How to Evaluate Inflation-Adjusted Annuities for Your Retirement Plan

Bob Carlson


A lifetime stream of guaranteed income is a goal for many people. Even better is to have that income-stream increase with inflation.

You can have a lifetime stream of guaranteed income that increases with inflation, but you must study the options, plan, and shop carefully.

An immediate annuity is the prime way to receive guaranteed income for life.

The problem is it doesn’t have inflation protection.

A separate investment portfolio can generate annual cash that supplements the annuity payments and maintains purchasing power. But there are no guarantees the investment portfolio will generate positive returns or enough cash to maintain purchasing power.

You have two choices if you want an income guaranteed for life that increases over time: inflation-indexed annuity and variable immediate annuity. They are very different vehicles.

An inflation-indexed annuity is a straightforward guarantee that your income payments will be adjusted for inflation (but not downward for deflation). The annuity makes periodic payments for either life or a term of years, whichever you select, and the payments are increased automatically each year to match increases in the Consumer Price Index.

The annuities usually have a maximum one-year increase of 10%. A variation, generally called growing annuities or variable immediate annuities, allows you to select a fixed percentage amount and the payment increases each year, instead of full CPI indexing. You might select 2% or 3%, for example.

A growing annuity should give you a higher first-year payment than a full CPI indexed annuity. Also, you’d know how much income will increase each year, and could factor that into long-term budgeting and spending, rather than having to wait to see each year’s CPI increase.

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Of course, if inflation is higher than the automatic increase rate you selected, at some point, you’d need to reduce expenses or supplement the income from another source.

The Downside to Inflation Protection Is That It Costs You

With an inflation-indexed annuity, your first-year payment is going to be 20% to 30% less than that of a fixed immediate annuity. The exact amount will depend on your age, life expectancy, and the inflation rates the insurer forecasts.

Hint: You don’t necessarily want to buy the inflation-indexed annuity that offers the highest first-year payout. The insurer could be assuming future inflation will be very low or that it will earn very high investment returns. You could be hurt down the road if the insurer runs into financial trouble because its assumptions were too optimistic.

Here’s how to compare a fixed annuity to an inflation-adjusted annuity, and compare different inflation-adjusted annuities…

Start with the first-year monthly payment amount. Then compare what the payments would be after 10, 15, and 20 years under different scenarios.

Assume a 70-year-old could purchase a non-indexed annuity with $500,000 and receive an initial $3,962.93 monthly payment. If he selected a 2% annual increase, the initial payment would be $3,375.54.

After 10 years under the 2% option, the payment would be $4,736.07. If he selected full CPI indexing, the initial payment would be $3,039.18; the payment after 10 years would depend on the inflation rate and you assume different inflation scenarios to estimate future payments.

You want to estimate how long it takes to reach the break-even point under different assumptions. That’s the point when the indexed annuity or growth annuity pays more than the fixed annuity.

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If you expect that point is within your life expectancy and can live on the lower income until then, you’re probably better off with the inflation protection.

Keep in mind the risk that assumptions can be wrong. Bypassing the fixed annuity means taking the risk that inflation will be lower than what you or the insurer is assuming. You could end up with lower lifetime income than you assumed.

Or you might select an annual increase without full inflation protection and take the risk that inflation will be higher than that.

An inflation-indexed annuity usually is not sold as a separate product. Instead, you shop for an immediate annuity and select an option to have the payments adjusted for inflation, or increase automatically at your selected rate.

If you want protection from high inflation in coming years, consider lower annuity income now in exchange for rising payments over time.

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