Abstract: The financial performance of retirement plans would be substantially improved by the repeal of Treasury rules prohibiting the use of Series I savings bonds and new-issue Treasury inflation protected securities inside retirement accounts.
Most people saving for retirement, either through a 401(k) plan or an individual retirement account, put most of their funds in stock and bond mutual funds, exchange traded funds (ETF) or a target-date fund, holding a combination of stocks and bonds where the combination of stocks and bonds varies with the age of the investor. Go here for a discussion of the most common 401(k) investment options.
Retirement funds with these types of holdings generally perform very poorly during periods of sustained inflation leading to higher interest rates.
A return to the sustained inflation of the 1970s would be a disaster for workers and retirees with most of their financial wealth allocated to funds holding stocks and bonds.
Note that financial incentives for a young person earning money and investing are substantially different for a young person who is earning and investing compared to an older person in retirement who is fully invested. The young worker with relatively little of her career earnings invested may be better off if the stock market falls or interest rates are low and likely to rise because future investments will be profitable. By contrast, there are no future investments for the newly retired worker.
New retirees in the 1970s did not have the option of defined contribution plans where their retirement assets would have been fully invested in stock or bond funds. Retirees of the 1970s would have been reamed if this had been the standard retirement vehicle.
In real inflation adjusted value, the S&P 500 lost nearly 50 percent of its value during the high inflation of the 1970s. Go here for a discussion of stock returns during the 1970s.
Some authors have noted that 10-year bond yields were positive in the 1970s, but future higher yields would have been little solace to a retiree fully invested in a long term bond fund, which would have fallen in value. Even a substantial amount of cash would have been insufficient insurance in a 1970s type of economic environment.
Traditional bond funds play an essential role in portfolios of retirees. Younger retirees could start with a 60/40 equity/fixed income portfolio, but the ratio could easily change to 20/80 for an 80 year old retiree.
The investment environment in 2020 was not as bad as the investment environment of the 1970s. However, the portion of retirement assets in bond funds in 2019 or 2020 when interest rates were low would have been decimated.
Consider Vanguard Total Bond fund BND.
· The return on the fund after account reinvested dividend is -2.7 percent over the January 2020 to February 2025 time period.
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The retiree would have been much better off in a bond like a Series I Treasury bond or a Treasury Inflation protected security (TIPS) where the value of the bond is linked to inflation. Go here for a discussion of both Series I Bonds and TIPS.
The safest possible asset for a retiree who must distribute funds regardless of returns is a Series I bond.
Series I Savings bonds are a Treasury guaranteed bond with returns determined by both a real interest rate set when the bond is issued, and an interest rate based on the rate of inflation reset every six months. The return on the inflation component does not fall below zero even if inflation is negative. There is no scenario (apart from a default by the U.S. Treasury) where the value of a Series I bond falls in value.
· A person who purchased a Series I Bond in around 2020 would have earned over 20 percent on the bond as of February 2025.
The Treasury Inflation Protected Securities (TIPS) also have returns determined by a real rate and inflation. The value of the TIPS can fall in value during periods of inflation, but the value of a TIPS new-issue bond held to maturity cannot fall below its issue price.
Both Series I bonds and TIPS can be purchased from the Treasury at zero transaction cost.
It is impossible to purchase a Series I bond inside a retirement account. (All Series I bond purchases must be done at Treasury direct.)
Most firm-sponsored 401(k) plans have a small number of ETF or mutual fund investment options and do not allow for the purchase of TIPS with 401(k) plans.
Individual Retirement Accounts and self-directed 401(k) plans allow for the purchase of TIPS on the secondary market, however, TIPS purchased and sold on the secondary market can fall in value. Treasury rules do not allow for the purchase of new issue TIPS through retirement accounts.
These restrictions make it very difficult to insulate retirement accounts from higher interest rates brough about by higher inflation.
Some investors will attempt to hedge against inflation by purchasing Series I bonds or TIPS with funds outside of a retirement account. There are limitations and problems with this hedging strategy.
First, many households have most of their financial assets inside a 401(k) plan. The highest priority for funds outside a retirement plan is usually a fund for emergencies. Households with relatively modest income and/or financial objectives like student debt generally do not have funds for the purchase of Series I bonds after pursuing other financial objectives. The proportion of households with a disproportionate share of financial assets inside retirement accounts will likely increase because of new regulations, which automatically enroll new workers inside 401(k) plans and periodically increase contribution rates.
Second, people who hold Series I bonds outside of a retirement account who hold the bond until maturity will have a large amount of interest and a large tax obligation when the bond matures. The possibility of higher tax obligations for investors in Series I bonds and TIPS can affect the taxation of Social Security benefits and Medicare premiums. Go here for an admittedly extreme example of a tax problem caused by use of Series I bonds.
Both the Series I bonds and TIPS are better hedges against inflation than conventional bonds or bond funds. Renewed inflation is not guaranteed but there is a non-trivial possibility this could happen.
The Treasury Department and the Department of Labor should create new rules allowing and facilitating the use of inflation linked bonds inside retirement accounts. Regulatory changes are urgent because federal policy, including tax incentives for retirement saving and newly adopted automatic enrollment rules, favor 401(k) investments over other savings vehicles and the U.S. government should not be steering households into suboptimal investment options.
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