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Don’t Buy an Annuity Without Weighing the Impact of Inflation

Prospective annuity buyers are notorious for the mistakes they make during the shopping process. They often don’t take enough time to consider which type of annuity best fits their particular needs and how it meshes with the rest of their portfolio. They don’t visit enough brokers or review enough products. They give insufficient thought to the downside of locking up their money in long surrender charge periods.

There is an additional oversight – if not outright mistake – commonly made by prospective annuity buyers and in this case seldom spotlighted: Insufficient focus on how much monthly income they need or want. Instead, they focus mostly on how much aggregate income they might receive if they live long enough, or, at best, how much they might get annually.

Why is this a problem? It boils down to one word – inflation. Payments from lifetime income annuities are rarely adjusted for rising prices. This is a problem, notwithstanding atypically ultra-low inflation in recent years. Annuity payments in future years will have less buying power – probably a lot less – and that is taken into little, if any, consideration.

“Many annuity shoppers, unfortunately, are like deer frozen in the headlights,” says Derek Stamos, a financial advisor at Somerset Wealth Strategies. “They’re looking at the total amount of income they may receive. What they are not looking at is the erosive effect of inflation over time. That is a significant mistake.”

Yes, you can buy a cost-of-living provision in many lifetime income annuities, but it seldom makes financial sense. AFYI will discuss this in a bit.

What, then, to do? Focus on how much you currently want or need a month, and then purchase an annuity accordingly. Most of the time, this will free up a chunk of money you would otherwise put into an annuity now, some of which can always be invested later at better terms. That’s because you will be older (pricing, in part, is based on age) and interest rates almost certainly will be higher.

You get the most bang for your buck in monthly payments if you buy a single premium immediate annuity, which includes principal payments. Say, for example, you’re a 60-year-old single man with $500,000 to invest and want to receive $500 a month for the rest of your life. That will typically cost you about $106,000, including return of unpaid principal to a beneficiary in the event of death.

This strategy, of course, frees up $394,000 for investments at a later time.

Say, for the sake of discussion, this man wants to buy an additional lifetime income guarantee for $500 a month 10 years down the road. That would cost him less — $89,500 – because he is older. And this assumes there is no increase by then in inflation and interest rates, which is extremely unlikely.

Meanwhile, of course, he is investing his remaining $394,000 outside of annuities. Say that relatively short-term interest rates move up to 3 percent – super-high today but not by historical standards. That $394,000 could be worth more than $529,000 in 10 years, depending on the timetable of rising rates. If interest rates kicked up to 4 percent, it would be worth more than $583,000.

Our man could – but definitely should not – buy a single-premium immediate annuity with a COLA (cost-of-living adjustment). If he paid extra for a 1 percent COLA, which is extremely low, that $500 a month would be reduced to $447 a month. If he bought a more typical 2 percent COLA, his monthly income would plummet to $397 a month. If inflation continuously rose, it would take him 13 years to get back to $500 a month.

Most people would agree that it makes little sense to take less money today, when they are younger and hopefully relatively healthy, so they are at least partially protected from inflation in the future. By that point, they may be living a highly restrictive life in a nursing home.

COLAs in a lifetime annuity make almost no sense. And given the vagaries of the economy and the ups and downs of inflation, neither is it advisable to buy a lifetime income annuity without seriously weighing the corrosive impact of inflation over time.

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