Inflation is the silent stalker of investment returns. Because it is neither paid directly, nor is it deducted—as taxes are—inflation often escapes detection even as it undercuts buying power. Even relatively low inflation, like the 2% average rate of the past decade, can cut purchasing power nearly in half over the course of a 30-year retirement.
Inflation hits fixed-income investors especially hard. A retiree may think his or her income needs will be met by a bond portfolio yielding a certain amount of interest. But as the years tick by, that interest income buys less and less due to the monthly creep of inflation.
To combat the inflation problem for fixed-income investors, Treasury Inflation Protected Securities (TIPS) were introduced to the public in 1997. Like traditional government bonds, a TIPS bond is assigned a fixed interest rate at the time it is originally issued. This is the rate used to determine the bond’s semi-annual interest payment. This interest is treated as interest income and is subject to federal income tax, but exempt from state and local taxes.