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Plan Sponsors Tipping into TIPS to Provide Inflation Protection
Defined contribution plans seek to more broadly diversify their fixed-income offerings

By Stephen Miller  4/15/2009

updated January 15, 2010

According to investment firm PIMCO’s 2009 Defined Contribution Consulting Support and Trends survey, nearly half of U.S. investment consulting firms surveyed (48 percent) said that plan sponsors are adding or considering adding Treasury Inflation-Protected Securities (TIPS) funds or inflation-adjusted annuities as investment options within their defined contribution plans, to provide participants with a hedge against inflation in the years ahead.

And that's not just PIMCO's assessment.  In 2009, TIPS funds were the most common investment  option that plan sponsors added to defined contribution plans, and they are likely to be so again in 2010, according to Callan Associates’ 2010 Defined Contribution Trends Survey (see the SHRM Online article 401(k) Plan Sponsors Focus on Strategic Initiatives in 2010).

“Plan sponsors shouldn’t wait until inflation spikes to add protection, just as participants shouldn’t wait until inflation spikes,” Stacy L. Schaus, PIMCO’s Defined Contribution Practice leader, told SHRM Online. “Inflation is one of the greatest risks participants and retirees face. While we anticipate inflation to be relatively low over the near term, we expect inflation to increase within the next couple of years,” she said, citing the federal government’s projected surge in deficit spending. (A March 2009 report by the Congressional Budget Office estimates that the administration’s budget proposals will add $4.8 trillion to baseline federal deficits over the 2010–19 period.)

While equities (stocks and stock funds) tend to rise with inflation, Schaus explained, over time they don’t keep pace with inflation, whereas “TIPS have historically outperformed the CPI,” or consumer-price index. She noted further that, as Treasury bonds, TIPS are backed by the full faith and credit of the U.S. government, but unlike traditional Treasuries their value increases rather than decreases as interest rates rise in an inflationary environment (i.e., the interest payments and underlying principal are automatically “stepped up” to compensate for inflation as measured by the CPI).

That, in Schaus’ view, makes TIPS bond funds an extremely low-risk capital preservation option, and one that sponsors of 401(k) and other defined contribution plans ought to consider to more broadly diversify participants’ investment options.

Financial  columnist Tim Middleton agrees about the capital preservation role that TIPS can play. In an April 2009 column, he writes that a byproduct of stimulating economic recovery is that "inflation is waiting in the wings," which is "very bad for bonds — except for TIPS."

That doesn't mean that the price of TIPS funds doesn't fluctuate or never declines. When interest rates spike upward sharply (or if bond investors expect that they will), the value of the underlying TIPS could drop more than the increase provided by the CPI-linked step up. Still, the falloff is likely to be considerably less severe than what nominal (non-TIPS) Treasury bonds—and bond funds—would suffer. 

SHRM Video:
Risk in Defined Contribution Plans
With the market meltdown, plan sponsors are weighing the risk levels in their defined contribution plans, says Stacy L. Schaus, Defined Contribution Practice leader at PIMCO.
View this video

Bond Imbalance

There’s also another reason to consider adding a TIPS fund to plan portfolios. For the first time since consultancy Hewitt Associates began tracking 401(k) accounts, American workers in February 2009 held less than half of their 401(k) money in stocks. Instead, most of these retirement dollars were now in either low-paying cash equivalents or fixed-income (bond) instruments, including money market, stable-value and bond funds, according to Hewitt. However, most defined contribution plans offer a wide array of equity funds but just a few fixed-income selections through which participants can diversify their holdings.

Guaranteed Income

Plan sponsors also are evaluating a growing number of products with insurance guarantees, such as annuities — some of which adjust income distributions upward for inflation but charge higher fees for that protection. “Many sponsors say they are concerned with [annuity] product fees and complexity as well as fiduciary oversight,” Schaus said. “These concerns need to be addressed over the coming years to help more sponsors move forward with such programs.”

So-called longevity insurance, which provides a guaranteed income that kicks in only if participants reach a certain age, such as 80, is also generating interest among plan sponsors as a means to safeguard that participants don’t exhaust their retirement savings, said Schaus.

  401(k) Plans Don't Give Bonds Their Due

Writing in the May/June 2009 issue of the Journal of Indexes, Robert Arnot, chairman of asset management firm Research Affiliates LLC, argues in "Bonds: Why Bother?" that bonds/bond funds (fixed income), as compared with stocks/stock funds (equities), are mistakenly relegated to supporting players in most investment portfolios, including 401(k) plan offerings – a fact that has lead to greater losses for many 401(k) participants.

"For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don't," Arnot writes. "Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market." He adds that beyond mainstream bonds and bond funds, overall risk can further be reduced through "true diversification" using "out-of-mainstream segments of the bond market."

"401(k) offerings…are overwhelmingly equity-centric," Arnot writes. "If 80-90 percent of the offering provided to our employees are equity market strategies, is there any surprise that 80-90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled?"

Stephen Miller is an online editor/manager for SHRM.

Related Article--SHRM: 

401(k) Plan Sponsors Focus on Strategic Initiatives in 2010, SHRM Online Benefits Discipline, January 2010

Target-Date Funds Receive Greater Scrutiny, SHRM Online Benefits Discipline, June 2009

Falling Account Values Erode Confidence of 401(k) Investors, SHRM Online Benefits Discipline, April 2009

Related Articles--External:

How Much Should Retirees Stake in TIPS?, Morningstar.com, February 2010

Yale's Swensen Recommends TIPS to Hedge 'Substantial Inflation,' Bloomberg.com, May 2009 

Savings Guarantees You Can Trust, Kiplinger's Personal Finance, April 2009

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