There are several signs of the economy’s continued recovery, including moderate wage growth, low unemployment and the raising of the federal funds rate by the Federal Reserve. While this is all good news, an increase in prices from a strengthening economy can also produce higher inflation. According to a recent Yahoo!Finance article, inflation has been climbing steadily since hitting 0.8% in July 2016. In February, the rate reached 2.7% and then settled at 2.4% in March, where it is expected to hover in coming months.
The rising inflation can cause issues for investors if returns aren’t able to keep up with increasing prices.
“It’s necessary to understand how powerful the effect of inflation can be on a retirement plan,” said Cathy DeWitt Dunn, president and CEO of DeWitt & Dunn in Dallas.
In 2016, a LIMRA study discovered that when inflation reaches 3%, the purchasing power of retirees may erode by more than $117,000 over a 20-year period. Additionally, at 2% the impact creates a shortfall of approximately $74,000. In order to protect yourself from the effects of inflation, an inflation-protected annuity may be right for you.
“Inflation-protected annuities are designed to help mitigate both inflation and longevity risks to retiree’s income,” said Justin Fort, a certified financial planner and president of Fort Wealth Management in Austin, Texas.
Sold by insurance companies, this type of annuity offers guaranteed fixed-income payments that are typically indexed to inflation based on an annual cost-of-living-adjustment factor. This factor is set at the time of purchase and allows for periodic increases in the annuity benefit as inflation rises.
“In some years, the [income] increases will outpace inflation and in other years, it will fall short,” said Ken Nuss, CEO and founder of AnnuityAdvantage. “Choosing a COLA factor which is near the average historical inflation rate will work on the average to offset increasing costs in retirement.
The drawback of this benefit is that the protection comes at a premium, which falls back on the policy owner.
“The features and benefits inside these annuities do come at a cost and the consumer should educate themselves,” said Dawn-Marie Joseph, founder of Estate Planning & Preservation. “Consumers aren’t naive in thinking that there’s such a thing as a free lunch. Every month, they look at their brokerage statements or bank statements and see how much they pay in fees for having someone take care of their money and the same holds true for annuities.”
While these annuities offer a measure of protection against inflation, it is crucial to weigh this value against upfront expense. As with all annuity products, they aren’t for everyone. And if the Fed decides to move on additional rate hikes, as many industry experts predict, it may be difficult for inflation-adjusted annuities to keep up.
“Alternatives may include purchasing an inflation-protected annuity ladder over time, waiting until interest rates rise to purchase [an inflation-protected annuity] or using fixed payment annuities along with other assets like dividend-paying stocks, Treasury inflation protected securities or real estate to offset inflation,” Fort said.
Other factors to consider before buying an annuity include the company’s financial strength and ratings, your overall health and life expectancy, where you are on the path towards retirement, liquidity factors, and how the company offers inflation protection.
“Some companies offer inflation adjustments based on the consumer price index for all urban consumers, while others offer income that increases based on other metrics,” DeWitt Dunn said. “Neither is inherently better or worse, but it’s important to understand what drives the inflation protection within a contract.”
Written by Rachel Summit