How to Build a TIPS ladder
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Interest rates have increased considerably over the past few years as the Federal Reserve has worked to fight back inflation. Rising rates have filtered through the economy, making borrowing more expensive and lending more attractive. Most interesting has been the dramatic rise in real (inflation-adjusted) interest rates. Since 2022 real rates on inflation-protected US Treasury bonds (i.e., Treasury Inflation Protected Securities or TIPS) have gone from below zero to over 2% (see Figure 1). Where savers were once willing to lend their money to the US government in exchange for locking in a real loss, they are now being compensated quite handsomely.
Figure 1. Inflation-adjusted interest rates on TIPS have risen dramatically in the past few years
For those preparing for or already in retirement, this is especially good news. Buying individual TIPS that mature across different years (i.e., building a TIPS ladder) can help you lock in a stream of inflation-adjusted income over a time horizon of up to 30-years.[1] [2]
Let’s put this into perspective. When real rates were 0% back in early 2022, it cost about $1M to build a TIPS ladder producing $100,000 of inflation-adjusted income each year for the next 10-years. Now, with real rates near 2%, the same $100,000 of inflation-adjusted income for 10-years costs about $900,000 [3]. Think about that for a minute. The same stream of dollars, producing the EXACT same amount of purchasing power, now costs $100,000 less–a considerable discount from where things were just over a year ago.
Lock in Your Living Standard
What exactly does this mean for your financial plan? Quite simply, it’s a relatively good time to build your TIPS ladder. Doing so can help you lock in a higher living standard, without taking unnecessary risk. Let’s be more concrete. Consider the Anderson’s, a 70-year-old retired couple with $40,000 a year in Social Security income and $2M in savings, including $1M in retirement accounts and $1M in taxable investments. Having run their financial plan back in early 2022, when real rates were 0%, they were told that if they built a TIPS ladder to cover all their spending over the next 30-years they could safely afford to spend about $49,671 on discretionary spending, adjusted for inflation, each year through age 100. Note that discretionary spending is spending on top of fixed spending, like housing, taxes and Medicare premiums. Now, with real rates at about 2%, the Anderson’s, with the exact same financial goals and resources, can safely afford to spend $69,579. In effect, the now higher real return on TIPS has safely increased their discretionary spending in retirement by $19,908 every year for life–equivalent to a 40% increase in their living standard (see Figure 2).
Figure 2. Higher real interest rates have increased how much the Anderson’s can safely afford to spend on their living standard every year throughout retirement
How to Build a TIPS Ladder
In practice, building a TIPS ladder means taking a chunk of money from your savings (e.g., cash, brokerage, retirement accounts) and buying a number of individual bonds that pay semi-annual interest and separately mature over a specific period of time. The goal is to have the TIPS ladder kick off a set amount of inflation-adjusted income, via a combination of interest and principal payments, each year to meet some (or all) of your spending needs.
Figuring out how much real annual income you need the ladder to produce, and for how long, is probably the most important question to address first. Figuring out which bonds to buy is relatively straightforward (e.g., try www.tipsladder.com) and buying them through your discount broker can be done in an afternoon. A great starting point is to consider building a TIPS ladder that produces at least enough additional income on top of Social Security (and any other guaranteed income you may have, like a pension or annuity) to cover all your fixed costs in retirement. Let’s consider the Anderson’s again. Between paying their taxes and covering housing and Medicare-related costs in retirement, their annual Fixed Spending is projected to be about $60,000, adjusted for inflation, for the next 30 years (see gray bars in Figure 3).
With $40,000 of inflation-adjusted annual Social Security benefits (see dotted black line in Figure 3), this means the Anderson’s will require an extra $20,000 of inflation-adjusted annual income from TIPS for the next 30-years to cover all their fixed spending ($60K - $40K = $20K). At today's real rate of 2%, this will cost them about $450,000.[4] Note that when TIPS rates were 0%, the equivalent ladder cost $600,000. If they wanted to cover some portion of their Discretionary Spending as well (see orange bars in Figure 3), they could invest even more into their TIPS ladder.
Figure 3. With $40K per year of Social Security, the Anderson’s need an extra $20K per year of real income from TIPS to cover their annual Fixed Spending of ~$60K
Buy TIPS and Invest For The Upside
Let’s say you want to use TIPS to safely cover all your Fixed Spending PLUS some minimum acceptable level of Discretionary Spending in retirement–what I call your living standard floor. Having locked in this living standard floor you can now engage in so-called Upside Investing, by investing your remaining savings in risky assets like stocks. If the stocks underperform (or go to zero) you can still safely maintain your living standard floor. And, if they perform as (or better than) expected you can safely increase your living standard floor each year by converting a portion of the stocks to TIPS over time. Let’s consider the Anderson’s again.
