An Annuity to Keep Pace with Inflation
Inflation is one of the biggest concerns retirees face. The possibility that your retirement income won’t buy as much as the years pass can be frustrating and scary. It’s actually more of a reality than a possibility so rather than just worrying about it, you need a plan that accounts for it.
Financial institutions know this so there are plenty of products and opinions that will claim to help you beat inflation. But most of the traditional advice you might receive actually works against you and does nothing to solve the problem of declining purchasing power.
I’m going to give you an example of an annuity that is designed to keep pace with inflation and explain why it doesn’t do the job. There are a couple of inherent flaws with all inflation-adjusted annuity contracts and it’s a difficult concept for many to grasp. Understanding this limitation is the first step to finding a real solution for inflation risk.
The first of the flaws shows that you don’t actually get more money out of a contract with planned increases, at least not for a long time. Let’s look at a standard example of the same annuity, with and without an inflation adjustment to see how they compare for cash flow.
This illustration comes from a leading carrier with very competitive payments, although it may not be the highest available payment it is very close.
Single Life Age 65.
Straight Life Payment is $548 per month for life.
Adding 3% annual inflation adjustment drops the initial payment to $405 monthly.
The inflation-adjusted payment doesn’t exceed $548 monthly for 11 years at which point aggregate cash flow from the straight life payment stream would have put an extra $10,000 in your pocket. So by age 76 you would have had more money going with the level payment. Aggregate cash flow from each payment stream is not equal until year 20 so you receive no real benefit from the adjusted stream until after age 85.
This is just a matter of simple math. Evaluating two options of any kind requires you to run a break-even analysis to see which the better deal is. Do you want a lot more money for the first 20 years of retirement or a little more for the last few years?
The other flaw of inflation-adjusted contracts is not quite as easy to pinpoint but it’s important to understand. Any fixed payment stream, whether increasing or not will decline in value because of inflation.
In the example above, the inflation-adjusted payment stream is scheduled to be $710 monthly in 20 years. What if interest rates increase substantially because of massive inflation? The payment will still be $710 regardless of what happens with interest rates. Sure it will buy more than you could get with $548 but it cost you plenty in lost payments to get to that point.
So what’s the answer? Well, you need growth that exceeds the rate of inflation, and locking into a low rate makes it impossible. Continued participation in the stock market is a really good way to offset inflation but the risk of volatility can hurt you even more.
And that’s the purpose of using annuities, to provide income free from market risk. But using an annuity the right way is the key to beating inflation. It doesn’t involve locking into low rates for a lifetime payment no matter how it’s structured.
Balancing a portfolio to reduce risk and keeping all investments flexible and short-term in nature will enable you to continually re-balance and put money to work in a rising-rate environment. Flexibility with assets is the only way to beat inflation. If done right you’ll have the safety you need, growth you want and the ability to take advantage of higher rates in the future.
If you have any questions about how to make it work then feel free to call or make an appointment.
Have a great weekend!
Bryan Anderson
800.438.5121
Further readings
Fixed Indexed Annuity Withdrawals
How Much Do Fixed Annuities Pay?
Last Updated on January 12, 2024 by Bryan Anderson
