Retirement is supposed to be relaxing – a reward for decades of hard work. However, concerns over having enough money can cause stress. From healthcare costs to housing, prices seem to rise every year. And with Americans living longer than ever in retirement, nest eggs have to stretch further. So inflation is no small issue…
As a financial advisor helping folks prepare for retirement, inflation questions come up frequently. Many clients choose products like annuities to secure guaranteed lifetime income. However, some worry whether fixed payments can maintain their purchasing power over lengthy retirements with rising inflation.
What is Annuity Income?
First, a quick primer on annuities. These insurance contracts come in many varieties, but in essence, convert a lump sum of savings into a stream of guaranteed income. You receive fixed payments for life or a set period of time in exchange for upfront premiums paid to an insurance company.
The income can start right away or years in the future. Some annuities offer growth potential through market investments. Others focus purely on guaranteed income without volatility. Lifetime income is the key feature that distinguishes annuities from conventional assets like stocks or bonds.
For retirees seeking both certainty and longevity protection, annuities deserve consideration. They insure against the risk of outliving savings by providing income you cannot deplete. This allows annuitants to spend confidently from monthly checks without worrying about draining principal too rapidly.
The Inflation Challenge With Annuities
Over long retirements, higher inflation poses a major threat to maintaining living standards. Healthcare, housing, food, energy – the prices of essential goods and services tend to rise over time. Even at moderate annual inflation rates of 2-3%, your purchasing power can decline substantially over 10, 20, or 30 years.
This hurts retirees living primarily from fixed income sources like Social Security, pensions, CDs, and bonds. Flat payments limit spending flexibility when expenses grow higher. Running out of money prematurely becomes a real possibility unless withdrawals from savings are managed judiciously.
With most immediate or deferred annuities, payments remain constant rather than increasing by the rate of inflation.
Consider This Example:
John retires at 65 with savings of $300,000. He uses $200,000 to purchase an immediate annuity paying $1,000 per month for life. The remaining $100,000 stays invested in 60% stocks/40% bonds to fund any discretionary expenses.
In John’s first year of retirement, his essential monthly expenses of housing, food, and medicine cost $1,500. So his $1,000 guaranteed annuity covers two-thirds of basic spending. John withdraws another $500 per month from investments for travel and entertainment budget.
By age 80 however, 15 years of 3% annual inflation has driven John’s basic costs up to $2,000. But his annuity still pays the initial $1,000. So now it only covers half of essential bills, forcing John to draw more from volatile assets earlier than desired.
This highlights the inflation vulnerability of guaranteed lifetime income. Annuity payments remain fixed over time rather than adjusting upwards to match rising prices. So while annuities protect against the risk of outliving savings, they cannot safeguard the purchasing power of that income over lengthy retirements in inflationary environments.
Balance Your Priorities
The loss of buying power over time presents a tradeoff to consider regarding annuity income. You gain protection against running out of money before you run out of years. But you may lose the flexibility to maintain desired living standards if inflation accelerates.
Ultimately retirement requires prioritizing your personal priorities and fears. I guide clients through a structured process, which I call the Hierarchy of Retirement Risks. We rank your concerns from greatest to least across three broad buckets:
- Essentials – Basic necessities like food, healthcare, housing etc.
- Lifestyle – Discretionary spending to enjoy life through activities that fulfill you
- Legacy – Assets remaining to gift heirs and causes you care about
For retirees focused chiefly on funding essentials, annuities make sense as part of an overall plan. They cover baseline expenses that must be met regardless of outside conditions. This income layer in retirement works hand-in-hand with Social Security to pay for recurring priorities through even prolonged market downturns or rising prices.
On the other hand, retiring investors with the ambition to extensively travel the world or leave large inheritances may wish to favor liquid assets. These provide greater flexibility to scale lifestyle spending up or down as inflation fluctuates. But they lack income continuity guarantees if invested too aggressively or drawn too liberally.
