Wednesday, July 3, 2019

The Best Inflation Protection You Never Heard Of

In a recent post, I discussed inflation's potential impact on your retirement income (see Remember Inflation?) and I warned against letting three decades of low inflation lull us to sleep.

Inflation rates are low right now, about 1.9% per year according to the U.S. Department of Labor. Even at that rate, a 2019 dollar in 2049 would purchase only $0.56 worth of goods and services in constant dollars of 2019 by the end of a 30-year retirement. Assuming the long-term average inflation rate of 3.15%, that dollar in 2049 would be worth only $0.38 in 2019 dollars.

Of course, there isn't a strong argument that inflation rates won't be significantly worse than average sometime in the next thirty years as they have been in four of the past eleven decades. The reality is that no can predict future inflation, mean or worst-case, with any certainty.

It is nearly certain that we will see some level of inflation over several years of retirement and even low levels will erode the purchasing power of nominal annuities and pensions. The only real question is how much.

Economist, Zvi Bodie and I recently published a paper[1] recommending that retirees consider purchasing CPI-adjusted annuities and CPI-adjusted bonds (TIPS)[2] instead of their nominal alternatives.

Retirees with pensions rarely enjoy inflation protection and when they do it is limited. I have several friends and family members covered by the Kentucky Teachers' Retirement System, for example. According to their website, their pensions currently offer a 1.5% cost of living adjustment which is much better than nothing but won't adequately compensate for historical average inflation or even today's low rate.

Annuities, whether CPI-adjusted or nominal, aren't the best solution for every household but there are other inflation-protecting alternatives to consider. TIPS are another choice for consideration but for this post I'll suggest U.S. Treasury Series I Savings bonds, or I Bonds.[3]

I Bonds are meant to be used as inflation protection for individual households and can only be purchased online at TreasuryDirect.gov®.[4] The interest rate they pay consists of a fixed rate, currently 0.5% plus a variable inflation rate, currently 1.4% per year, that is recalculated twice a year. The fixed rate has been as high as 3.4% in 1998. These components constitute a "composite rate" that is currently 1.9% per year. Before you lose interest in a 1.9% return, consider several additional features of I Bonds that distinguish them from CDs or money market funds that don't compensate for inflation.


The best inflation protection you never heard of.
[Tweet this]


CD's typically can be purchased with terms up to five years. I Bonds pay interest for 30 years.

The early withdrawal penalty for a CD depends on its term. A 5-year CD, if redeemed before the end of its term, will typically incur a penalty of about nine months of interest and a 1-year CD typically three months. I Bonds can't be redeemed for one year after purchase but there is no penalty for redemption after five years and only a 3-month penalty for redemptions between one and five years.

If I Bond interest rates decline, you have locked in your rate for up to 30 years. If rates increase, you can sell your old bonds and buy new ones, subject to annual purchase limits described below.

According to Dr. Bodie, "...another advantage of I Bonds is that [should interest rates rise,] investors could then cash out their existing I Bonds (and keep principal plus accrued interest) and buy new ones at the higher rate of interest. In other words, whether interest rates go up or down, the investor is protected. (But note that if you buy new I Bonds you would be subject to the $10,000 limit.) If you have the money, you would have to be nuts not to invest in I Bonds up to the limit."

I Bonds can never yield less than zero, so in the worst case your investment will maintain its purchasing power. In the event of deflation, I Bonds would increase in value.

From a tax perspective, according to TreasuryDirect.gov®.[4], I Bonds are somewhat similar to a non-deductible IRA in that tax on interest can be deferred. You don't have to pay taxes on earnings until the bonds are redeemed, though you can choose to pay annually if that benefits you. I Bonds are subject to federal income taxes but not state or local income taxes. CD and money market fund interest can be subject to all three if held in a taxable account and interest is taxed as it accrues annually.

I Bonds do have some drawbacks. A household can purchase a maximum of $10,000 per Social Security number per year. Still, that's $20,000 per year for a couple. Additional purchases can be made up to $5,000 per Social Security number per year if the purchase is made from a federal tax refund.

Some advisors suggest that the maximum annual purchase limitations mean I Bonds will be less interesting to households with a lot of savings. Perhaps, but I find them too good a deal to pass up even if I'd like to buy more (and I would).

I Bonds can't be purchased in a retirement account. Certain entities in addition to individuals, however, are permitted to open TreasuryDirect.gov®.[4] accounts including a personal trust, such as a revocable or "living trust."[5]

The real interest rate on I Bonds will be relatively low because they are extremely safe, backed by the U.S. Treasury and protected from inflation.

With the very low early-withdrawal penalties, I Bonds can be an excellent solution for investing an emergency fund or for any other future liability beyond one year and for protecting that investment against inflation. They are accessible by retirees with limited resources in denominations as low as $25. Even households with large retirement savings may want to max out I Bond purchases before buying TIPS.[6]

It's a struggle to find retirement strategies for under-saved households but I Bonds provide one. Households that are able to save some of their early-retirement income from pensions and Social Security benefits could use those savings to purchase I-bonds that would then provide inflation-protected consumption later in retirement.

To find out more about Series I Savings Bonds and how to purchase them, go to TreasuryDirect.gov®.[4]. Creating an online account at TreasuryDirect.gov®.[4] is currently the only way you can purchase them. If you prefer video explanations, please see the links below.

