Plan sponsors may think they are doing the right thing by including target-date funds as an option in their 401(k) plan but nominal bonds don’t do well when inflation and interest rates go up.

Jake Tshudy, director of defined contribution investment strategies at SEI Institutional, believes that any TDF included in a DC plan needs to find a way to hedge against the risks posed by nominal bond funds in an inflationary environment.

Treasury Inflation Protected Securities were developed specifically as an inflation hedge in the late 1990s. TIPS are marketable Treasury securities whose principal is adjusted according to changes in the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases, according to the U.S. Department of the Treasury.

“In target dates, the tendency is to become more conservative – investing in bonds, cash and things that are less risky than equities,” Tshudy says. “However, the problem with nominal bonds is they perform in an inverse relationship to inflation. As inflation goes up, nominal bonds tend to suffer. This is where TIPS come in, particularly in target-date funds.”

They aren’t meant to replace traditional bonds, just to add an additional safeguard to an individual’s account when inflation and interest rates go up.

In a recent white paper, SEI said that shorter term TIPS — with a bond maturity of zero to five years — do a better job of controlling inflation in a TDF than mid-term or long-term TIPS.

There’s a “tendency to run projections using what’s called break-even inflation [with] an input of long duration TIPS. That input is used in the modeling and it is used to create valuations for some consultants,” he says. The problem with that is it “unnecessarily steers individuals to long duration TIPS,” which add additional risk, says Tshudy.

Tshudy says that the only reason his company would use long duration TIPS, break-even inflation, is that they have some predictive value. Unfortunately, “break-even inflation doesn’t pan out in real life.”

With the shorter term TIPS, “we see better correlations, a better hedge to inflation over time and protection of purchasing power to the end investor,” he adds.

Any time an individual holds bonds with a longer maturity, they are taking a greater amount of risk Tshudy calls uncompensated risk.

Shorter term TIPS “bring the bond closer to maturity, closer to the realization of what it is supposed to be doing vs. the market speculating about what will happen over the next 15 years, for example,” he says.

Inflation is a very real investment risk, he adds. It’s one that might not be important to a 20- or 30-year-old but is important for someone who is 55 or 60 and expecting to retire soon.

“This is their protection against the changing value of groceries and fuel and every other day-to-day aspect,” Tshudy says.

The other benefit of holding TIPS in your retirement account is that their maturity amount will never go below their principal value but they do have the opportunity to go up.

According to Treasury, if deflation occurs, the principal is adjusted downward and a person’s interest payments are less than they would be if inflation occurred or if the CPI remained the same. At maturity, if the adjusted principal is less than the security’s original principal, the investor is paid the original principal.

Many investors had problems with their target-date funds at the beginning of the Great Recession, which called into question how TDFs are organized and the best glide path to use to get investors safely to retirement. The “to” glide path decreases an investor’s risk until the day they retire and then maintains a conservative approach through retirement. The “through” glide path, which is the one Tshudy prefers, continues to offer some risk to investors through retirement because with retirements reaching 30 years and beyond, many people still need the ability to earn income on their retirement savings.

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