As with most aspects of retirement planning, balance is imperative based on your personal savings, risk appetite, and income hierarchy. Annuities reduce risks related to lifetime earnings and market volatility. Meanwhile, equities and variable investments provide growth potential to outpace inflationary loss of purchasing power.
Ways to Combat Inflation
Fortunately, some options exist to help annuities keep up better with rising prices. They either adjust income payments based on an external inflation gauge or allow you to allocate funds across investment subaccounts likely to earn inflation-beating returns.
Some fixed annuities offer riders allowing periodic boosts to income payments based on changes in the Consumer Price Index (CPI). For example, a 2% annual inflation rider would bump up your initial $1,000 monthly payout by $20 per year to offset rising prices.
Cost-of-living adjustment provisions are also common in employer pension plans. So this rider aims to replicate that feature. However, understand a few key points if considering an inflation rider on an annuity purchase:
- Availability tends to be limited – only around 1 in 4 annuity carriers provide this optional benefit
- It lowers the initial quoted monthly income versus a comparable fixed payout product
- Annual increases may be capped at 3-5% even if inflation runs higher
- If inflation turns negative as in brief deflationary periods, so could your payment
Annual incremental bumps realistically won’t match short-term price spikes for specific household items. And caps limit participation in extreme inflation scenarios. But for conservative retirees wanting steady predictable growth of guaranteed income to offset gradual inflation, a modest CPI rider can be helpful.
Variable Annuities with Investment Subaccounts
Rather than contractually-guaranteed adjustments, allocating funds to professionally managed investment subaccounts provides an alternative inflation hedge. These variable annuities function similarly to mutual funds within the wrapper of guaranteed lifetime income distributions.
You can select from stock funds, bond funds, or other assets likely to earn investment returns exceeding inflation over extended periods. Historically the stock market returns 8-10% annualized or around 5-7% above annual price increases. So equities in particular bolster purchasing power of annuity payments.
Key features like lifetime withdrawal benefits allow spending a percentage of account value annually without draining principal. This maintains liquidity to adjust withdrawals higher or lower depending on inflation’s impact in a given year. As market investments, subaccounts do carry sequence of return risk where a downturn early in retirement can significantly reduce earnings.
But for comfortable retirees with adequate fixed sources of essential income from Social Security and pensions, inflation-resistant variable annuities warrant consideration. They facilitate lifetime income scaled according to market performance and rising costs.
Conclusion – Inflation Protection Has Tradeoffs
At the end of the day, all sources of retirement income face inflation risks over time. Annuities provide lifetime earnings through conservative guarantees rather than chasing stock market growth. This reliability appeals to retirees focused on funding essential expenses as long as they live.
Now we could certainly augment annuities by adding inflation riders or investing in subaccounts with equity exposure. But either option involves tradeoffs – reduced initial spending power or market volatility respectively.
The reality is annuities don’t exist in a vacuum. You can mix guaranteed and growth-oriented assets to capitalize on their complementary strengths. Annuities provide a base level of lifetime income to cover fixed costs. Meanwhile, stocks, funds, and CD ladders allow responding to inflation’s impact in a given year.
Balancing these tradeoffs based on what matters most requires tailoring personalized portfolios to your priorities. That’s why guidance from an advisor is so valuable. Don’t leave protection from rising costs over a 30-year retirement to chance. Get in touch to schedule a session about building durable inflation-resistant income!
Q: What is an annuity contract?
A: An annuity contract is a financial product issued by an insurance company that provides guaranteed income either immediately or in the future in exchange for upfront premium payments.
Q: What is a deferred income annuity?
A: A deferred annuity is an annuity contract that begins paying out income at some point in the future, allowing funds to grow tax-deferred until payments start. This delays receiving income rather than starting payments right away.
Q: What are inflation-adjusted annuities?
A: An inflation-protected annuity is a type of annuity product that provides payments linked to an inflation gauge like the Consumer Price Index, reducing the inflation risk. Payments rise by a set measure or cap to help offset the loss of purchasing power from rising prices over time.