by Archie M. Richards, Jr., CFP^®
May 20, 2002

Let's say you want an investment that provides protection from inflation and complete safety of principal. You're willing to receive relatively low investment returns. Inflation-Indexed Treasury Securities might be the answer.

The informal name, TIPS, stands for Treasury Inflation-Protected Securities. These are loans to the U.S. Treasury, with repayments backed by the United States government.

With other kinds of Treasury bonds, both the amount of repayment at maturity and the regular interest payments remain level.

With TIPS, neither the amount of repayment nor the regular interest payments remain level. Both are continually adjusted for inflation. (The repayment amount per bond is usually called the "par value.")

The first TIP was issued in January 1997. The par value of each bond was $1,000. The interest rate was 3.375 percent.

Let's assume no inflation during the first year. That year's interest payment would have been $33.75 per bond (3.375 percent of $1,000).

With TIPS, the par value is adjusted every day for inflation. The adjustments are based on the latest Consumer Price Index for urban consumers (CPI-U). The CPI-U is the best measurement available of the general price level for all U.S. urban dwellers.

We assumed no inflation during the first year. No change to the par value was made.

It's now the second year. Assume that rising prices have caused the CPI-U to register an increase in inflation of 3 percent. This causes the par value of the TIPS to be raised from $1,000 to $1,030.

The "real" return, after adjusting for inflation, remains at 3.375 percent. In the first year, the interest payment was 3.375 percent of $1,000, or $33.75. The par value is now increased to $1,030. The interest payments rise as well. The interest payment for the second year is 3.375 percent of $1,030, or $34.76. (Interest payments from TIPS are made twice a year, but we disregard this for simplicity.)

The increases in both the par value and the interest payments compensate for inflation. At maturity, the bond pays off at whatever the adjusted par value may be at the time.

You can buy or sell existing TIPS any time. The prices of these transactions are also based on the adjusted par value.

If inflation reverses and prices fall instead of rise, the par value would come down. But the par value of a TIP cannot fall below $1,000.

From a tax standpoint, TIPS have two disadvantages:

1. Increases in the par value are taxable currently. But the cash resulting from par value adjustments isn't paid to the investor until the TIP is sold or redeemed. This may be many years later. In the year the tax is due, no cash is received with which to pay it.

2. Increases in the par value are taxable as ordinary income, not as capital gains. Ordinary income is taxed at relatively high tax rates and capital gains at relatively low rates.

Within traditional IRAs and other qualified retirement plans, earnings accumulating within the plans are not currently taxed. Withdrawals are taxed as ordinary income. When TIPS are held in qualified retirement plans, the tax disadvantages mentioned above therefore have no effect. The tax treatment of qualified plans nullify the tax disadvantages.

To acquire TIPS, check out www.treasurydirect.gov or call 800-722-2678. You can buy the bonds with no commissions for as little as $1,000. Payments to and from the U.S. Treasury are electronically transferred to and from your account at a bank or brokerage firm.

TIPS provide inflation protection and are as secure as the U.S. government.

Josie asks, what are Guaranteed Investment Contracts?

GICs are creations of insurance companies, Josie. Approximately two-thirds of all 401(k) plans offer them as investment options. Generally, the interest rates are slightly higher than those of certificates of deposit.

"Participating" GICs pay interest with variable rates. As interest rates change, the rate paid by a Participating GIC changes as well.

"Non-Participating" GICs offer fixed interest rates.

What interest rates will do during the next year or two I do not know. But over the next ten or fifteen years, I expect interest rates to fall. In the long run, Non-Participating GICs would probably be the better choice.