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Which Annuities Offer The Best Inflation Protection?

FYI: Recent articles in Advisor Perspectives by David Blanchett and by Zvi Bodie and Dirk Cotton have dealt with single-premium immediate annuities (SPIAs) used to generate lifetime income in retirement. The focus of those articles was the pricing and the risks of going without inflation protection. In addition to SPIAs, insurers also offer variable annuities (VAs) and fixed-indexed annuities (FIAs) with optional riders known as guaranteed lifetime withdrawal benefits (GLWBs). I’ll expand on the recent articles by comparing the income-generating properties of SPIAs versus VAs and FIAs, and place particular emphasis on how inflation risk impacts inflation-adjusted income.
Regards,
Ted
https://www.advisorperspectives.com/articles/2019/06/17/which-annuities-offer-the-best-inflation-protection

Comments

  • Here's an older (2012) article by Wade Pfau summarizing a research paper he did on the subject:
    Efficient Frontiers: Inflation Assumptions, Fixed SPIAs, & Inflation-Adjusted SPIAs

    While it dates from a few years ago, I figure that interest rates haven't changed much since then, especially since they've backslided in the past half year.

    Like Tomlinson (the original linked article), Pfau observes that "Today ... fixed SPIAs performed so much better than inflation-adjusted SPIAs." He's looking at completely fixed SPIAs as opposed to Tomlinson's SPIAs with fixed annual increases." Either way, the nominal amounts are set in stone, independent of inflation (despite Tomlinson calling them COLA SPIAs).

    What I like about Pfau's article is that he shows how these results can be incorporated into a full investment plan:
    In the case study used the article, a 65-year old heterosexual couple requiring a 4% withdrawal rate to meet their lifestyle goals (and whose minimum spending needs were set equal to the lifestyle goal) was best served by combinations of stocks and fixed single-premium immediate annuities (SPIAs). At current product pricing levels, there is little need for bonds, inflation-adjusted SPIAs, or immediate variable annuities with guaranteed living benefit riders (VA/GLWBs).
    This relates back to another thread that explained why having an annuity allowed one to be more aggressive with the rest of one's portfolio. According to Pfau (assuming one has enough of an annuity income stream), one can not be merely more aggressive, but invest entirely in stocks.
    https://mutualfundobserver.com/discuss/discussion/50475/here-s-why-advisors-may-urge-retirees-to-load-up-on-equities

    While Tomlinson and Pfau both use Monte Carlo simulations, comparing and contrasting their articles helps to highlight the limitations and deficiencies of the simplistic models implemented on web sites.

    They each acknowledge how sketchy their input is:

    Tomlinson: "The current Treasury/TIPS spread is just under 2% and we also know that the Fed is targeting 2% inflation. However, my purely subjective view ..."

    Pfau: "Your views about future inflation are quite important to this decision."

    Tomlinson uses his subjective sense to construct a skewed distribution of inflation rates (something many tools can't handle), while Pfau falls back on a normal bell curve. These people are making subjective, albeit well educated, guesses on distributions, and admitting that whatever they guess has a major impact on their conclusions.

    That's not an argument against trying. It's an argument for putting a lot more effort into the guessing than letting a website pick a default and pressing a button. It's an argument for using a model that has the flexibility to deal with sophisticated guesses. Otherwise, all you've got is GIGO.

    Pfau summarizes the potential impact of higher inflation nicely:
    Note that higher inflation would also hurt the performance of the VA/GLWB strategy since its guarantees cannot be expected to keep pace with inflation, and it would also hurt bond mutual funds since the interest rate increases accompanying higher inflation would result in capital losses.

    Higher inflation will not completely overturn the idea that the efficient frontier consists of stocks and SPIAs, but it could influence the result about whether the appropriate SPIA choice is a fixed SPIA or a real SPIA
  • Hi @msf
    We've been down this discussion road before; but I would still opt for Fidelity's annuity offering.
    With the offerings available, one should not have a problem with beating inflation; and with fairly low risk, IMHO.
    Even with a somewhat aggressive investment choice of Fidelity's VIP Balanced fund, one has very low costs: .57% expense ratio (same as retail offering) and .25% of account balance for the fee. And no surrender charges found in more common annuity types, usually after the first 7 years of the contract; and the normal spousal/non-spousal beneficiary choices.
    For those not familiar with this product, check the link and read through everything....investment choices, etc.

    Fidelity's Personal Retirement Annuity

    Have a good remainder,
    Catch
  • The article discusses guaranteed income streams upon annuitization, or in the case of deferred annuities with GLWB riders, drawing down according to a guaranteed lifetime withdrawal rate.

    Those guarantees are the whole point. If a portion of your income is certain (e.g. Social Security), then you can plan the remainder of your portfolio around that. Absent the guarantee, an annuity is nothing but a tax shelter - a higher priced, non-deductible T-IRA.

