Annuities are investment products, which are contracts with insurance companies. Usually, investors purchase various types of annuities as a means of providing a steady income stream in their retirement years. Yet, are annuities a smart option from inflation protection? In this article, 4 experts weigh in on whether or not annuities are a good investment for inflation protection.
Many Respected Analysts Believe It’s A Tall Order For Annuities To Outpace Inflation With The Premium Cost In The Mix
“Annuities are a favored investment vehicle for many retirees or near-retirees. To cut a long story short, if inflation hits a consistent 3% per annum or even 2%, the average retirees purchasing power will erode by $117,000 and $74,000 over 20 years, respectively (LIMRA 2016 study).
The question is, can an inflation-connected annuity protect your buying power, or are there better alternatives? Indeed, some annuities that feature inflation-indexed payments based on an annual cost-of-living-adjustment factor. The latter is factored in on at the time of purchase (on a prediction) and adjusted accordingly at time intervals as inflation increases. The overview is quite complicated on the premise that most understand there’s no free lunch. Add to this that annuities, at the best of times, are complicated without inflationary considerations. Ken Nuss, CEO and founder of AnnuityAdvantage in Medford, Oregon, says, ‘In some years, the [income] increases will outpace inflation and in other years, it will fall short,’ Nuss says.
Choosing a COLA factor which is near the average historical inflation rate will work on the average to offset increasing costs in retirement. Here’s the problem: Buying inflation protection costs an upfront premium, depending on the COLA factor you select. For example, a 65-year-old man pursues a $100,000 level annuity, and is quoted an expected monthly benefit of $512. Now, if that same annuity connects to the same $512 benefit but with, say, a 3% COLA built-in increase each subsequent year, the $100,000 purchase price shoots up to $137,089. What are you ready to pay for inflation protection? What COLA factor makes sense versus the added cost? The bottom line is that the answer is not straightforward, and there are conceivably higher returns in other areas of the investment arena. We live in a low inflation environment, which is the case no doubt, and unlikely to change anytime soon.
Many respected analysts believe it’s a tall order for annuities to outpace inflation with the premium cost in the mix. There are more complications to think about that center on your health and your life expectancy. In simple terms, a significant upfront COLA premium is likely the wrong call if you die soon after taking out an annuity. It’s an iffy call in any event with all the other uncertainties highlighted above. Also, weigh up the liquidity factor when thinking about buying an inflation-protected annuity with a COLA premium. Once done, the investment is somewhat inflexible for the rest of your life, typically limiting the amount of liquidity available. It’s vital to appreciate the drivers of inflation protection in an annuity contract.”
Gordon Polovin, Finance Expert, Serves on the advisory board for Wealthy Living Today
It Depends On The Type Of Annuity
“The answer is that it depends on the type of annuity. For example, the single premium immediate annuity (SPIA) or deferred income annuity are very attractive vehicles from the standpoint of guaranteeing a certain level of income but the income will not increase if inflation rises since it is fixed at the time the income commences. Since rising inflation usually translates into rising interest rates and the income of SPIAs is directly impacted by the current interest rate environment, clearly inflationary pressures would be to the detriment to an investor receiving income from a SPIA.
On the other hand, if you believe that various asset classes will appreciate as a result of rising inflation, then investments in either variable annuities or equity indexed annuities may be attractive. In the case of variable annuities, there may be a sub-account available that invests in TIPS (Treasury Inflation-Protected Bonds) where the principal will rise in concert with the CPI. Also, there would likely be available a sub-account that invests in REITs (real estate investment trusts) that should appreciate with a rise in inflation. And finally, stocks may also appreciate due to inflationary pressures. Since equity indexed annuities are tied into the stock market, they could benefit as well.”
Cliff Caplan, CFP(r), AIF(r), Neponset Valley Financial Partners
There Are Many Types Of Annuities, So It Depends On A Couple Factors
“There are many types of annuities, so it would really depend on what type of annuity you have, whether or not it is an investment and if it provides inflation protection. There is a Fixed Annuity that provides a fixed rate of return. You can equate a Fixed Annuity to an enhanced Certificate of Deposit (CD) because the annuity will typically pay a higher rate of return and it is a tax-deferred vehicle. A Fixed annuity may not be your best choice if you are looking for inflation protection.
You can also put money into an Equity Index Annuity (EIA), which will have several options including a fixed rate option. The EIA allows you to put some money into other choices where your return would be based on the change in an index like the S&P 500. You have upside interest potential with a maximum rate, but no downside risk because your principal is protected. So, in an Equity Index Annuity, you have better inflation protection.
Finally, there are Variable Annuities, which would provide you with the most inflation protection over time because you can invest money into mutual funds like investments within the Variable Annuity. In addition, the variable annuity is tax-deferred, so you get to keep what you earn each year until you take
money out of the annuity.”
Denise Nostrom, Owner/Financial Advisor, Diversified Financial Solutions
People Need To See The Value In Weighing The Long Term Benefits Compared To The Lump Sum They Pay Upfront
“Annuities pay out a steady amount of cash over time. They are often used to fund people’s retirement years. These annuities are contracts between an individual and a financial institution. There are a few ways people can start their annuities, individuals can either pay a lump sum upfront or make scheduled payments to a financial institution, most often an insurance company. An agreed-upon date will determine when this financial institution will then start making scheduled payments, distributions, back to the individual.
The money that is originally paid upfront is then invested and then grows, till the agreed-upon date when an individual starts benefiting from the distributions. The individuals who hold annuities are responsible for paying taxes on the distribution they receive.
Many individuals often add annuities to their retirement package. As for inflation protection and before signing a contract, people need to see the value in weighing the long term benefits compared to the lump sum they pay upfront for annuities. Many have purchased inflation-protected annuity overtime. However, before people sign a contract they should validate that they are a reputable company before signing a contract with them. Individuals also need to know which component drives their inflation protection within their unique type of annuity. It is very popular for individuals to add annuities as an addition to their retirement plan. But many individuals make the mistake of adding annuities to their retirement plan when in reality it doesn’t fit with their long-term retirement plan.”
Annuities are often a popular choice for investors who desire a way to generate steady income in retirement. However, there are several components that factor into whether or not an annuity is a good investment for inflation protection. If you are interested in investing in annuities, always do your due diligence and consult a financial expert before investing.