Using TIPS Funds as a Social Security Bridge — Oblivious Investor

A reader writes in, asking:

“This might be a question other people have too, but it’s certainly on my mind: you’ve spoken a lot about social security bridges using TIPs. If I were to use a TIPS fund instead of individual TIPS bonds, and the start of the bridge is about 1-2 years away, would it be better to use a shorter duration fund like VTIP rather than an intermediate duration fund?”

With TIPS mutual funds rather than individual TIPS, in theory the idea is that the fund’s average duration should match the average timing of the cash outflows.

For example, if the first payment were 1 year from now and the last were 8 years from now, we’d want an average duration of 4.5 years: (1+2+3+4+5+6+7+8)/8 = 4.5.

But a key point here is that the duration of a bond fund will stay more or less constant, whereas we actually want the duration to decline over time, as the desired cash outflows come closer and closer to the present.

In our example above, after one year has elapsed, we’d want the average duration to be 4 years: (1+2+3+4+5+6+7)/7 = 4. Another year later, we’d want the average duration to be 3.5 years: (1+2+3+4+5+6)/6 = 3.5. And so on.

So, for the best match, we need to use two different funds and adjust the balance between them over time (i.e., shifting more toward the fund with the shorter duration) in order to keep the weighted average duration where we want it.

But at that point, it’s actually more work than just buying 8 individual TIPS all in one sitting to begin with. (With a ladder of individual TIPS, the work is all up-front. Once they have been purchased, you just let them sit there until they mature and you spend the money. And if we’re talking about a fairly short ladder such as an 8-year Social Security bridge, you’re only buying a handful of different bonds.)

So in short:

• In most cases, I’d suggest just buying the actual individual bonds. It’s usually going to be less work, and you’ll have a better match between cash inflows (from bonds maturing) and cash outflows (i.e., spending the money).
• If we’re talking about a situation where you don’t have access to individual bonds (e.g., we’re talking about an employer-sponsored retirement account that provides access to TIPS funds but not the ability to buy individual bonds), then I’d follow the approach described above with a shifting allocation between two different funds.
• And if we’re talking about a situation where we’re placing a very high premium on simplicity rather than on risk mitigation, I’d just buy a fund that has a shorter duration than the current average duration of the cash flows, to account for the fact that the average duration of the cash flows will be declining over time. But it would be important to recognize that that isn’t a perfect fit, because the duration will currently be too short, and toward the end it will be too long.