The Easiest Way To Beat Inflation
Inflation is defined as the rise in the general level of prices for goods and services over time. Basically, what this means is that the same stuff we buy today will cost more over time. It’s a real force that we’ve dealt with in the past, and one we’ll likely have to deal with in the future. Fortunately, there are ways to protect yourself from it. The easiest way to do this is to purchase Treasury Inflation-Protected Securities, or TIPS.
How Inflation Is Calculated
Before we get into how these securities beat inflation, we should know how inflation is actually calculated. Inflation is determined by calculating the rate of increase in the Consumer Price Index, or CPI. The CPI measures the average prices of goods and services purchased by the typical consumer. This number is published on a monthly basis, and can be found at the Bureau of Labor Statistics website. For example, using this data, the inflation rate from January 2009 to January 2010 can be calculated as follows.
First, subtract the CPI figure from January 2009 from the CPI figure for January 2010. Once we have this number, we divide it by the figure from the earlier period (January 2009 in this case). Finally, after we turn this number into a percentage, we have our inflation rate. So following these instructions, the inflation rate from January 2009 to January 2010 is calculated as follows:
[(216.287-211.143)/211.143]*100 = 2.63%
So an item that cost $100 in January 2009 would now cost $102.63 in January 2010.
How TIPS Work
When you invest in a TIPS, not only does the principal amount increase with inflation automatically, but it also decreases with deflation, as measured by the CPI. So in theory, you could lose money if deflation were to occur. Fortunately, when TIPS mature, you’re paid either the adjusted principal or the original principal, whichever is greater. Therefore, TIPS are a pretty low-risk investment.
TIPS pay interest twice a year, at a fixed rate that is predetermined. This rate applies to the adjusted principal amount. So just as principal adjusts with inflation and deflation, the interest payments rise with inflation, and fall with deflation. These periodic interest payments are what helps you beat inflation. Let’s see how this works with an example.
Suppose you purchase a $1,000 note that pays 3.375% interest per year. Also, suppose that at the time of the first semi-annual interest payment, the inflation index ratio (the multiple by which your principal increases) is 1.01095. Your original $1,000 investment would now be worth $1,010.95 due to inflation. At this point, you will have only kept up with the rate of inflation.
Now, to calculate your interest payment, you would divide the interest rate by two (since you receive payments twice per year), and multiply this number by your inflated principal amount. This interest payment would be the amount by which you beat inflation. Here’s the actual calculation:
($1,000*1.01095) = $1,010.95 – inflated principal amount
3.375%/2 = 1.688%, or 0.01688 – semi-annual interest rate
$1,010.95*0.01688 = $17.06 – interest payment for the period
So during this period you beat inflation by $17.06, and the remaining principal adjustments and interest payments would be calculated in a similar manner.
A Few Tax Considerations
The interest payments that you receive twice a year are subject to federal income tax.
Another note to be aware of is that as your principal increases each year, you’ll also have to pay federal income tax on the amount of the increase annually, even though you won’t receive the adjusted principal until the bond is redeemed.
However, both the principal amount and interest payments are NOT subject to state and local income taxes.
Where To Buy Them
Two of the main ways that you can buy TIPS are either directly from TreasuryDirect, or indirectly through a mutual fund from a brokerage such as Vanguard or Fidelity. However, if you’re making a purchase through an inflation-protected fund, you should be aware that not all of them invest solely in TIPS. Some may invest a small percentage of the portfolio in corporate bonds in an effort to increase returns. Be sure to explore all of the details before making a purchase.
Lastly, if you buy TIPS through a mutual fund, you’ll have to pay the expense ratios that are associated with the fund. But if you buy them directly, you’ll avoid any commissions and expense ratios.
How do you protect your money from inflation? Do you invest in TIPS? If so, do you buy them directly, or through a mutual fund?
First photo by jekert gwapo; Second photo by Jason Gulledge