TIPS: (the old-fashioned kind) TreasuryDirect.gov®.[4] is an excellent informational website but it could be a better e-commerce site. Don't enter "TreasuryDirect.com" into your browser (it's "TreasuryDirect.gov"). Likewise, don't enter "Treasury.gov", that's a different website. To purchase I bonds, go to the homepage "TreasuryDirect.gov" and click on the green "Open an Account" link toward the upper right.

For more help creating an account and funding it, see Navigating the TreasuryDirect.gov®.[4] Maze.





REFERENCES

[1] Hedging Against Inflation with Real Annuities, Zvi Bodie and Dirk Cotton.



[2] TIPS in Depth, TreasuryDirect.gov.



[3] Series I Savings Bonds, TreasuryDirect.gov.



[4] America’s Best Kept Financial Secret: I Bonds, Zvi Bodie on PBS.



[5] How To Transfer I Bonds to an Entity Account, TreasuryDirect.gov.



[6] Comparing I Bonds to TIPS, TreasuryDirect.gov.



[7] How to Buy Digital Savings Bonds Online, VIDEO.



[8] How to Buy Digital Savings Bonds as Gifts, VIDEO.



[9] How to Protect Your Nest Egg from Inflation, Zvi Bodie, VIDEO.



[10] Guided Tour for Opening an Individual Treasury Direct account, TreasuryDirect.gov.






11 comments:

  1. The other thing you can do is use I Bonds and TIPS to create a stream of income while in retirement. While you won't get the longevity insurance, I Bonds and TIPS are a great alternative to a real annuity.

    ReplyDelete
  2. Hi Dirk. Great series of articles on inflation. Thank you. Harry Sit has a recent interesting post titled, When to Sell Your I Bonds. https://thefinancebuff.com/when-to-sell-i-bonds.html. Just curious, would you ever consider selling your I bonds prior to maturity? I did a few years back but kinda regret that I did that.

    ReplyDelete
    Replies
    1. Thanks.

      There are several reasons I might sell I Bonds. If interest rates went up, I would sell and buy new ones at the higher rate. If I were using them as an emergency fund, I would obviously sell them in a emergency. You might sell them to pay expenses in a bear market instead of selling stock (though that increases your equity exposure).

      But, since I use them for long-term inflation protection, I expect to hold them a long time.

      Thanks for the question!

      Delete
  3. I would love to purchase I-Bonds but TD's policy of not making account holders whole in cases of hacking, fraud, etc. gives me pause. So, I stick with CDs.

    ReplyDelete
    Replies
    1. You raise a good point probably worth an entire post. A bank CD is probably quite safe. Bankrate says:

      "So, who pays when data or money get taken?

      If someone stole money out of your personal bank account, you’d likely be made whole by your bank if you had an individual (non-business) account, you weren’t lax about safeguarding your information and you notified your bank promptly, says Stuart Gerson, former acting U.S. attorney general under President Bill Clinton and shareholder at Epstein, Becker & Green, a law firm in Washington, D.C.

      Federal law says that if someone takes money from your bank account you will get all of your money back if you notify your financial institution within 60 days after the fraudulent transaction appears on your bank statement.

      “(But) you can’t have done dopey things that exposed your account,” Gerson says.
      "

      I'm guessing making your password "1234", for example, would be "dopey."

      TreasuryDirect says:

      "You are solely responsible for the confidentiality and use of your account number, password, and any other form(s) of authentication we may require. We will treat any transactions conducted using your password as having been authorized by you. We are not liable for any loss, liability, cost, or expense that you may incur as a result of transactions made using your password."

      That's pretty scary but so is this statement from Vanguard:

      "You are responsible for maintaining the confidentiality of any account information, user names, logins, passwords, and security questions and answers that you use to access any page or feature on this Site, and for logging off of your account and any protected areas of the Site. Further, you are fully responsible for all activities occurring under your accounts, user names, logins, passwords, and security questions and answers that result from your negligence, carelessness, misconduct, or failure to use or maintain appropriate security measures. If you become aware of any suspicious or unauthorized conduct concerning your accounts, user names, logins, passwords, or security questions and answers, you agree to contact Vanguard immediately. Vanguard will not be liable for any loss or damage arising from your failure to comply with this paragraph."

      On the plus side, TreasuryDirect verifies that the bank account registered by you to which your redemptions will go has the same registration as your TD account. The hacker would then need to gain access to your bank account, too, to actually steal your money. Seems challenging but hackers have done worse.

      The problem here is that your CDs are pretty safe but most people can't fund retirement solely with CDs. The alternative is to use excellent password hygiene. Use a long random password string. Write it down and keep it in a safe place instead of on your computer. Create "wrong" answers to the security questions and write those down, too. A hacker can easily find out where you were born, so if that was New York, use Wisconsin, instead. Don't use the same password for different accounts.

      Stroing passwords are important for TD but equally important for all financial accounts. Even if your bank is safer you should prefer not to have to go through the recovery process if you don't have to.

      I suspect that a lot of people assume these financial accounts enjoy the same protections as credit and debit cards but that does not appear to be the case.

      Thanks for the comment!

      Delete
  4. This comment has been removed by a blog administrator.

    ReplyDelete
    Replies
    1. This comment has been removed by the author.

      Delete
  5. So I can start buying I bonds for as low as 25.00 a pop?

    ReplyDelete