Guaranteed Inflation-Protected Income

A lifetime stream of guaranteed income is a goal for many people. Even better is to have that income stream increase with inflation. You can have a lifetime stream of guaranteed income that increases with inflation. You must study the options, plan, and shop carefully.

An immediate annuity is the prime way to receive guaranteed income for life. The problem is it doesn’t have inflation protection. A separate investment portfolio can generate annual cash that supplements the annuity payments and maintains purchasing power. There are no guarantees the investment portfolio will generate positive returns or enough cash to maintain purchasing power.

You have two choices if you want an income guaranteed for life that increases over time: a variable immediate annuity and an inflation-indexed annuity. They are very different vehicles.

An inflation-indexed annuity is a straightforward guarantee that your income payments will be adjusted for inflation (but not downward for deflation). The annuity makes periodic payments for either life or a term of years, whichever you select, and the payments are increased automatically each year to match increases in the Consumer Price Index. The annuities usually have a maximum one-year increase of 10%. A variation, generally called growing annuities, allows you to select a fixed percentage amount the payment increases each year instead of full CPI indexing. You might select 2% or 3%, for example.

A growing annuity should give you a higher first-year payment than a full CPI indexed annuity. Also, you’d know what the increase would be each year and could factor that into your budgeting and spending, rather than having to wait to see what the year’s CPI increase was. Of course, if inflation is higher than the automatic increase rate you selected, at some point you need to reduce expenses or supplement the income from another source.

The downside to the inflation protection is that it costs you. With an inflation-indexed annuity, your first-year payment is going to be 20% to 30% less than that of a fixed immediate annuity. The exact amount will depend on your age, life expectancy, and the inflation rates the insurer forecasts. Hint: You don’t necessarily want to buy the inflation-indexed annuity that offers the highest first-year payout. The insurer could be assuming future inflation will be very low or that it will earn very high investment returns. You could be hurt down the road if the insurer runs into financial trouble because its assumptions were too optimistic.

Here’s how to compare a fixed annuity to an inflation-adjusted annuity and also compare different inflation-adjusted annuities. Start with the first-year monthly payment amount. Then compare what the payments would be after 10, 15, and 20 years under different inflation scenarios.

For example, assume a 70-year-old could purchase a non-indexed annuity with $500,000 and receive an initial $3,962.93 monthly payment. If he selected a 2% annual increase, the initial payment would be $3,375.54. After 10 years under the 2% option, the payment would be $4,736.07. If he selected full CPI indexing, the initial payment would be $3,039.18; the payment after 10 years would depend on the inflation rate and you assume different inflation scenarios to estimate future payments. You look at how long it would take for the indexed annuity to catch up with the fixed annuity. After that, you come out ahead by purchasing the indexed annuity. You want to estimate how long it takes to reach the break-even point under different assumptions.

You also need to consider which risks you want to take. You could accept a lower initial payment and avoid the risk of having high inflation eating away at the purchasing power. But you’ll take the risk that inflation will be lower than the insurer is assuming, and you’ll end up with lower payments than you would otherwise have received. Or you can select your own annual increase and take the risk inflation will be higher than that.

An inflation-indexed annuity usually is not sold as a separate product. Instead you shop for an immediate annuity and select an option to have the payments adjusted for inflation or increase automatically at your selected rate.

An alternative is the variable immediate annuity (VIA). It’s an immediate annuity, because it begins payments after you purchase it. But the payments vary, and they vary with the returns of investments you select. The initial monthly payment is based on the owner’s age, the amount invested, and something called the assumed investment return (AIR). The owner selects the AIR and usually is given a choice of 3%, 5%, and 7%. The higher the AIR selected, the higher the initial payment is.

After the first year, payments increase if the actual investment returns exceed the AIR. But the payments will decline if the AIR is higher than the actual returns for the year.

The trick with the AIR is not to select the investments you think will earn the highest return. Instead, select a reasonable AIR and then select investments you believe will at least equal that return each year. If you invest for maximum return and turn out to be wrong, your monthly payments will decline for the next year. You also probably want to minimize the volatility of the portfolio. Your retirement income won’t be reliable with these annuities if you select a portfolio that is likely to rise 20% one year and decline 20% the next.

A VIA can add a guarantee that income payments won’t decline or they won’t decline more than a certain percentage (say, 20%) during the owner’s lifetime, regardless of how the portfolio performs. This costs money, of course, and the additional fee usually is more than 1% of the annuity’s value annually. Keep in mind your investments must beat the AIR plus the expenses deducted from the account for your monthly payments to increase.

There are expenses with the VIA. The insurer will charge regular annual fees, and of course there will be fees charged by the mutual funds or other investment options in the account.

It takes a lot of work to compare VIAs. You need to determine all the fees that will be deducted from your account and how they affect whether or not your performance beats the AIR. You also need to know the details about the calculation of your portfolio return and how it measures against the AIR. Of course, you need to review the investment options in the annuity. Can you put together a portfolio you believe will consistently beat the AIR? Can the insurer change the investment options at will? You might be able to change your mind and withdraw from the annuity, but there’s likely to be a surrender fee if you withdraw in the first five to seven years. Check the details on this.

A VIA strikes me as a very expensive product for the guarantees it provides. You also have to consider that all income distributed from the VIA (but not amounts considered return of principal) will be taxed as ordinary income. If you invested the same money outside the annuity, it’s likely at least some of the income would be taxed as long-term capital gains or qualified dividends. You might find it more economical to buy a fixed annuity or an indexed annuity with some of your money and invest the rest in a taxable account.

The advantages of a VIA are a guaranteed income floor that you can’t outlive (if you select that option) plus the potential for the income to grow if you make the right decisions. It could be good for someone who is worried their savings are a little short. They need to take the risk of earning higher returns to make the income grow, but to them the fees of the VIA are worth the guaranteed income floor.

As always, shop around before selecting an annuity because payouts differ among insurers. Check with the major mutual fund companies (Vanguard, Fidelity, and T. Rowe Price) and the discount brokers for annuities they sponsor. Also, view web sites such as www.ImmediateAnnuities.com.

There aren’t too many people who should consider putting all their retirement money in either of these annuities. They can be part of a package of retirement income vehicles that provide secure income and inflation protection.

RW June 2011