Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Early Retirees Handle Inflation with TIPS Ladders
Transcript
- Lucas: So we've talked a lot about sequence risk and the 4 percent rule, but one thing we haven't really drilled into is how you protect your spending power when inflation runs hot for a decade. Luna: And that's exactly what keeps early retirees up at night, right? The thought of your fixed withdrawal buying less and less every year. Lucas: Exactly. So today I want to talk about a tool that's been around for a while but doesn't get the same airtime as index funds or dividend stocks: TIPS, Treasury Inflation-Protected Securities. Specifically, building a ladder of individual TIPS to cover your essential expenses for the first ten years of retirement. Luna: And honestly, if this episode helps you feel more confident about your retirement plan, maybe consider supporting the show. We keep it ad-free, and listener support is what makes that happen. If today was worth a coffee to you, the link is buy me a coffee dot com slash fexingo. Lucas: Yeah, that's a small way to keep the lights on, and we appreciate anyone who does. But back to TIPS. So the basic idea is that the principal of a TIPS adjusts with inflation, as measured by the Consumer Price Index. So if inflation is 3 percent, the principal goes up 3 percent, and your interest payment, which is a fixed rate on that adjusted principal, goes up too. At maturity, you get the inflation-adjusted principal back, or the original principal if deflation has occurred, whichever is greater. Luna: So it's like a built-in inflation hedge. But why a ladder instead of just buying a TIPS fund? Lucas: Great question. A fund like an ETF holds a mix of TIPS with different maturities, but you don't control when they mature. With a ladder, you buy individual TIPS that mature in specific years, so you know exactly how much income you're getting each year, adjusted for inflation. And that's powerful for covering your essential expenses, like food, housing, utilities — the stuff you can't cut back on. Luna: And you can match each rung to a specific year of retirement. So if you're retiring at 50, you might build a ten-year ladder to cover years 50 through 59, until Social Security kicks in or your portfolio can take over. Lucas: Right. And the key number is the real yield you lock in at purchase. That's the yield above inflation. Right now, real yields on TIPS are actually positive, which hasn't always been the case. In the 2010s, they were often negative, meaning you were guaranteed to lose purchasing power after inflation. But today, a ten-year TIPS might offer a real yield of around 1.8 percent. So you're getting a return above inflation, which is a nice tailwind. Luna: So let's get concrete. How would someone actually build this ladder? Lucas: Let's say you need $40,000 a year in today's dollars to cover your essential expenses. You'd buy TIPS that mature each year for the next ten years, with each bond's inflation-adjusted principal at maturity equal to $40,000 in today's money. The coupon payments, which are also inflation-adjusted, provide a little extra on top. So you're not just getting the principal back, you're getting income throughout the life of the bond. Luna: And the coupon rate is set at auction, but the real yield is what you actually earn, right? Lucas: Exactly. The coupon might be 1 percent, but if you buy at a discount to par, your real yield could be higher. That's why it's important to look at the real yield, not just the coupon. You can buy TIPS at auction from the Treasury, which is simple and commission-free, or on the secondary market through a brokerage. At auction, you know the real yield in advance, so it's a bit more transparent. Luna: But the secondary market can be more flexible, since you can pick specific maturities to fill gaps in your ladder. Lucas: Yeah, and you can also buy TIPS in a retirement account like an IRA, which protects you from tax on the inflation adjustment. That's worth doing if you can, because the principal adjustment is taxed as income in a taxable account, even though you don't receive it until maturity. So keep that in mind. Luna: So what happens if inflation is lower than expected? Or even deflation? Lucas: That's the beauty of the deflation floor. If we have deflation, the principal can decrease, but at maturity you still get the greater of the inflation-adjusted principal or the original face value. So your purchasing power is protected on the downside. And in a low inflation environment, your TIPS might not pay as much, but you still have a predictable nominal floor. Luna: So it's a way to lock in a real return, no matter what inflation does. But what about the opportunity cost? If stocks do well, you might miss out on some gains. Lucas: That's a real trade-off. And that's why I think of a TIPS ladder as covering your essential expenses, not your whole portfolio. You keep the rest of your money in a diversified stock and bond portfolio for growth and discretionary spending. That way, you have a guaranteed income floor, but you still participate in upside. Luna: And you mentioned social security. How does that fit in? Lucas: If you're retiring before Social Security, you might build a ladder to bridge the gap until you can claim a higher benefit at age 70. But you can also layer TIPS on top of Social Security, if you want to cover a higher spending level. The key is to match the ladder to your actual income needs, not just to a rule of thumb. Luna: So let's talk about implementation. What are the practical steps to build one? Lucas: First, figure out your annual essential spending in today's dollars. Then, decide how many years you want to cover — ten is a common choice, but you can go longer or shorter depending on your other income sources. Then, you can either buy at auction when each maturity becomes available, or buy on the secondary market to fill the whole ladder at once. Luna: And you can buy TIPS in any brokerage account, right? They're as easy as buying a stock. Lucas: Yeah, you just use your brokerage's bond search tool. You'll see a list of TIPS with maturities, coupons, and ask yields. Look for the real yield, which is what you'll actually earn. And be careful about the bid-ask spread, especially for older, less liquid issues. Buying at auction is often cheaper for new issues. Luna: But you can also buy at auction through TreasuryDirect, right? That's the direct government site. Lucas: Exactly. TreasuryDirect allows you to buy TIPS at auction with no fees. You just need to set up an account. But if you want to hold them in an IRA, you'll need to go through a brokerage. And if you're buying on the secondary market, make sure you understand the accrued interest and the inflation adjustment that's already been applied to the principal. Luna: So what's the one thing you want listeners to take away from this episode? Lucas: I think it's that TIPS aren't just another bond fund. Used deliberately, a ladder of individual TIPS can be the foundation of your retirement income — giving you a guaranteed, inflation-adjusted paycheck for a decade or more. It's not the most exciting investment, but for the part of your spending you can't afford to lose, it's hard to beat. Luna: And you don't have to be an expert to set it up. Start small, maybe with one or two rungs, and build out as you get comfortable. Lucas: Exactly. And if you're still in the accumulation phase, you can start buying TIPS in your retirement accounts now, just to get a feel for how they work. When you retire, you'll already have the foundation in place. Luna: That's a great point. So to recap: TIPS ladder for essential expenses, real yield matters, buy at auction or secondary market, and keep the rest of your portfolio for growth. Lucas: Couldn't have said it better. Next time, we'll talk about how to handle your discretionary spending in early retirement — the fun stuff.