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How Inflation-Indexed Bonds Fit a Financial Plan by Deloitte & Touche OnLine

Updated Monday, January 27, 1997

The Treasury's new inflation-indexed bonds won't fit every financial plan. Chris Parsons, a Deloitte & Touche tax partner and financial planner, explains when they might be useful, when they might not, and why. E-mail him with your questions, and we'll post the answers.

Why you need to consider inflation: There must be some accommodation for inflation in any financial plan – whether you’re saving to buy a house three years from now, or to retire 20 or 30 years from now. Here’s why:

Say you retire this year as you had planned, with enough savings, investments and pensions to pay you $25,000 a year. Unless you’ve accounted for inflation, you’ll see that $25,000 buy less and less each year. If inflation continues at its historical long-term average, by the year 2006 you’ll need an income of nearly $34,000 to purchase then what $25,000 can buy today.

For retirement, you should plan to save enough money to provide income for the duration of your retirement, which could easily exceed 20 years. If it will give you $25,000 in your first year of retirement, it should give you more than that in Year 10, and still more in Year 20. How much more depends on your expectations of inflation.

Inflation is personal: Let's say you’re saving up for a house and planning to buy one three years from now. You should consider inflation in your savings plan, knowing that the rate of inflation in housing is different from the overall rate of inflation, and it can vary widely from city to city.

If you’re saving for your child’s education, keep in mind the inflation rate on college tuition averaged nearly 8% annually for the last 10 years – more than double the rate of inflation in the economy overall. If you’re planning for retirement, the average inflation rate over the past 20 years has been 5.4%.

Inflation-indexed government Treasury notes and bonds: What the government proposes are bonds with maturities of 10 to 30 years, linked to the Consumer Price Index for All Urban Consumers (CPI-U).

If you think these bonds will work like variable-rate mortgages – paying an interest rate a few points above an index – forget it. With inflation-indexed bonds, the principal amount of the bond would be adjusted periodically to correct it for inflation. The interest rate offered on the bonds will be comparatively low compared to other securities – likely in the range of 3% to 4% -- but it would be "real." If you own a bond that pays 7% interest, but inflation is 6%, the real return on your money is only 1%. That 1% is the effective gain on your investment, after the purchasing power has been adjusted for inflation. With inflation-indexed bonds paying 3%, for instance, the adjustment of the principal means you’ll earn a true 3% year in and year out, until the bond matures.

The interest rate means everything: Long-term, stocks have historically offered the best returns. Over time, stocks have returned 7% to 8% annually after inflation, though they come with greater volatility. Long-term government bonds, on the other hand, have only returned about 2% after inflation. The difference is that over shorter periods of time, bonds are less volatile than stocks.

For investors looking at 15- to 30-year horizons, stocks have historically offered higher returns than bonds.

For investors looking at shorter horizons – for example, 8 years or less – bonds have traditionally been the vehicle of choice, because the return comes with less volatility.

Inflation-indexed bonds may become the instrument of choice in the short and intermediate term – generally up to 10 years -- if they offer returns of 3% or more above inflation.

But there’s a catch.

Taxation is the catch: Under changes in the law proposed by the Treasury, any upward adjustment to the principal of a bond for inflation would be considered ordinary income, and would be taxed as such. If you own an inflation-adjusted bond with a $1,000 face value, and inflation that year is 3%, then the value of the bond will be marked up by $30, to $1,030. That $30 increase would be taxed currently as ordinary income. That would mute the inflation adjustment.

When they’ll be useful: Because of the taxation, these bonds and notes are well suited to use in tax-deferred accounts such as 401(k) plans and Individual Retirement Accounts. And assuming these bonds will pay about 3%, they may be best for investors looking at short to intermediate investment terms, generally less than 10 years. Conservative investors looking for less volatility may also be drawn to these bonds.

When they’re not useful: For investors looking at time horizons of 15 years or longer, stocks have historically offered higher returns than bonds, government or otherwise. And if you’re saving for something like college tuition or medical expenses – where the inflation rates have been higher than inflation generally – these bonds may not be able to help in meeting your savings goals.