The Anderson’s desire a living standard floor of about $50,000 per year, adjusted for inflation. To accomplish this, in addition to covering all their fixed spending in retirement not already covered by Social Security, they invest about $1.57M of their savings into a TIPS ladder that produces about $70,000 of annual real income for 30-years (i.e., $20K to cover their residual Fixed Spending plus $50K to cover Discretionary Spending for their living standard floor).[5] Then, they take their remaining $430,000 of savings and invest it in stocks, like a low-cost Total World Stock index fund. Each year that goes by they sell a portion of the stock (e.g., 1 divided by 100 minus their age) and convert it to TIPS, thereby increasing their living standard floor consistently throughout retirement. If the stocks perform poorly (see red line in Figure 4), their living standard floor may not increase too much. But, if the stocks perform as expected (see green line), they’ll be able to spend well above their living standard floor (see orange area in Figure 4) by capturing the market’s upside.
In a sense, Upside Investing is like having your cake and eating it too. By using TIPS to cover your fixed spending and lock in a desired living standard floor in retirement, you can more safely invest in stocks for their potential upside. The lower you set your living standard floor, the greater is your potential upside, and vice versa.[6]
Figure 4. The Anderson’s build a TIPS ladder to lock in their living standard floor at $50K and invest the rest in stocks. By then converting the stocks to TIPS overtime they can safely increase their discretionary spending throughout retirement—by how much, depends on market returns.
How a TIPS ladder can Help
With inflation-adjusted (real) interest rates higher than they’ve been since the Great Recession, you can now safely afford to spend more without taking unnecessary risk. This strategy involves building a TIPS ladder, i.e., buying a number of individual inflation-protected US Treasury bonds that separately mature over the coming years. Locking in a stream of real income payments in retirement via a TIPS ladder can both safely cover your fixed spending and create a living standard floor. Surprisingly, this approach can also make investing in stocks less risky from a living standard perspective. By setting a comfortable living standard floor using TIPS, you can effectively afford to take more risk with your remaining investments in hopes of increasing your living standard throughout retirement.
Footnotes
[1] Buying and holding individual bonds to maturity, as opposed to buying them in a low-cost index fund, eliminates interest rate risk, i.e., the risk that you have to sell your bonds at a reduced price if interest rates have gone up, and vice-versa. This is a key benefit of building a bond ladder vs holding bonds in an index fund. Importantly, when long-term real interest rates are high, it allows me to increase the duration of my bond holdings without having to take on more interest rate risk. For example, if I buy a 20-30 year TIPS fund I may be able to get a higher expected yield than buying a 0-5 year TIPS fund, but now I’m taking on substantially more interest-rate risk. On the other hand, if I buy 20-30 year individual TIPS and hold them to maturity I have eliminated the interest rate risk entirely—in effect, I don’t care what happens to the price of my bonds if I hold them to maturity!
[2] You can buy 5-, 10-, or 30-year TIPS at auction with cash directly from the US Treasury (www.treasurydirect.gov). You can also buy them on the secondary market (i.e., from other investors) in your Brokerage or IRAs through your discount broker. This functionally allows you to build a full ladder of bonds all at one time.
[3] This calculation is as simple as using the PV function on your calculator or in excel. For this example, I assume the number of years (n) equals 10, the interest rate (i) equals 2, the annual payment (PMT) equals $100K, and the future value (FV) equals $0. Solving for the present value (PV) tells me the total hypothetical cost of the bonds would be $898,258.50.
[4] For this example, I assume the number of years (n) equals 30, the interest rate (i) equals 2, the annual payment (PMT) equals $20K, and the future value (FV) equals $0. Solving for the present value (PV) tells me the total hypothetical cost of the bonds would be $447,929.11.
[5] For this example, I assume the number of years (n) equals 30, the interest rate (i) equals 2, the annual payment (PMT) equals $70K, and the future value (FV) equals $0. Solving for the present value (PV) tells me the total hypothetical cost of the bonds would be $1,567,751.89
[6] This is a subtle but important point about Upside Investing. Essentially, there’s no free lunch. If you want to increase your living standard floor you’ll need to put more into the TIPS ladder, thus leaving you with less to invest in stocks for their potential upside. On the other hand, if you are willing to reduce your living standard floor you’ll need to put less into the TIPS ladder, thus leaving you with more to invest in stocks for their potential upside. The key word here is potential.