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Annuities and Inflation: Contractual Facts Matter

Annuities and Inflation

Inflation is the gorilla in the retirement room. It’s the cloud that perpetually hangs over any investment decision that retirees and pre-retirees have to make. It’s an unseen nemesis and the perfect example of trying to nail jello to a wall. With that being said, every U.S. citizen already owns the best inflation product on the planet and most people are not aware that it is an annuity lifetime income structure.

It’s called your Social Security benefits.

Social Security is a transfer of risk lifetime income stream that has an increase to the income stream that is determined by our elected officials in Congress. No actuaries are needed for this added income amount, it’s a political football that is too often used as a “vote carrot.”

Now that you know you already own an annuity that adjusts for inflation and is issued and backed by the government, you need to know the facts on how commercial annuities can adjust for inflation as well. Before buying an annuity of any type, you need to know the contractual facts behind the sales hype. In other words, don’t buy the dream because you are going to own the contractual reality.

Drink the COLA?

COLA in the annuity world stands for Cost of Living Adjustment. A COLA is an annual increase to the income stream that is contractual and for the life of the policy. At the time of application, with some annuity types you have the choice of adding a COLA to that income policy. You decide on the actual annual percentage that you want your income to increase by on the contract anniversary date.

For example, you can choose a 3% or a 5% COLA at the time of application. That means that your income stream will increase by that amount every year. Sounds great in theory, but annuity companies have the big buildings for a reason. They don’t give anything away. Once you add a COLA to your income annuity, that carrier drastically lowers the payout amount compared to the same annuity without a COLA.

Remember that lifetime income payouts, regardless of the type of annuity contract, annuity income is a combination of return of principal plus interest. That income payment amount is determined at the time you start the payments and is primarily based on your life expectancy. Interest rates play a secondary role.

The primary types of annuities that utilize COLAs are Single Premium Immediate Annuities (SPIAs) and Deferred Income Annuities (DIAs). SPIAs are for income needs as soon as 30 days from the policy issue date and up to a 1 year deferral. DIAs have income starting as soon as 13 months from the policy issue date and up to a 20 to 40 year deferral (depending on the carrier). Both SPIAs and DIAs are categorized as a fixed annuity, and are issued by a life insurance company.

In my opinion, inflation risk is as much of a concern to most people as longevity risk.

In the past, there were CPI-U (i.e. Consumer Price Index of Urban Consumer) increases that could be contractually attached to a SPIA or DIA policy. Unfortunately, those CPI-U offerings have pretty much disappeared from the competitive annuity landscape. In my opinion, COLAs work better because they are straightforward and easy to understand. CPI-U increase attachments had limitations on the upside, and were always being “adjusted” by the issuing carrier.

The bottom line is that a COLA attached to an annuity contractually increases your monthly income by resetting on an annual basis (typically on the contract anniversary date). This increase over time to your retirement income is a contractual weapon against annual inflation. It’s not perfect inflation protection, but no annuity product qualifies for that distinction.

In my opinion, inflation risk is as much of a concern to most people as longevity risk (i.e. outliving your money). By structuring your income annuity with a contractually increasing COLA, you can lessen that rate of inflation risk in retirement. In combination with your increasing Social Security payments, you can legitimately combat the potential decrease in your purchasing power...contractually.

Indexed Unicorns Chasing Contractual Butterflies

The current go-go annuity sales pitch is to buy a deferred annuity like a Fixed Index Annuity (FIA) and attach a special Income Rider to the policy at the time of application. Income Riders are attached benefits to a policy that can be used for future lifetime income. It’s a separate calculation from the Accumulation Value (i.e. walk away amount). I call Income Rider values a phantom account or monopoly money, but that’s not how it’s sold by too many agents.

Some Income Riders attached to FIAs have a base income starting amount that can “increase” by the return of an index call option. Sounds fantastic in theory, and looks even better at a bad chicken dinner seminar or non-guaranteed proposal return scenarios. But always remember, once again, that annuity companies have the big buildings for a reason. There are no philanthropists issuing annuity contracts. Nothing is given away.

Once you add any “potential” increase to an Income Rider payment, the annuity company significantly lowers that initial payout amount when compared to the same Income Rider without that “potential” increase. That doesn’t make it a bad product, but it does bring into view the contractual realities of the sales pitch.

Whether it’s a SPIA or DIA with a COLA increase or a FIA with an “increasing” Income Rider, you have to compare those contractual numbers to the same annuity without that increase. Figure out what the break even amount would be. In other words, how many years would it take for the “increasing” payments to reach the level of the contractual income amounts of the non-increasing annuity policies. Don’t just fall for the sales pitch. Run the numbers.

When shopping for COLAs or Income Rider increases, you need to find an objective inflation-adjusted annuity calculator in order to get the highest contractual guarantees available for your specific situation. Annuities are commodities, so all carriers need to be shopped. In addition, be aware that all annuity quotes are like a gallon of milk. They expire every 7 to 10 days unless locked in during the application process.

The good news is that you already own the best inflation annuity ever. Social Security. The question is, do you need another increasing payment using a commercial annuity contract like a Single Premium Immediate Annuity (SPIA), Deferred Income Annuity (DIA), or Income Rider. It’s simple math, so take your time and make your decision on your terms and on your time frame.