How Inflation Affects Annuities

Introduction

In the Summer of 2022, we all say the headlines, “Consumer Price Index increases to 9%1.”  In other words, the cost of living got a whole lot more expensive for everyone that summer.  Anyone on a fixed income was justifiably distressed.  In fact, back in 2021, 71% of retirees had already listed inflation as their biggest concern2.  

But what does inflation mean for the retiree with an annuity as part of their retirement income?  The answer to that question depends upon the type of annuity and the makeup of their portfolio. 

Types of Annuities and Their Inflation Risk

First, what is an annuity?  An annuity is, “an investment product that you buy from an insurance company. You’ll purchase the annuity with a lump sum payment, in exchange for their guarantee to pay you a monthly, or yearly, payment3.”

Fixed Annuity

A fixed annuity is, “a type of financial instrument that guarantees a particular rate of return. There are several types of fixed annuities; some come in the form of life insurance policies, where you make a lump-sum payment for an annuity and the insurance company pays it out to you as income over the course of your lifetime, some are long-term investments that provide a predetermined amount of income for a predetermined period of time, etc.3.” Having the confidence that you will never outlast this payment can bring much peace of mind to a retiree.  However, the downside to this is that as inflation increases, the value of the payment continues to decrease.  

Variable Annuity

A variable annuity is typically tied to underlying investment options such as stocks, bonds, etc.  Returns then fluctuate based on the performance of those investments6.  This can provide some protection from inflation so long as the market outpaces inflation, generally a sizable “if.”  The other downside is that the market must also perform well enough to overcome the typical fees that can be associated with these types of annuities (asset management fees, fees associated with extra benefits, etc.).  

Inflation Protected Annuities

As a result of the increasing inflation rates we’ve seen over the last couple of years inflation protected annuities have been growing in popularity4.  These types of annuities are indexed to the inflation rate.  But with all annuities there are potential drawbacks to consider.  They tend to have lower payouts and the withdrawal is also, most likely, subject to a cap.  

How to Address Inflation in Retirement?

There are several ways to address inflation in retirement.  The risk profile, availability of a pension plan, amount of investable assets and other factors will determine the types of strategies that can be utilized.  

Planning and Diversification

The first step in addressing inflation in retirement is to start saving early.  The earlier you start to save in retirement the larger the nest egg that will be accruing interest during your retirement years.  Another step is to consider annuities as part of an overall retirement plan.  Many Americans (myself included) never had access or have very limited access to a traditional pension plan.  However, we can invest in an annuity to take the place of a pension plan.  You can consider this annuity to be a financial foundation. Whether it is an immediate annuity guaranteeing a certain income for life or a variable annuity guaranteeing a certain rate of return, this can form the bedrock of a retirement income.  Having this set income stream then requires less work from your investable assets to make up for inflation over the course of your retirement.  Combining annuities with investable assets as well as vehicles such as Treasury Inflation-Protected Securities (see more below) can greatly diversify your portfolio thus providing a better hedge against inflation.  

Annuity Riders

Annuity riders are optional features of an annuity that can be purchased and added to your contract to address specific needs.  For instance, one of the primary reasons the purchasing power of a retiree shrinks is due to the increasing cost of healthcare as they age.  Long term care riders can be purchased to offset this cost later in life.  Germane to this article would also be cost of living adjustment riders that can be purchased to offset the eroding power of inflation.  Availability and cost will vary depending upon the company products purchased.  

Withdrawal Timing

Depending on the contract, you may be able to choose to delay withdrawal from an annuity to gain a larger payment.  The larger the payment during the life of the annuity contract, the more time it will take inflation to erode that purchasing power.  

Treasury Inflation-Protected Securities and Social Security

Treasury Inflation-Protected Securities (TIPS) are securities offered by the U.S. government that are indexed to inflation5.  TIPS are sold at 5-, 10- or 30-year terms with a rate of return indexed to inflation.  As stated on Treasury Direct (the government marketplace where TIPS are sold), “Unlike other Treasury securities, where the principal is fixed, the principal of a TIPS can go up or down over its term.  When the TIPS matures, if the principal is higher than the original amount, you get the increased amount. If the principal is equal to or lower than the original amount, you get the original amount5.”  Interest rates are fixed at the time of auction and are paid every six months.

Social Security benefits can increase the longer you delay taking them.  The maximum benefit you can receive will be the amount stated at your full retirement age.  Like the withdrawal timing above, the longer you delay receiving the benefit the larger the payment will be.  And since Social Security benefits are tied to inflation (although they tend to rise at a slower rate than inflation) the purchasing power of the benefit will decrease less over time.  

Conclusion

For a growing, healthy economy or an economy coming out of the throes of a pandemic, inflation will always have to be dealt with.  But with good preparation, including the right kind of annuity, it does not need to steal the peace of mind we all seek in our golden years.