TIPS bonds guarantee positive real rate of return

March 1, 2008

Treasury Inflation-Protected Securities have caused physicians to take a closer look at bonds as a viable alternative or complement to their equity holdings.

Q I would like to invest in government bonds for their safety and guarantees, but am concerned about rising inflation. Do you have any suggestions?

TIPS, also known as inflation-indexed Treasuries, differ from conventional Treasury bonds that offer fixed semi-annual interest payments and a guaranteed principal payment at maturity. Unfortunately for those bondholders, the impact of inflation may ultimately cause the rates of return to be negative. In contrast, TIPS are guaranteed to provide the investor a positive after-inflation real rate of return. The principal value is linked to the constantly changing Consumer Price Index (CPI).

Because market prices of TIPS do not react to changes in "expected" inflation, their returns have very low correlations with stocks and other bonds. Correlation (the degree to which returns from two investments move in the same direction) is a key element of constructing a well-diversified portfolio. Investors enhance their portfolio diversification by mixing assets not closely correlated with each other.

TIPS are issued with 10- and 30-year maturities and are guaranteed against default by the U.S. government with regard to the payment of principal and interest. Current income is paid on a semi-annual basis through the use of inflation-adjusted coupons. From an income tax standpoint, income generated is free from state income taxes, but is taxable at the federal level. The federal tax also applies to the positive inflation adjustments. Although the investor doesn't benefit from the principal adjustments until the bond matures, the inflation adjustments are still considered income, and federal taxes are due each year an adjustment is made. To avoid exposure to the TIPS-inherent tax inefficiency, TIPS can be placed in tax-deferred vehicles such as qualified retirement plans or IRAs.

TIPS, like other government bonds, can be purchased directly from the government through its Treasury Direct program or online at http:// without commissions or fees.

Q I purchased an annuity 20 years ago, and I am now 65 and recently retired. I would like to start taking distributions from the annuity but am concerned that once I start, I may not take out the full value before I die. Are there other options available for annuity withdrawals?

A To provide a more equitable form of income payment, insurance companies have tied income payments to a variety of guaranteed time periods. Referred to as life with term certain, this arrangement guarantees the owner income payments for the rest of his life, but in the event of a premature death, payments would continue to the beneficiary for the guaranteed time period.

Other payout options include:

Joel M. Blau, a Certified Financial Planner, is president of MEDIQUS Asset Advisors, Inc. in Chicago. He can be reached at 800-883-8555 or