Tips can offer protection against inflation

February 10, 2011

Understand whether you can protect investments against future inflation.

Q: Can investing in treasury inflation-protected securities really protect my investments against future inflation?

A: Since the U.S. Treasury introduced them in 1997, treasury inflation-protected securities (TIPS) have become the most widely known example of what are known as inflation-protected securities.

Although TIPS pay slightly lower interest rates than equivalent treasury securities that don't adjust for inflation, an inflation-protected security guarantees that your "real" return will keep up with inflation. Your TIPS principal is automatically adjusted twice a year to match any increases or decreases in the consumer price index (CPI).

In this example, the 2.5% interest rate would be applied to the new $20,300 figure, meaning that instead of $250, your next semi-annual payment would be $253.75.

Similarly, if the CPI is lower after the 6-month period, your principal would be adjusted accordingly when it's recalculated; that in turn would affect the amount of your next interest payment. If there is a prolonged period in which the CPI is negative, your principal and interest payments would thus experience a substantial decrease.

The inflation adjustment feature means that if you hold TIPS until they mature, your repaid principal likely will be higher than when you bought the bond. Even if the economy experiences deflation, the amount you'll receive when the bonds mature will be the greater of the inflation-adjusted figure or the amount of your original investment.

Keep in mind, however, that if inflation turns out to be less over time than you had anticipated when you invested, the total return on TIPS could be less than that of a comparable treasury security without the inflation-adjustment feature.

Lawrence B. Keller, CFP, CLU, ChFC, founder of Physician Financial Services, a New-York based firm specializing in income protection and wealth accumulation strategies for physicians.