The vast majority of employees today have to save and plan for their own retirement. They face enormous challenges: inflation, low interest rates, an extremely volatile and unpredictable stock market, and job insecurity. It wasn’t always that hard. Decades ago, many more employees worked for companies that offered defined benefit pension plans that promised their employees an inflation-adjusted basic stream of retirement income upon retirement. Most of those plans have been terminated and replaced by defined contribution plans, such as 401(k)s. Today, most employees have to save and plan for their own retirement.
So how can today’s employees save and prepare for retirement effectively, on their own, if they don’t want to trust their retirement security to the vicissitudes of the stock market? Many simply invest their money in Certificates of Deposit (CDs). But with CD interest rates generally low, inflation generally high, and all interest taxed every year, this is a very poor option. Some retirees will choose to purchase an immediate income annuity. But annuities are generally expensive. The premiums support not only the annuity payments, but also a large commission, a generous compensation package for the insurance company’s executives, and the large general, operating, and advertising expenses of the insurance company.
Fortunately, there’s a better option: buy inflation-indexed bonds known as Treasury Inflation-Protected Securities (TIPS). In 1997, the US Treasury began issuing TIPS with maturities of 5, 10, and 20 years. Unlike Treasuries, TIPS protect the holder from inflation through adjustments, based on the Consumer Price Index (CPI), to the principal. Because they are backed by the full faith and credit of the US government, TIPS are as safe as an FDIC-backed CD and safer than an annuity.
However, interest issued by TIPS, unlike capital gains, is taxed at ordinary income tax rates. Therefore, TIPS are best purchased through a tax-advantaged account, such as a self-directed IRA. There are some low-cost stockbrokers that allow clients to purchase TIPS through a self-directed IRA, so call a few of them and find out.
Instead of creating a tiered portfolio of CDs, retirees should consider creating a tiered portfolio of TIPS of different maturities, in a self-directed IRA. Retirees should also consider delaying their claim for Social Security benefits until they reach age 70, and take distributions from an IRA that has TIPS until they reach age 70.
To execute a TIPS retirement strategy, retirees must calculate the retirement expenses that a TIPS-based portfolio would bear. For example, a $1 million IRA portfolio of tiered TIPS with a 3% real yield would support inflation-adjusted retirement expenses of more than $65,000/year for 20 years.