Inflation-Protected Never-Ending Lifetime Income with Annuities

Retirement planning boils down to solving two problems: providing an income for life, and ensuring that income retains its purchasing power. Running out of money and watching the purchasing power of one’s income erode are two of the greatest retirement fears.

Financial services companies constantly are developing products and strategies to alleviate these fears. As the Baby Boomers age, companies are putting more resources into developing products, and the products are becoming more attractive.

It is easy to ensure a lifetime income. Simply buy an immediate annuity for life. This annuity will pay regular income, usually monthly, for the rest of your life. There are two major risks to an immediate annuity. One risk is that the insurer might become insolvent and be unable to continue making the payments. This risk can be reduced by examining and monitoring the insurer’s financial status. The other risk is a reduction in the purchasing power of the payments. Traditional immediate annuities make fixed payments. Over time, inflation eats away the purchasing power of the payments.

There are several ways to reduce the risk of losing purchasing power.

• Keep saving. Don’t spend all the annuity income for a while. Save and invest a portion of it. After a while, spend more of the annuity income. Finally, tap the reserve fund to maintain your purchasing power. 
• Inflation-indexed annuity. Once rare, more of these are available. The annuity pays income for life or a term of years just like an immediate annuity. But the payments are adjusted to reflect changes in the Consumer Price Index. Usually there is a limit to the adjustment. For example, a standard limit is that the payments will not rise more than 10% in one year. 

  The disadvantage to the inflation-indexed annuity is that the feature reduces the initial payment by 20% to 30%. It takes a few years for selecting inflation-indexing to pay off. Some annuities allow the owner to limit the initial reduction by choosing to limit the annual increase or accepting a fixed increase of 2% or 4%.

  Vanguard has offered inflation-indexed annuities since November 2004 under the name Vanguard Lifetime Income annuity. A 70-year-old purchasing a non-indexed annuity with $100,000 would receive an initial $757 monthly payment. If he selected a 2% annual increase, the initial payment would be $644. After 10 years the payment would be $785. If he selected full CPI indexing, the initial payment would be $569; the payment after 10 years would depend on the inflation rate. (The Vanguard annuity actually is offered by AIG, which offers the annuity through other companies.) At the Vanguard web site, you can check the payouts you would receive under different scenarios.

• Variable immediate annuity. Most of you are familiar with variable deferred annuities for accumulating retirement funds. Most do not realize that the variable investment feature can continue after distributions begin. Using this vehicle, the annuity payouts can change with the investment returns of the annuity account. 

  The VIA is a bit more complicated than an indexed annuity. 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.

  That is why most advisors recommend selecting a relatively low AIR of no more than 5%. That reduces your initial payment but makes future reductions less likely.

  Of course, no one wants to see a reduction in his retirement income, even if it is temporary. Because of that, many VIAs offer options that will eliminate or limit reductions. Of course, these options cost money. Count on paying around 1% in extra annual expenses to limit or prevent payout reductions.

  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 recently rolled out a new 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.

• Variable annuity with living benefits. These actually are variable annuities with an option often called the guaranteed minimum income benefit (GMIB). The policies are fairly complicated. 

  Let’s say you invest $100,000 in one of these annuities that has a 6% GMIB rate. That means 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 account loses 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 on each of the anniversary dates of its purchase, less withdrawals taken after that. That means you can receive immediate annuity payments based on your initial investment even if your account never appreciated beyond that. The annuity payout tables, however, might not be as generous as those that used for a straightforward immediate annuity.

These are complicated vehicles, and the insurers charge fees to offer these benefits. Avoid an annuity that has a surrender charge, and insist on seeing what the results would be under different scenarios. If you choose a GMIB option, you’ll want to invest for growth with the variable annuity account to maximize the potential return.

Of course, there are simpler approaches to preserving the purchasing power of your income than using these products.

I do not recommend putting 100% of a portfolio into immediate annuities. Instead, put 20% to 50% into annuities and invest the rest for growth or both growth and income. The annuities provide a guaranteed floor to your income. The investment portfolio supplements that and allows you to maintain purchasing power after inflation.

Another alternative is what I call “growth bonds.” These are investments that pay a relatively high yield now and are likely to increase the amount of their average payouts over time. Investments with these features include high-yielding stocks, utility and other energy stocks, and real estate investment trusts. These are included in our Income Growth Portfolio. These investments might not increase their yields every year. But over time the amount they pay should increase. In addition, there is the potential for capital gains. Eventually the stocks can be sold at higher values to supplement income.