How to Ensure Inflation Protected Lifetime Income with Annuities

As the Baby Boomers age, financial services firms are interested in meeting their needs. One need is for guaranteed lifetime income that replaces old-style defined benefit plans. Another need is for that income to retain its purchasing power over the years. Some investment advisors used to say that owning stocks for the long term met these needs, but the bear market that began in 2000 refuted that argument.

There are several investments available to accomplish these goals, and more are being developed by insurers.

• Buy an immediate annuity and keep saving. A traditional immediate annuity achieves the goal of lifetime income. The income payments, however, are fixed. Over time inflation erodes the purchasing power of the income.There are two major advantages of the standard immediate annuity. One advantage is that they have a long history; investors know how they work, and insurers know how to manage and price them. The other advantage is that the initial payout is higher than for the alternatives. The added features of newer annuities come with costs.

  An investor searching for reliable income should consider buying an immediate annuity but not spending all the payouts. To support purchasing power over time, save and invest some of the distributions.

• Buy an inflation-indexed annuity. These annuities make regular payments for either life or a term of years, just like immediate annuities. The payments, however, are adjusted to reflect increases in the CPI. There usually is a maximum one-year increase of 10% or so.The annuity owner, however, pays for inflation indexing. The initial payment generally is 20% to 30% less than that of a standard immediate annuity. The initial reduction is less when there is a lower ceiling on the maximum one-year increase. (Inflation-adjusted annuity payments generally can rise or fall with the CPI. Payments will not decline below the initial payment amount, but negative CPI changes that are not reflected in the payments will offset future CPI increases.)

  Inflation-adjusted annuities still are not widespread. Vanguard offers an inflation-adjusted option as part of its Vanguard Lifetime Income Annuity. A 70-year-old purchasing a non-indexed annuity with $500,000 would 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 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. (The Vanguard annuity actually is issued by AIG, which also offers the annuity through other companies.) At the Vanguard web site, you can check the payouts you would receive under different scenarios.

• Buy a variable immediate annuity. In variable deferred annuities, the amount accumulated in the annuity account depends on the investment returns earned by the account’s investments. There also are variable immediate annuities for which the distribution each year depends on the performance of the investments.The VIA is fairly complicated. The owner selects an assumed investment return (AIR) from among several choices offered by the insurer. The higher the AIR, the higher the initial payment will be. Future income payments will vary based on how the investments selected for the account perform relative to the AIR. If the returns are above the AIR, payments will rise, but if actual returns do not at least equal the AIR, the payments will decline. You should realize that if the account’s return is positive but less than the AIR, the next year’s payments will decline.

  To avoid an income reduction, select a relatively low AIR of no more than 5%. That reduces your initial payment but makes future reductions less likely. Most VIAs also offer an option that eliminates income reductions, but that costs about 1% in extra annual expenses.

  VIAs are available from many companies. You can limit expenses and commissions by purchasing the direct-sold options through Fidelity, T. Rowe Price, and TIAA-CREF. Vanguard doesn’t explicitly offer this annuity, but its Variable Annuity has a payout option that is similar. Fidelity has a Fidelity Freedom Lifetime Income annuity that sets a 3.5% AIR and invests the account in the Fidelity Freedom mutual funds. It also offers a traditional immediate variable annuity which allows you to select the AIR.

• Buy a variable annuity with living benefits. This is a variable annuity with an option often called the guaranteed minimum income benefit (GMIB). Such annuities provide the opportunity for the income to increase with little risk of reduced income.Let’s say you invest $100,000 in one of these annuities that has a 6% GMIB rate. The policy guarantees you $6,000 the first year, which you can take in cash or leave in the annuity. At the same time, you choose how the annuity account is invested. If the investments do well, the account value grows. Then, after 10 years, there is an annual option to convert the variable annuity into an immediate annuity.

If the investments lose money, you still aren’t out of luck. When you switch to an immediate annuity, the payout is based on the variable annuity’s highest value among each of the anniversary dates of its purchase, less any withdrawals taken. That means you can receive immediate annuity payments based on your initial investment even if your account never appreciated. Even so, the annuity payouts are not computed the same way as for standard immediate annuities; your payout is likely to be less than it would have been for a traditional immediate annuity. With these annuities be sure to invest for growth with reasonable risk.

No matter which annuity you lean toward, be sure before buying that you understand the version other than the standard immediate annuity. Review what the results would be under different circumstances. Also, realize that the additional features cost money. Review the fees and how much your income is reduced. Most important is to compare redemption or cancellation fees. Often, it is difficult to exit one of these investments without a steep cost.

An easy way to increase income is to shop around for an immediate annuity. My research over the years consistently shows that payouts among insurers with top safety ratings differ by about 20%. You might get a 20% income boost by shopping for an annuity.