Are US Treasury Inflation Protected Securities (TIPS) a complete hedge against inflation for retirees ?

This article was posted on November 1, 1998.

Surprisingly, no.

The Consumer Price Index (CPI) that the Treasury Department uses to calculate inflation is based on a market basket of goods and services that may not match the items that the typical retiree purchases. The Labor Department's Bureau of Labor Statistics (BLS) calculates several CPI indices. The most familiar index, the one the Treasury uses to adjust inflation indexed securities and the one Dan Rather reports on the evening news, is the non-seasonally adjusted US Cities Average All Items Consumer Price Index for all Urban Consumers (CPI-U). Federal benefit checks (including Social Security) are adjusted using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Since 1982, the BLS has also calculated the Consumer Price Index for the Elderly (CPI-E) on an experimental basis.

While the Wall Street Journal reports that "the CPI-E is considered a more accurate reflection of the cost of living for Americans over the age of 61", the Bureau of Labor Statistics has a different view. Since the CPI-E is experimental, it is not as refined or robust as the CPI-U or CPI-W. The BLS estimates that it would cost $40 million per year to bring the CPI-E up to the same level as the other two "official" indices. Refining the CPI-E would require changing the outlet sample to concentrate on places where the elderly shop (if different from the rest of the population) and adjusting population weights. Congress has not provided the budget or mandate to do so.

Largely because of health care costs, the CPI-E is increasing at a faster rate than the other two indices. All three indices are plotted below using December 1982 = 100 as a base.

It's all in the market basket.

The differences in the three CPI indices are largely explained by the contents of the "market baskets" used to compute the indices. For instance, the CPI-E has almost twice the percentage of medical goods and services than CPI-U or CPI-W. Table One below shows these percentages (statisticians call them "relative importances") for each of the three CPI indices. While the three indices do not have the same level of refinement and are not equivalent, the big question is how they compare to an individual retiree's spending pattern. Readers may want to compute their own "relative importances" based on their current spending and see how it compares with these published indices. Early retirees paying their own premiums on an individual (non-group) health insurance policy may find their medical care "relative importance" far higher than those shown in Table One. (See, The Consumer Price Index--Why the Published Averages Don't Always Match An Individual's Inflation Experience)

The Bureau of Labor Statistics (BLS) maintains an excellent web site that explains how the CPI index is calculated and publishes updates as they are released (See, The Consumer Price Index Home Page.) Data series for CPI-U and CPI-W can be downloaded from the BLS web site. The CPI-E is not available for download, but the helpful economists at the BLS will E-mail you a file with the CPI-E data series if requested.

What's the most reasonable interpretation of these results.

The average retiree can't do much to change the index. (Congress directed the Social Security Administration to use CPI-W to calculate the COLA for Social Security benefits in 1972. The Treasury Department decided to use CPI-U to adjust the value of TIPS in 1997.) However, if a retiree understands how the index is calculated and how it compares with his personal spending pattern, he may be able to make adjustments elsewhere in his finances to pick up the slack.

• Medical costs appear to be the source of greatest concern.
  
  Medical costs have increased 144% since 1982 while the CPI-U index as a whole has only increased 63% during the same time period. Folks with a larger than average percentage of their income going to pay health care expenses are at risk.

• If you have good health insurance, paid for by somebody else, you're probably O.K.
  
  A few people who retired from good union or government jobs still have lifetime healthcare paid for by their former employers. Obviously, if your health insurance premium is being covered by others, and your "out of pocket" medical expenses are insignificant, medical cost inflation won't be much of a problem.
  
  If you are paying your own health insurance premiums, there may be cause for worry. Even if you have comprehensive health insurance with low "out of pocket" expenses, your health insurance premiums should rise at least as fast as medical cost inflation. With premiums for a 60 year old running as high as $700/month in some parts of the country, health care costs can make up a large percentage of a retiree's budget. Often far larger that the 5.6% weighting that medical costs have in the CPI-U.

• Retirees should maintain some equities in their portfolio.
  
  Unless you are one of the few with first dollar health coverage from your former employer, you need to hedge against the likelihood that your personal inflation rate will exceed the CPI-U. A portfolio of 100% TIPS won't do that. Keeping a minimum of 20% of your retirement portfolio in stocks offers the best chance of keeping up with inflation.