    People lament the demise of the pension (guaranteed income stream for life), yet consistently decline to make the rational choice to annuitize. Without appreciating the value of any guarantee (apparently unless it comes from the government or an employer), it is difficult to evaluate the relative merits of different types of guarantees.

    The Fidelity annuity does provide an income guarantee, but like many annuities, that guarantee locks in a fixed monthly payment amount. No more VIP Balanced Fund. The options offered by the Fidelity annuity are extremely limited: only single life with 10 years certain and joint life with 10 years certain. No annual increases, no adjustments for inflation. ( See p. 17 (pdf p. 23) of its prospectus.)

    So its guarantee doesn't provide inflation protection (the subject of Tomlinson's article). If you want to gamble that inflation will stay moderately low, then, as Pfau observed, fixed annuities without adjustments such as Fidelity's can pay off better. And the guarantee does provide longevity protection so long as the payments doesn't get eroded too much by inflation.

    These days, if you want some potential upside from the market while still having a guaranteed floor on your income stream and a guarantee for life, you look into living benefit guarantees, such as the GLWB rider discussed in the article. Fidelity's annuity doesn't provide this option, but Vanguard's does, as do Schwab's two VAs. You can do a 1035 exchange into them when you're ready to start drawing cash out.
  • @msf
    You noted: "The Fidelity annuity does provide an income guarantee, but like many annuities, that guarantee locks in a fixed monthly payment amount. No more VIP Balanced Fund. The options offered by the Fidelity annuity are extremely limited: only single life with 10 years certain and joint life with 10 years certain. No annual increases, no adjustments for inflation. ( See p. 17 (pdf p. 23) of its prospectus.)"

    The prospectus you linked for April, 2019 includes VIP Balanced, as well as the other choices.

    Perhaps, I should have provided a more direct path for the type of annuity I would use (below).
    I'm not writing about what one may name as "traditional" types of annuities as you noted above.

    The Fido page I intended for use for annuity money is HERE:

    I'm sure I've only confused those reading here. As it should be, one must read and understand the documents.
    Away I must be...
    Catch
  • From the prospectus' cited page:
    To provide annuity income, on the Annuity Date, all Accumulation Units in the Investment Option will be redeemed and the money will be transferred to our general account. All money used to support annuity income payments will be held in our general account thereafter.
    You get an income guarantee only if you elect to take annuity income (or you're forced to, by age). When you get that guarantee, no more VIP Balanced Fund. It is redeemed, traded in for the guaranteed income stream.

    This may help:
    Think Advisor, Understanding Deferred Variable Annuities’ Two Phases
    https://www.thinkadvisor.com/2017/08/14/understanding-deferred-variable-annuities-two-phas/?slreturn=20190518131749

    The only guarantee that the Fidelity annuity provides is in the second phase, the distribution (annuitization) phase as described above. There are ways some annuities provide inflation protection while guaranteeing lifetime income. But the Fidelity annuity simply doesn't do this.

    In its accumulation phase you get a form of inflation protection by being able to invest in the market. In its distribution phase, you get a cash flow guaranteed for life, but one with no protection against inflation. To get that guarantee for life, you have to give up your VIP Balanced.
  • Thank you, @msf
    Available fund investment returns for "x" years historically would keep one ahead of the 2.9% annualized inflation rate, prior to the cash position noted.
    Perhaps it is time I leave the stage.
    Catch
  • edited June 2019
    Why do you think inflation is or will remain at 2.9%?

    A jar of fruit (one of my favorites) that had been selling for $1.00 at WalMart jumped 17 cents overnight last week. That doesn’t sound like much. But it’s a 17% overnight increase. I’m amazed how most people seem to underestimate the real increases in cost of living.

    Don’t believe the govt. figures. They have a vested interest in making inflation appear as low as possible (SS adjustments being one example).
  • Anyone who believes that overall inflation is running anywhere close to 3% is living in a dream world. Hell, a round-trip senior MUNI fare just went from $2.70 to $3.00 (over 10% increase) and that's just one random number. Everything in the SF Bay Area is going up steeply and regularly, and has been for a few years now.
  • --- Inflation rate
    A common measure of inflation in the U.S. is the Consumer Price Index (CPI). From 1925 through 2018 the CPI has a long-term average of 2.9% annually. Over the last 40 years highest CPI recorded was 13.5% in 1980. For 2018, the last full year available, the CPI was 2.2% annually as reported by the Minneapolis Federal Reserve.

    --- Rate of return
    This is the annually compounded rate of return you expect from your investments before taxes. The actual rate of return is largely dependent on the types of investments you select. The Standard & Poor's 500® (S&P 500®) for the 10 years ending December 31st 2018, had an annual compounded rate of return of 12.1%, including reinvestment of dividends. From January 1, 1970 to December 31st 2018, the average annual compounded rate of return for the S&P 500®, including reinvestment of dividends, was approximately 10.2% (source: www.standardandpoors.com). Since 1970, the highest 12-month return was 61% (June 1982 through June 1983). The lowest 12-month return was -43% (March 2008 to March 2009).

