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.