How to Handle Inflation with a Fixed Annuity
By Shane Flait © 2012

If you worry about how to juggle your investments and withdrawal rates to preserve your retirement income, you may be better off just buying an annuity contract. It’ll pay you a fixed payout for the rest of your life. But inflation is the bane of fixe payout investments. Here are some considerations for handling both an annuity and inflation to keep your purchasing power more or less constant.

An annuity payout has a couple of advantages over living off certificates of deposit in addition to a lifetime payout. The interest rates that insurers typically use to calculate immediate annuity payments are higher than CD rates. And also, each annuity check includes an untaxed return of principal portion - whereas all of the CD return is taxed as interest income. You can’t touch the CD principal without undermining the interest you can earn.  

And, of course, how much you receive for your monthly annuity payout depends upon your age, sex, and the amount you pay as premium into the contract. The older you are when you begin and the more you put down, the bigger your monthly payouts become.

 

Unfortunately one hazard that fixed annuity payout’s can’t avoid is inflation.

 

How much damage can inflation do?

Investing in a fixed income annuity avoids the risks of market downturns, but the fixed payout can really suffer in the buying power of that monthly as the years go on. That’s because inflation erodes the value of those payout dollars so that monthly payout buys less over time. Just a 3% inflation rate  - see figure - shows that if you begin payouts at age 65, the purchasing power of your monthly payout drops about 25% by age 75, and 50% by age 89. A 50% reduction in payout power means you’ll have to pay twice as much as you used to in order to purchase the same products.  

 

If you’re a man aged 65, your life expectancy is 82 but you still have a 50% chance of living longer than that. And if your family history shows a lot of longevity, you may easily surpass even that by many years.

 

What about inflation- adjusted annuities?

Because of the damage that inflation can do to fixed payouts, some insurance companies offer a way to combat inflation with inflation-adjusted annuity payouts. You can get inflation-indexed life annuities tied to the Consumer Price Index (CPI) or simply fixed cost of living adjustments (COLAs) for them. How does this work, though?

 

Unfortunately, the way the insurance companies handle this for the same investment amount you make, is to start out your inflation-protected monthly payments far below those of the regular fixed payout variety. Although these adjusted payments would slowly increase over the years, it may take about your remaining life expectancy to get to the breakeven point with those of the fixed types. Beyond that your payouts will continue to increase.

 

What alternative way can you handle this inflation-payout dilemma?

A better way to address the inflation problem is to avoid putting all your money into an immediate annuity.  Instead, invest some money in a diversified, low-cost portfolio of stock and bond index funds with some investments that thrive (increase) under inflation – such as precious metals.

 

Live on the fixed annuity payout as long as possible. As inflation starts taking its toll on your payout, supplement the ‘loss to inflation portion’ by withdrawing money from your investments.

 

This approach keeps you in control of more of your money, and if you die early, it leaves a legacy for your loved ones.

 

 

 

 

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com