? The federal government inflation fairy?

This is similar to the law increasing social security payments by inflation. Believe it or not arne, you and not the inflation fairy pay for this with your social security taxes.

# posted by

Bart DePalma : 8:56 AM

Arne has the right idea in terms of diversifying internationally. At the end of the day, we're talking about actual countries, their governments and their people, and how well the economy is run. The best run economies right now, in my view, are those of The Netherlands and Sweden.

Buy securities from these countries, which many investors have already done. The Bank of Sweden had to pull the plug on selling securities for a while because of too much demand.

# posted by

Jacob : 11:08 AM

The TIPS bonds are being pitched because they pay more interest as inflation rises.

And less interest as deflation occurs. Not to mention, as "hedge" investments, with nominally more stability, you take a hit on the guaranteed interest rate. It's guaranteed ... but lower. You get stability at the price of (potential) return. Funny I should have to explain that to a Nobel laureate economist of the intricacies of free markets....

If not the tax payers, who precisely do you believe will pay the increased interest on these TIPS bonds? The federal government inflation fairy?

As I pointed out, in an inflationary era, the federal money supply is growing. Not necessarily one-to-one, of course, but nonetheless there's more money to be passed out. I'm not saying this a "Republican Free Money™" scheme; rather, the overall losers will be tend to be those that didn't invest in such more stable but lower return securities. But they took their chances and lost. C'est la vie.

Cheers,

# posted by

Arne Langsetmo : 12:50 PM

Jacob:

Buy securities from these countries, which many investors have already done. The Bank of Sweden had to pull the plug on selling securities for a while because of too much demand.

If they auction off bonds (as we do), the price will rise as demand does, and things will stabilise.

Cheers,

# posted by

Arne Langsetmo : 12:52 PM

OT to the proprietors:

Prof. Lederman has been noticeably absent for a while. Is this a good sign? Can we look forward to his joining the administration?

Best to him, of course, and I hope that our commentary here on his posts hasn't hurt him in any way....

Cheers,

# posted by

Arne Langsetmo : 12:58 PM

I'm sticking with Cramer.

# posted by

Anonymous : 8:57 PM

How about survival tips for those of us who cannot afford to ever retire?

# posted by

Patrick S. O'Donnell : 2:12 AM

How about survival tips for those of us who cannot afford to ever retire?

Ayup.

# posted by

mattski : 9:28 AM

How about survival tips for those of us who cannot afford to ever retire?

# posted by Patrick S. O'Donnell : 2:12 AM

You should consider becoming a DWI attorney in Colorado. They appear to have a lot of free time.

# posted by

Bartbuster : 4:21 PM