It's somewhat ironic that retirees often worry about longevity. They want to live a long and rewarding life, but if that comes to fruition, then they need to worry about outliving their assets. That's the primary reason many retirees invest in annuities. Unfortunately, those same annuities didn't protect against inflation, until recently.
In this article, we're going to cover the topic of inflation-protected annuities, or IPAs. As part of that discussion, we'll briefly describe how annuity offerings are traditionally structured. Next, we'll talk about inflation, and provide an example that demonstrates the impact it has on an investment. Finally, we'll talk about inflation-protected annuities, and the benefits they offer over time, as well as the short term impact they have on investors.
An annuity is basically an insurance agreement in which the issuing company promises to make a fixed dollar payment to the contract holder, or annuitant. Since the insurance company guarantees payment to the annuitant, they allow the contract holder to reduce their exposure to the volatility of the stock market. The only exposure the annuitant has is to the creditworthiness of the insurance company.
Fixed income annuities can also be structured to guarantee payments to the contract holder for as long as the annuitant lives. This is attractive to retirees that fear they may outlive their savings. The problem with annuities is that as the contract holder ages, inflation will erode the purchasing power of their fixed payments.
So while the annuity has provided the investor with a hedge against longevity, and removed the risks associated with the stock market, they still leave the contract holder exposed to the forces of inflation. Let's see how this can happen using a simple example.
An initial premium was paid by a 65 year old male retiree that generated an income stream of $1,000 per month or $12,000 per year. From 1914 until 2013, the average annual rate of inflation was 3.2%, so a conservative assumption would be that inflation will continue at a rate of around 4.0% per year. At this rate, inflation would erode the purchasing power of the $1,000 in monthly income to $675 by the time the annuitant was age 75. At age 85, that same $1,000 would be worth only $456.
The above example clearly demonstrates that a traditional annuity only partially protects a retiree wishing to guard themselves against a future income shortfall. The income stream keeps flowing, but the value of that stream is greatly diminished.
Fortunately, inflation-protected annuities, also known as inflation-indexed or real annuities, do offer investors a hedge against longevity as well as inflation. These annuities guarantee the holder a "real rate of return" that is equal to or greater than the rate of inflation.
While not as popular among investors in the United States as fixed income annuities, inflation-protected annuities are not a new concept here in America. In fact, the Social Security retirement benefits system provides the exact same payment structure as these investments. They provide monthly payments for the lifetime of the participant, with an annual cost-of-living adjustment (COLA) feature.
While the benefits of Social Security are certainly appreciated, the income offered by the system is frequently inadequate to meet the financial needs of Americans. Unfortunately, it's not easy to find financial institutions that offer inflation-protected annuities. The Vanguard Lifetime Income Program - Inflation-Protected Securities Fund is one example of this type of offering in the United States.
When shopping for an offering, insurance companies should be able to provide several payment options to the potential annuitants, including:
While these payment options are as flexible as those offered by more traditional annuities, IPAs remain somewhat unpopular with investors and retirees.
The lack of popularity of these investments stems from two sources. The first has to do with the securities market itself. If an insurance company wants to offer inflation-protected annuities, they need to find an asset that matches the duration and features of the IPA. This is where inflation-protected securities come into play.
An inflation-protected security, or IPS, could take the form of a Treasury Inflation-Protected Security (TIPS) or a Corporate Inflation-Linked Bond. The challenge for the insurance company is to match the length of these securities with the potential duration of the IPA contract, which could be 40 years or more. Matching durations lowers risk, and lower risk to the insurance company translates into more competitive payments to the contract holder.
The second reason IPAs remain unpopular has to do with their inferior initial payments relative to immediate annuities. Retirees certainly understand, and have experienced, the affects of inflation and its impact on their cost of living. But it's easier to give up something in the distant future for an immediate benefit.
Vanguard offers a very competitive product, yet their initial payments will be approximately 20 to 30% lower than the payments received from an immediate annuity. With that kind of discount, and an inflation rate of 3.4%, it would take between seven and nine years before the inflation-protected annuity's payments would surpass those of the immediate annuity.
Clearly there are benefits associated with these flexible and forward-thinking income sources, and including them as part of a diverse portfolio of income streams seems like a reasonable approach. Unfortunately, not everyone is able to resist the impulse of the immediate, and understand the delayed gratification IPAs have to offer..
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