Inflation risk in retirement captures the possibility that the prices of goods will increase beyond what your retirement income and savings can handle. Annuities do not do a good job protecting you from that risk, and instead are built to protect you from the other two big risks: market risk and longevity risk.
- Inflation, or the general increase in prices over time, is one of the three big retirement risks
- Annuities do not do a good job protecting you against inflation, especially when compared to Social Security and the stock market
- However, with a portfolio that includes all three (Social Security, annuities, and market investments), you’ll be in good shape for all three risks
It’s hard to read, listen to, or talk about anything regarding finances without the word “inflation” coming up. In fact, a lot of people hear the word used all the time, but don’t really understand what inflation means, and how it relates to their money or retirement.
What Is Inflation?
So what exactly is inflation? It’s an increase in the price levels of goods and services in the economy over time. In other words, prices increase over time, and inflation is the rate at which they’re increasing. When there is inflation, your purchasing power drops, meaning that the same $100 today, for example, will be able to get you less “stuff” in the future. Over the last 20 years the inflation rate has hovered somewhere between 1% and 3%, and the federal reserve targets 2% inflation levels.
Inflation Risk in Retirement
There are three big retirement risks, and inflation is one of them. (The other two are market risk, or the risk that the market performs poorly, and longevity risk, or the risk that you run out of money.) With inflation, the risk is that an unexpected increase in inflation, or the amount goods cost over time, results in you not having enough income or savings in retirement. Of the three retirement risks, this is the hardest to protect against. But, with a diversified retirement portfolio, you can get close:
Are You Protected?
||Pensions & Annuities
Social Security is the ultimate source of retirement security because it’s protected from all three. (1) You are’t affected by the market. (2) You have a source of income you can’t outlive. (3) It’s indexed for inflation with an annual CPI adjustment. (The CPI, or Consumer Price Index, is an official measure of the change in prices paid by consumers for goods and services.) But, since Social Security only covers, on average, 40% of one’s expenses in retirement, it needs to be supplemented with something else.
Pensions and annuities offer the next best protection. (1) They’re isolated from the market. (2) They also provide income you can’t outlive. But, (3) they don’t usually offer protection from inflation, with some exceptions.
Market investments, such as through IRAs and 401(k)s round out the pack. (1) They’re invested in the market, so not protected from it. (2) Once you start spending that money, you can’t guarantee it’ll last for life. But, (3) since inflation affects the prices of stocks, you can reasonably expect that your market investments will increase with inflation.
While inflation is an important risk to consider in retirement, it is partially mitigated by an important fact: on average, Americans’ spending drops at retirement and then continues to decline yearly thereafter. The initial drop results from the fact that you’re no longer putting money aside for retirement, and you no longer have work-related expenses. Then, later on, spending on entertainment, personal care, and travel declines. So, the potential increase in prices of goods in retirement is partially offset by the fact that you’ll be buying less of those goods.
Inflation and Annuities
How does all this relate to annuities? In two ways. First of all, expected inflation, among other factors, influences interest rates. And, interest rates influence the price of annuities. Secondly, inflation levels determine how much the future annuity income checks will actually buy, meaning the purchasing power of those checks.
By default, the annuities on our platform do not include any inflation protection. That means that the income you see quoted is in today’s dollars, not future dollars. While it is possible to add inflation riders that increase your annuity income check over time, they don’t typically provide real inflation protection, as the increase is set at a fixed amount (1-5% annually) instead of indexed with inflation. The few exceptions to this include Principal and AIG, who do offer a CPI indexed rider, and which you can access through our annuity quotes portal.
So, while some might tell you that inflation riders protect you against inflation, they really don’t. Here’s why:
- First, no company will protect you against inflation risk during the deferral period. If you’re purchasing an immediate income annuity, you don’t have to worry, but if you’re purchasing a deferred income annuity, this should be an important consideration.
- Second, unless you’re purchasing an inflation rider that is tied to an actual consumer price index, the payout will not go up in lockstep with actual inflation. Most companies have 1%, 2% or 3% inflation riders, but chances are annual inflation will never be exactly that amount. AIG is one of the only insurers that offers a “CPI” inflation rider, meaning it adjusts payouts based on what measured inflation actually is.
- Third, the insurers generally try to profit from riders and there’s a good amount of evidence indicating that inflation riders are not quite “actuarially fair.” We explore what that means below.
Implied Cost of an Inflation Rider
To determine the value of the inflation rider, we charted the payouts available with and without inflation riders for a 50-year-old male spending $100,000 to get income starting at age 70. The payouts allow us to determine approximately what rate of inflation the insurance companies are currently forecasting in their payouts. Note that these are the income payments in the first year, after which they will increase by the amount stipulated.
||First Income Payment
|No Inflation Rider
|1% Inflation Rider
|2% Inflation Rider
|3% Inflation Rider
|CPI-U Inflation Rider
|4% Inflation Rider
$100.000 Principal deferred income annuity rates including the refund at death for a 50-year-old male with income starting at age 70. Rates as of 4/5/2018.
The payout for the policy with CPI-U rider in this example provides a payout between the 3% inflation rider and 4% inflation rider option. The implied inflation rate for the CPI-U payout if we did a linear interpolation between the 3% and 4% amounts is approximately 3.27%.
No matter how you look at this, 3.27% implied inflation seems expensive. Why? Well, the Federal Reserve, the body that determines interest rates, targets a long-term inflation rate of 2.00%. And recent auctions of Treasury Inflation Protected Securities imply a 10 year break-even inflation rate of 2.05%.
Our view? Foregoing monthly income on your annuity purchase to include an inflation rider is not cost effective given the current implied rate. Why not use your equity portfolio to hedge your inflation risk? Or maybe even buy TIPS? Rather than doing it with an annuity purchase, creating an inflation hedge through your market-based assets will almost always make more sense.
If you’re getting close to retirement or have enough money to buy all the retirement income you need today, take a look at our marketplace of annuities by clicking below. It’s there in the advanced setting that you’ll be able to play around with the inflation rider options.
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