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Annuities and Inflation- Like Oil And Water?

annuities and inflationMany of our readers are concerned about inflation, and rightly so.  Inflation is a creeping erosion of the purchasing power of the dollar and is like a shadow drag on consumers.  Many consider inflation to be a hidden tax too.

So how can an annuity protect you from inflation?  The truth is, no annuity will protect you per se.  There is really no asset that has guaranteed protection because the future rate of inflation is an unknown.  But used prudently, annuities form an important part of a smart inflation protection strategy for your overall portfolio.  Take a look here at what we wrote a few months ago about how annuities mitigate inflation risk.

But let’s talk about inflation for a moment.  Consider this:

As the cost of goods and services go up, income hopefully goes up too, yet purchasing power may remain flat or trend down.  Standards of living may not rise with income, yet tax receipts increase as incomes increase.   The dollars earned and the taxes paid go up, yet people do not feel any better off.  In this way, inflation is a shadow tax on quality of life.

Benefits of Inflation:

So who benefits from inflation? Inflation favors borrowers.  If you borrow a dollar today and use it for some constructive purpose or spend it, and inflation is 3%, it will only cost you $.97 in today’s terms to pay off that dollar one year from now.

Multiply this by trillions, and you can see that the government is the biggest beneficiary of inflation.  As they borrow and spend, the dollars used in the future to repay that debt will be easier to come by and worth less than they are today.  Of course, the government plays by its own rules and creates money out of thin air so can create new dollars when needed if they ever intend to repay the debt.

But for normal mortals, borrowing and buying assets that may appreciate with inflation is a smart move.  Take commercial real estate for example.  If you borrow $1 million and buy an asset that produces $50,000 a year net income, and your debt service cost you $40,000 a year, you have $10,000 to spend.  Hopefully you purchased a fixed rate mortgage…

But over time, that net income may rise to $100,000 per year, but your debt service remains constant at $40,000 per year.  Your spending income from the property increases, while you’re expenses stay relatively flat.

Of course, commercial real estate has different risks associated with it, and depreciation is a real erosion of the asset that requires maintenance dollars to keep up.  Tenant credit risk, maintenance, real estate taxes, utilities, interest rate exposure, and a host of other variables all contribute to make real estate a more risky play.

For average homeowners, long-term fixed rate mortgages today are such an incredible value in the 3.5% to 4.5% interest rate range that it is easy to see homes once again becoming a store of household wealth.

Annuities and Inflation:

Annuities will not protect you from inflation.  But inflation can be estimated and accounted for to the best of our abilities today.  Looking at historical tables available online here, you can see inflation over a very long data set since 1913.

Since 1913, inflation has averaged 3.3% per year.  Since 1990, and has averaged 2.7%.  Since 1970, which includes galloping inflationary years, the average is 4.4%.  And of course, this is based on the CPI –U index, which is a limited measure of consumer prices.  Not all things go up in price relative to purchasing power every year, some things go down, and others go through the roof like healthcare.

So how do you deal with inflation?  The most reasonable way to address it is to use a reasonable assumption like 3% and make sure your income in retirement increases by this amount to at least keep your purchasing power constant.  This will not be exact, but it is a prudent way to start.

Here is a quick table showing $60,000 per year income and what is required to maintain purchasing power with a 3% inflation out to year 100 starting from age 49.  The rows in green skip forward many years just to save space.

Inflation And Income

Income needed to maintain $60,000/ year purchasing power given 3% inflation over 52 Years

When using annuities, many of our clients use deferred longevity income annuities to produce lifetime income starting in the future.  For a 49-year-old in this example, an LIG contract that starts paying at age 85 should produce $173,000 of income per year to keep purchasing power constant.  Buying an LIG contract today that only pays $60,000 starting in 37 years will leave you way below your needs.

Another prudent way to use annuities to protect yourself from inflation is to pick the highest yield annuity you can find and put the least amount of money into it.  By giving you some degree of protection and guaranteed income, you then free your remaining assets to be used in more aggressive growth strategies and you remove pressure from your remaining assets to produce income.  We detailed this here:

Inflation and Annuity Summary:

Don’t let the fear of inflation freeze you in inactivity.  Annuities form an important floor of income and remove pressure from remaining assets, so in the annuity protected portfolio may very well be much safer and more resilient than a portfolio heavy on bonds that carry intense principal risk in a rising rate environment.

How Annuities Mitigate Inflation Risk

money-bill-inflationInflation is the gradual erosion of the purchasing power of your dollar.  Inflation has averaged about 3.3% per year from the start of the US Government data set in 1910 to today- this includes the galloping years in the 1970’s. Check out the Government’s own Inflation Calculator HERE:

Now, I’ll be clear, an annuity itself will not protect you from inflation.

What an annuity CAN do, however, is increase your overall safety AND simultaneously allow you to invest more aggressively.  Let me explain…

How A Flooring Strategy Helps:

One of the primary benefits of ‘flooring’ your income with a guaranteed annuity is that you can invest the rest of your assets for more growth.

It is growth, and exposure to assets that are resilient and increase in value with inflation, that will protect you in the long run.

So here’s the thing- how can you have exposure to ‘risky’ growth assets while safely protecting your nestegg? It’s actually quite simple….

By allocating a PORTION of you assets to be dedicated to guaranteed income in an annuity, you free up the REST of your assets to be safely invested for growth!

If you are protecting one pile of money, and simultaneously trying to make it grow AND be safe AND produce income, all at the same time (traditional asset management and systematic withdrawals), you are running a grave risk.

Because of the competing priorities, the performance of that one pile of money trying to perform well on each of these different fronts will be compromised.  Your money is divided, and you’ll be conquered

Instead, by allocating a portion for income in an annuity, and allocating a different portion to growth, the growth portion can simply grow…. without pressure to sell in a down market for income… and without pressure to be conservatively allocated for safety….

This gets to the heart of our approach, namely, to put yourself in a position of strength by building a floor level of guaranteed income to cover your essential expenses.  Then the rest of your assets can be more aggressively invested, yet your overall risk profile is quite safe.

It just makes sense.

Conventional “Wisdom”

Wall Street’s usual recommendation is to be increasingly weighted to bonds as you get older, for safety and income.

Following this poor advice, not only are your assets at grave risk of loss due to interest rate rises, but you are likely NOT invested in assets that can jump with inflation, such as equities, metals, or real estate.

You could be stuck nursing an overweighed conservative portfolio in an inflationary environment, losing purchasing power, yet not be able to allocate to growth for fears of volatility or loss.

Following the ‘Thundering Herd’ and conventional wisdom, you’ll get trampled to death.

Inflation Risk Summary

Inflation needs to be recognized, and many people shy away from annuities due to inflation fears.

However, a guaranteed income from an annuity actually frees your remainder assets to be invested for growth and inflation protection WITHOUT the pressures of safety and income on those remainder assets.

Therefore, guaranteed income from an annuity is actually a critical component of an optimal inflation protection strategy.