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Treasury Inflation-Protected Securities (TIPS) and Inflation Risk
Inflation is an important consideration for many U.S. adults planning for retirement. Changes in consumer prices can affect purchasing power over time, particularly for individuals who rely on fixed income sources. One investment often discussed in the context of inflation is Treasury Inflation-Protected Securities (TIPS). Understanding how TIPS function, as well as their potential benefits and limitations, can help investors evaluate whether they align with broader retirement planning goals.
The Federal Reserve and Inflation
The Federal Reserve plays a central role in managing inflation through monetary policy. In February 2018, Jerome Powell was appointed Chair of the Board of Governors of the Federal Reserve System, becoming the 16th individual to lead the U.S. central bank. One of the Fed’s primary responsibilities is adjusting short-term interest rates to support price stability and overall economic conditions.
For much of the period leading up to 2021, inflation remained relatively subdued, which allowed the Federal Reserve to maintain lower interest rates. Following the COVID-19 pandemic, inflation rose sharply, prompting the Fed to increase short-term rates in an effort to moderate rising prices. More recently, policymakers have emphasized ongoing monitoring of inflation data, including the Consumer Price Index (CPI), when considering future policy decisions.
What Are Treasury Inflation-Protected Securities (TIPS)?
Treasury Inflation-Protected Securities are U.S. Treasury bonds designed to adjust with changes in inflation. Unlike conventional Treasury bonds, TIPS have a principal value that is linked to the Consumer Price Index, a widely used measure of inflation in the United States.
When the CPI increases, the principal value of a TIPS is adjusted upward. If the CPI declines, the principal value may be adjusted downward. These adjustments occur semiannually and directly affect both the bond’s value and the interest payments received by the investor.
How TIPS Interest Payments Work
TIPS pay interest at a fixed rate, which is determined at issuance. However, because this fixed rate is applied to the inflation-adjusted principal, the dollar amount of each interest payment can vary over time. When inflation rises and the principal increases, interest payments generally increase. When inflation slows or turns negative, interest payments may decline.
This structure means that TIPS respond differently to inflation than traditional fixed-rate bonds. While the interest rate itself does not change, the inflation adjustment can influence the total income received.
Principal Protection at Maturity
At maturity, holders of Treasury Inflation-Protected Securities receive either the adjusted principal or the original principal amount, whichever is greater. This feature is designed to address periods of deflation, although it does not eliminate other risks associated with holding bonds, such as interest rate risk or opportunity cost.
It is important to note that while TIPS are backed by the U.S. government, their market value can fluctuate prior to maturity. Investors who sell TIPS before maturity may receive more or less than their original investment, depending on interest rate conditions and inflation expectations at the time of sale.
Tax Considerations for TIPS
Interest income from TIPS is exempt from state and local income taxes but is subject to federal income tax. In addition, annual increases in principal due to inflation adjustments are generally taxable in the year they occur, even though the investor does not receive the adjusted principal until the bond matures.
This feature, sometimes referred to as “phantom income,” may affect cash flow planning. Individuals evaluating TIPS may wish to consider how these tax rules align with their broader financial situation and account types.
Inflation Trends in Context
Over the 20-year period ending in 2024, the Consumer Price Index averaged an annual inflation rate of approximately 2.6%. Inflation reached higher levels in 2022 before moderating in subsequent years, with an average rate of about 2.9% reported for 2024. These historical figures highlight how inflation can vary over time and why some investors look for ways to address inflation risk within diversified portfolios.
Considering TIPS in a Broader Strategy
Treasury Inflation-Protected Securities are often discussed as one way to manage inflation-related risks, but they are not suitable for every investor or every situation. Factors such as interest rate movements, tax treatment, time horizon, and overall asset allocation can influence how TIPS behave within a portfolio.
A review of long-term retirement goals, income needs, and risk tolerance may reveal whether inflation-sensitive investments, including TIPS, align with an individual’s overall strategy. As with all investments, understanding both potential benefits and limitations is an essential part of informed decision-making.