    Hi @hank
    I don't underestimate or have a blind eye to inflation. B.O.L. CPI is a bit twisted with what is used for calculations.
    I don't allow the data in the above 2 displays to cause me to think that things won't change.
    Hell, I/we still keep a paper ledger for all expenses by category; a habit I've had since 1970.
    As I've stated here numerous times........this time is different. And so it remains, seeking a financial path since the market melt.
    Too tired to think or write more tonight.
    Good night.
    Catch
  • @Catch22- As far as I'm concerned CPI might as well stand for Complete Political Inaccuracy. Whatever they claim to have been measuring has little or nothing to do with on-the-ground reality of the actual cost of living.
  • Truth, Old Joe.
  • edited June 2019
    Excerpt: “Originally, the CPI was determined by comparing the price of a fixed basket of goods and services spanning two different periods. In this case, the CPI was a cost of goods index (COGI). However, over time, the U.S. Congress embraced the view that the CPI should reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has evolved into a cost of living index (COLI). ... Over the years, the methodology used to calculate the CPI has undergone numerous revisions. According to the BLS, the changes removed biases that caused the CPI to overstate the inflation rate. The new methodology takes into account changes in the quality of goods and substitution. Substitution, the change in purchases by consumers in response to price changes, changes the relative weighting of the goods in the basket. The overall result tends to be a lower CPI. However, critics view the methodological changes and the switch from a COGI to a COLI as a purposeful manipulation that allows the U.S. government to report a lower CPI.”. https://www.investopedia.com/articles/07/consumerpriceindex.asp

    A few take aways:

    - The methodology for computing CPI has undergone several changes over the years So, it’s not the same yardstick today as it was 30, 40 or 50 years ago. Looking at long term historical CPI numbers as some type of norm is tantamount to comparing apples to oranges (or at least mixing them together)..

    - These changes were to an extent politically inspired.

    - CPI purports to take into account the increased value of the products consumers purchase. So, if you choose to drive a stick shift car with an AM radio and roll-down windows and without power steering, seat-belts or side view mirrors, than the price of new cars has increased by only 2-3% annually. (Good luck finding one.) You could also hue to that government figure by switching to B&W TV and sticking an antenna on your roof instead of enjoying cable. And if you could still find one in a box somewhere, buying a “new” Vic-20 home computer or maybe an Apple II E would allow you to fully appreciate that 2.9% inflation rate. Finally, (at great risk of being redundant), if you can find a physician willing to provide only the level of health care (including prescription medications) you would have received 50 years ago, than your health care costs may have increased by that 2-3% number.

    - It would be nearly impossible to measure the change in the value of some products. Take air travel for instance. How in jiggers do you calculate the real cost difference when the airlines keep tacking on fees for things like checking a bag, using the overhead storage compartment or selecting a window seat? But if you could, you’d still have to figure out how to account for the diminished value stemming from the discontinuance of meals on flights (once standard), non-refundable tickets and smaller more uncomfortable seats.

    - CPI doesn’t consider the increasing need for medical care as the population ages. So CPI for those of us 70+ may be a bit different (I suspect somewhat higher) than for a much younger individual.

    I don’t know whether those numbers Catch quoted included the effect of compounding. But suspect not. When running a 3% inflation rate through a compounding calculator I get a 15.93% cost increase over 5 years. Inflation looks a bit more onerous when viewed over longer periods.
  • msf
    edited June 2019
    Averages are just that, averages. Some prices go up more than average, some less.

    I believe the two fastest growing costs are health care and education. While health care tends to hit older people disproportionately hard, education costs tend to bypass seniors. In San Francisco, while the cash fare for a MUNI ride is about to go up from $1.35 to $1.50 for seniors, the Clipper card fare will remain the same $1.25 that it was in 2017.
    https://www.sfmta.com/sites/default/files/reports-and-documents/2018/08/fiscal_year_2019_and_2020_fare_table_2018_0802.pdf

    Not to mention that the value of that fare was recently (Sept. 2018) increased. A single fare now gets you a transfer good for two hours instead of 90 minutes. This allows "customers the ability to complete round-trips for shorter errands, such as medical appointments, shopping or dining". As someone who still games these systems (and keeps a Clipper card on hand for trips to the Bay Area), I appreciate that.
    https://www.sfmta.com/blog/fare-time-limits-increase-two-hours-and-new-cheaper-all-day-passes-way

    Consumers tend to notice the prices that jump while downplaying the prices that remain relatively stable. Similar to investors feeling worse about their investments going down by 10% than they feel good about their investments going up by 10%.
  • An immediate annuity can have a place in your retirement portfolio, particularly if you feel you need to have at least one stream of income you can count on. But because interest rates are so low, you should wait until rates rise again before purchasing an annuity.
  • @msf- Thanks much for that MUNI fare schedule. I was considering a Clipper Card, and that pretty well clinches it.
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