Advanced Personal Finance

Now is not a great time to be a saver.  In fact, it’s a down-right lousy time.  Rates on everything from high-yield savings accounts to CDs are way down.  In the meantime inflation is up (though still moderate by historical standards), by even the federal government’s dubious accounting.  Mix that together and what you get is negative real interest rates.  I’m going to explain exactly what that means to you and your finances.

My use of the term ‘negative real interest rates’ refers to the phenomenon when the return from completely safe investments is lower than the Consumer Price Index (CPI) - commonly known as ‘inflation.’ 

So you know exactly where I’m coming from, let me specify a couple of the elements.  I consider ‘completely safe’ to be FDIC insured or US government backed.  For our simplified purposes, let’s take that to mean a high-yield savings account.

While the term ‘inflation’ isn’t technically correct in this context, it’s close enough.  Inflation for our purposes is the increase in year-over-year consumer prices.

Here’s where the numbers are for these elements right now:

• CPI 2007: 4.1%
• Typical high-yield savings account represented by ING Direct: 3.4% APY

If you keep your money in this savings account, after inflation, your real return is a negative 0.7%.

Strategies

A couple of thoughts on how to deal with the situation:

1. Consider saving using TIPS.  Treasury Inflation Protected Securities are essentially savings bonds that guarantee a real rate of return after inflation.  There are all kinds of things to consider when thinking about TIPS (like the tax implications), but for some situations they work.
2. Pay down debt.  I know this may seem counterintuitive but consider paying off high interest debt (think credit cards) at an accelerated rate instead of saving more money.  Sure you need an emergency fund, but if it just gets smaller in real terms, you’re losing.
3. Shift savings/investments into retirement accounts.  If you save and invest outside a retirement account, now might be a good time to bump up the amount you put into that tax-advantaged retirement account if possible.  Your investments inside those accounts will likely be slanted toward a more aggressive allocation.
4. Don’t try to ‘make up the difference’ by seeking out unnecessary risk.  So your super-safe savings are returning a negative real rate.  Don’t lose sight of what those funds are for and why they’re in a safe place to begin with.

That’s just what I could come up with.  Anybody want to chime in with other suggestions?  I’m interested to know how other people deal with negative real interest rates in practice.

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I’ve been reading and learning about the Consumer Price Index (CPI), otherwise known in layman’s terms as the ‘rate of inflation.’ The CPI is calculated by the Bureau of Labor Statistics (BLS) and is reported periodically (monthly is the most common number quoted). The original idea of the CPI was to periodically collect the prices for a basket of consumer goods in order to gain information on price increases or decreases. So far so good.

What I’m learning, however, is that the CPI grossly understates actual consumer prices. To understand why, you have to known a little more about how CPI is calculated. Bear with me, this’ll get good.

Here are the components of the CPI:

Notice the three largest pieces of the pie: housing, transportation, and food. Here’s where it gets good. Let’s take a look at housing for evidence of how the CPI understates inflation.

How CPI underestimates the cost of housing

Within the housing category are three subcategories - shelter, fuel and utilities, furnishings. Within the shelter subcategory is our bogey - owners’ equivalent rent.

Every month, BLS polls 50,000 landlords and tenants to come up with owners’ equivalent rent. But because of the recent housing bubble, rents nationwide have been suppressed as more people could ‘afford’ a home and bought one. This caused a glut of unoccupied rental units and hence kept a lid on rents. That’s why people like Flexo at Consumerism Commentary are now comparing the wisdom of renting versus buying.

We know from government census data that the homeownership rate as of 2005, the most recent data available, stood at 68.9% That means 31% of the U.S. population rents. So when the CPI is calculated, 23.4% of the entire number is derived from 31% of the population’s situation. The increased cost of housing for 69% of the U.S. population is ignored. According to the OFHEO (the government agency charged with tracking these things), for 4Q2006 home prices were 5.9% higher than a year earlier. That’s after three years of price appreciation in the teens.

After looking at the situation in this light, I believe the CPI understates actual inflation to a surprising degree. Why would the feds publish this lower inflation number? Oh, I can think of a couple of reasons…

• Lower COLAs for military and other government workers
• Smaller COLAs for Social Security recipients
• Lower payments for Treasury Inflation Protected Securities (TIPS) and similar bonds
• Tax brackets are adjusted more slowly, increasing tax revenue

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I’ve been reading a couple of different things lately that suggest the U.S. is headed for a period of higher inflation. I can think of a few items that are clearly heading that way like health care, education, and gas. It got me wondering what the best action to take is if you expect a rise in inflation.

I know the most common inflation hedge is gold. The problem with that as I see it is gold has had an enormous run-up lately. It’s gone from around $300 per ounce five years ago to pushing $700 today. That looks like buying at the top to me. Besides, I’m not entirely sure of the mechanism involved.

Inflation-protected Treasury securities is another option. I’ve talked about TIPS before. You can’t put a large portion of your portfolio in TIPS, though. The yield is too low for most situations.

A third possibility is ‘hard’ assets like REITs or natural resources. For REITs, it’s the same fundamental problem as gold. The price of real estate has run up recently. I think there’s not much gas left in REITs. As for natural resources, I don’t know anything about timber, oil, or natural gas. That’s out.

So what to do? If I think inflation is headed up, what moves, if any, should I make in my finances? Looks like I’ll be doing more reading…

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I wanted to write a bit more about TIPS (Treasury Inflation-Protected Securities) and a peculiar tax treatment quirk they have. As you recall, TIPS have an underlying rate and an inflation-adjusted rate added on top. Because they’re inflation-adjusted though, if you don’t hold them in tax-deferred accounts, you could be hit with a rather insidious tax issue.

You’re taxed on the income from your bond. If inflation is low, your apparent income, and thus taxes, are low. However, if inflation is higher, you will have an apparently larger income from the bond even though your real (after-inflation) rate of return is the same as before. For example, say you have a TIPS with a nominal rate of 4% and inflation is running 4%. You’re getting paid 8%. Say you’re taxed on that in the 25% bracket. You’re really getting 6% after taxes and your real return is 2% after inflation. Now let’s say inflation rockets to 12%. Now you’re getting paid 16% nominally (but still 4% real). Now you’re only getting 12% after taxes (75% of 16%). After inflation, you’re not making a dime. Nice, huh?

This is sometimes known as the ‘tax on the inflation tax.’ And it’s another reason why you should keep TIPS in tax-deferred accounts.

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So the title is a double entendre and corny. So what? Seriously though I want to talk about using Treasury Inflation Protected Securities (TIPS) in your retirement portfolio.

As the name implies, TIPS are Treasuries that are adjusted for inflation. They have a base interest rate and then an inflation-adjusted piece that gets adjusted every six months. Because interest payments and the inflation adjustment is paid out in cash every six months, these bonds should be kept inside a tax-deferred account like a Traditional IRA or 401(k). That way, you’re getting the full real (after-inflation) rate of return without having to pay taxes on it.

In a IRA, you can buy the TIPS directly through Treasury Direct. They come in 5, 10, and 20-year maturities. You can also buy them through a index bond fund. If you look at the composition of the fund, you’ll get an idea of what percentage of the fund is in TIPS and what the average maturity is. If you’re investing through a 401(k), you have to go the bond fund route (if your plan even offers one).

What I really love about TIPS is their guaranteed real return. I don’t know of any other instrument (besides Series I savings bonds) that offer that. And in the unlikely event of deflation, the value cannot go below zero. Nice. Just remember to keep your TIPS in your IRA or 401(k).

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