Annuities and Inflation Risk

Fixed income annuity contracts are a great hedge against longevity risk that can help provide retirement income sufficiency in an increasingly uncertain environment. But even with a fixed annuity, income sufficiency is a tricky goal to attain when you’re walking uphill against inflation.

Since a $100,000 annuity pays the same $650/month in January 2032 as it does in January 2012, it must be paired with a strategy that hedges against inflation. Writing for Forbes earlier this month, Stephen Horan, Ph.D, discussed the lesser-known cousin of the fixed annuity, the inflation-protected annuity.

An inflation-protected annuity is generally a “fixed” annuity that includes a component that ratchets up payments each year to account for inflation. There are two general types of inflation protected annuities: (1) those that account for inflation by increasing payments by a fixed percentage (e.g., 4%) each year to account for inflation; and (2) those with a variable increase that is tied to an inflation indicator like the Consumer Price Index.

Although Horan stopped short of recommending inflation-protected annuities, he closed his article by asking his readers “to consider what role a deferred or inflation-protected annuity could play in... [their] long-term financial planning as an instrument for assuring a lifetime income stream.”

The inflation protection sounds good in theory, but what does it cost?

Inflation protection will reduce early annuity payments fairly significantly—usually between 20% and 30%–depending on the annuitant’s age. That’s a lot of ground to make up.

Because of the significant hit that early payments take when inflation protection is selected, some commentators recommend against inflation-protected annuities for every consumer. Lynn O'Shaughnessy, author of the Retirement Bible, counsels that it is “[b]est to reject annuities that feature an inflation rider,” regardless of the client’s situation.

According to O'Shaughnessy, “If you added up all the payments generated by the inflation annuity, they wouldn't surpass the string of regular annuity payments during the customer's expected lifetime.”

But a 2009 study by the Employee Benefit Research Institute (EBRI) reaches the opposite conclusion. After running the numbers for retirees at various ages, EBRI concluded that “retirement income plans should anticipate inflation rates of at least 4%.” And the study contradicts O’Shaughnessy’s blanket rejection of inflation-protected annuities, concluding that, “after adjusting for taxes … and inflation,” the drawback of lower starting payments equalizes rapidly with inflation-protected annuities.

Illustrating the effectiveness of the product and contradicting the critics, the study found that for an age 65 male, payments from an inflation-protected annuity will begin to surpass those of an ordinary fixed annuity around year eight. And when taxes are factored into the equation, the differential between early payments from fixed and income-protected annuities draws down from 35% to about 17%—significantly reducing the downside of inflation protection.

Even the simplest fixed annuities get their share of bad press, so it’s often an uphill battle for advisors trying to convince a client that a longevity hedge is in their best interests. And despite evidence that inflation-protected annuities are a good deal for many retirees, you may have to bring out the big guns—like the EBRI study—to counteract the negative press.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.

See also The Law Professor's blog at AdvisorFYI.

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