Using a TIPS Ladder

I routinely use TIPS as a theoretical baseline. This baseline has often turned out to be the best approach. Peterperson has looked into the practical aspects of having a TIPS portion of a retirement portfolio. He has found that a TIPS Ladder has many advantages. One is that it can be tax efficient since the nominal principal is left untaxed. Another is that the ladder always returns par plus inflation at maturity. Another is that there are no fees at maturity.

A TIPS Ladder is highly predictable. A significant fraction of the TIPS Ladder matures each year. You can tap the principal to cover rough spots and/or take advantage of opportunities. Or, you can buy new TIPS to replace the old.

The question remains as how to use it most effectively.

Two effects are going on. They are in conflict. I constructed a series of calculators to gain a better understanding. I looked at a variety of simple allocation approaches. The calculators allowed me to move money from bonds into stocks (and, in one instance, to move money from stocks into bonds) without rebalancing.

I have mentioned many times that what kills retirement portfolios is selling stocks when prices are low. This turns out to be a short-term phenomenon. Your TIPS Ladder does not have to protect your portfolio for anywhere near a decade. It just has to allow you to coast through two or three years until stock prices are more favorable.

Over longer periods of time, you should adjust your allocations in line with your valuation indicators. You should own more stock when P/E10 is low and/or when dividend yields are high. You should sell stock when P/E10 is high and/or when dividend yields are low.

The best use of your TIPS Ladder is to take advantage of opportunities. Load up on stocks when stocks are cheap. I am not talking about fair value. Think in terms of P/E10 of 12 or 13 and lower and/or dividend yields of 8% or higher.

Based on Historical Surviving Withdrawal Rates alone, we should allocate nothing to stocks at today’s valuations.

It is best to temper such a numerical analysis with other considerations. Always act on the basis of commonsense.

There are valid reasons for owning both stocks and bonds at all times in spite of the market outlook. For example, Ben Graham recommended that you should always allocate 25% and 75% of your portfolio to both stocks and bonds just in case something entirely unexpected happens.

Allowing one’s stock allocation to grow gradually by taking money away from bonds turns out to be slightly better than maintaining a fixed allocation and rebalancing each year. Your initial stock allocation should be very low. Your annual reallocation should be of the order of 2% to 4% of your original portfolio (plus inflation). The advantage was very small, 0.1%, but it is another condition that speaks against rebalancing.

In terms of another extended dry spell comparable to the inflation years of the 1960s and 1970s, your best tactic is to dump stocks early, when their intermediate-term prospects are bleak. You should not use your TIPS Ladder to keep stocks in the intermediate-term. Instead, use it in the short-term. Give yourself enough breathing room so that you can get a reasonable price when you dump your shares.

Have fun.

John Walter Russell
I wrote this on May 2, 2005.