One of the greatest dangers to any retirement plan is that insidious erosion of purchasing power commonly known as "inflation."
A weekly trip to the gas station or supermarket is enough to drive home the point. While younger, working Americans have opportunities -- often through increased earning power -- to overcome inflation, those in retirement or close to it are particularly vulnerable.
"The greatest risk retirees face is inflation, not short-term volatility of the stock market," says Tom Orecchio, national chair of the National Association of Personal Financial Advisors. "People focus on the market today as opposed to their purchasing power 25 years from now, and that's a mistake."
These investments can help retirees protect against it
Treasury-Inflation Protected Securities
How they work: TIPS protect against inflation through their connection to the Consumer Price Index. Specifically, TIPS' principal rises with inflation and falls during deflation. If someone buys $100,000 in TIPS and inflation increases by 3 percent, the TIPS principal will be worth $103,000 by the end of the year. (Adjustments are made every six months.) When TIPS mature, investors receive the original principal amount or one that's been adjusted, whichever is greater. TIPS pay interest every six months. This interest rate is constant, but the earnings fluctuate because they're based on the inflation-adjusted principal.
Who they're good for: Retirees, and anyone else living on a fixed income.
Cost: TIPS are sold directly from the U.S. Treasury Department in increments of $100. You also can purchase shares of mutual funds that primarily invest in TIPS, such as Harbor Real Return or Vanguard Inflation-Protected Securities.
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Liquidity: TIPS are very liquid. You can sell them at any point in time, though there's no guarantee you'll make money: If you sell before the TIPS maturity date you incur a risk of selling at a premium or discount of what you've paid for it.
Pros: Inflation protection.
Cons: Taxes. Investors must pay ordinary income tax rates, which can be as high as 35 percent, for the interest they receive as well as for any increase in value in the TIPS principal. Experts recommend that TIPS be held in tax-sheltered accounts such as a 401(k) or an IRA.
Risk: The value of the principal can go down, so if you sell prior to maturity, you may get less than what you paid.