Protecting Lifetime Income from Inflation

Seniors are realizing the advantages annuities can provide for their retirement portfolios. Annuities pay steady income. Investors don’t worry about the volatility of their principal or income or whether to change the investment in volatile markets. Yet, there is a key disadvantage to annuities that keeps more people from using them.

In this visit we are talking about immediate annuities that pay regular income soon after they are purchased. The payment schedule is fixed and guaranteed by the insurer. We are not talking about deferred annuities, variable annuities, equity-indexed annuities, or any other types of annuities.

In past visits we discussed several times how immediate annuities enhance retirement portfolios. Studies show investing a portion of a portfolio in immediate annuities is likely to make the portfolio last longer and reduce its volatility. It is a good way to replace the defined benefit pension plans that used to be available to many retirees.

The major disadvantage of an immediate annuity is the lack of inflation protection. The guaranteed lifetime income (usually paid monthly) is fixed. Its purchasing power steadily erodes as the cost of goods and services rises with inflation. A couple of decades of even modest inflation dramatically reduces the purchasing power of fixed income.

There are several ways to overcome this disadvantage – some “home made” and some offered by insurers.

? Supplement the annuity. Few advisors recommend purchasing annuities with your entire retirement portfolio. For most people, immediate annuities are appropriate for 25% to 50% of the portfolio. This ensures you have steady income to pay for necessary expenses in the early years of retirement and perhaps longer. The rest of your portfolio is invested to generate additional income and to grow. The goals and allocation depend on your needs and ability to take risk.

The non-annuity portion of the portfolio can pay for extras above necessary expenses but also will supplement the annuity income over time as inflation reduces its purchasing power. If you invest well, it also provides a legacy for heirs.

? Save some income. You can buy an annuity that generates more income than you need to pay for your expenses in the early years of retirement. Save the excess and invest for the future. As the purchasing power of the annuity income declines, you save less of the income and spend more of it. Eventually, you spend all of the annuity income, and then start drawing from the investment fund to maintain your standard of living.

? Buy inflation-indexed annuities. You don’t have to be locked into immediate annuities with fixed payments. There also are inflation-adjusted annuities that increase payments annually to reflect changes in the Consumer Price Index or some other formula.

Most indexed annuities increase payments by the last year’s CPI with the annual increase limited to around ten percentage points. The payments usually do not decline from the prior year’s level if there is deflation. Instead, after inflation resumes the previous negative CPI is subtracted from future CPI increases before the payout is increased.

You pay a price for inflation protection. The cost of an inflation-indexed annuity is a lower first-year payout. On average an indexed annuity initially pays about 25% less the first year than a comparable standard immediate annuity, though in some cases the difference is less. But the difference in payouts requires a closer look, and a long-term look.

It is important to consider the after-tax amount of the distributions. For each type of annuity, a portion is tax free unless the annuity is purchased through a retirement account. The tax-free amount is the same, regardless of the amount of the payout. The result should be a greater after-tax distribution from the indexed annuity in the early years. One study concluded that after considering taxes an indexed annuity payout is only about 17% less than an immediate annuity’s.

Over time, as inflation persists the payout from the indexed annuity increases. The rate of increase depends on the rate of inflation, and the long-term advantage of the indexing depends on how long you live. After 20 or 25 years the indexed annuity is likely to be paying more than the standard annuity. Try a few scenarios of different rates of inflation to see how long it takes for the indexed annuity to overtake the standard annuity. Compare that with what you might accumulate by not spending all of the standard annuity distributions and investing the difference.

Some indexed annuities, known as graded payout annuities, provide a steady payment increase of 2% to 3% annually. These have higher initial payouts than fully indexed annuities, but annual increases do not fully reflect CPI increases above a stated amount.

When considering an indexed annuity, pay attention to the formula. Is the increase based on monthly compounding of inflation or annual compounding? Monthly compounding results in higher payouts. Does the inflation index used reflect your spending? If it doesn’t the inflation in the index will be different from what you experience. Are the accumulated increases simple or compound? Compound increases result in higher payouts over time. Also, check the level of inflation indexing. Some annuities provide full CPI indexing. Others either have a cap on the annual increase or raise payouts by a percentage of the CPI increase. Of course, the more inflation protection you have, the lower the initial payout will be.

? Variable immediate annuities. You might receive higher payouts over time from a variable immediate annuity. A VIA is invested in mutual funds selected by the owner. The annual distributions from the annuity are adjusted depending on the performance of the investments.

But the VIA has some complications. You select an assumed investment return (AIR) from several choices, usually 3%, 5%, and 7% annually. The higher the AIR selected, the higher the initial payment. The amount of future payouts depends on how well the investments do relative to the AIR. Payments rise when performance exceeds the AIR. Unlike other annuities, payments can decline when returns are less than the AIR. Payments can decline even when returns are positive if they are less than the AIR. It is best to select a relatively low AIR. You also can select an option that eliminates income decreases, but you’ll pay 1% or so in higher annual expenses.

As always with annuities, check the financial stability of an insurer before choosing an annuity. You might want to buy annuities from several insurers to spread the risk. Shop around, too. Payouts among insurers differ considerably. Many mutual funds and discount brokers offer different annuities with low expenses. Be sure to check their web sites for offerings.

December 2009. RW