Inflation-Adjusted Annuities.

This article was posted on April 1, 2002.

In the past year or so insurance companies have expanded their offerings to include true inflation-indexed life annuities tied to the Consumer Price Index (CPI). This is in contrast to life annuities with fixed cost of living adjustments (COLAs) which have been offered for years by vendors like GE Capital Assurance .

One vendor of inflation-adjusted life annuities (Lincoln National Life Insurance Company) even offers online quotes. These are the values used in the analysis below.

Comparing the initial payout from an inflation-adjusted annuity to inflation-adjusted withdrawals from a simple portfolio consisting of an S&P500 index fund and TIPS or cash yielded some interesting results. The annuity greatly increased withdrawals for older retirees, but did very little for younger folks.

For a 45-year-old, an inflation-adjusted annuity increased the "safe" withdrawal only 0.31% (4.39% vs. 4.08%) over a stock/cash portfolio invested at the efficient frontier (i.e. 77% S$P500/23% cash). For this slight increase in current income, the annuity purchaser forgos the very real chance of increasing withdrawals well beyond inflation in subsequent years with a stock/cash portfolio. (See the Pay Out Period Reset Method.)The chart below shows the expected terminal values of the portfolio after 10, 20, and 30 years. At the end of 38 years, the median terminal value was $5,195 for an initial $1,000 portfolio. The portfolio exceed $589 in 90% of the 38-year pay out periods examined.

The 50% S&P500/50% TIPS results are included for discussion purposes only. It's likely that substituting TIPS for cash would improved the safe withrawal rate, but there's no way to gaurantee that since the longest maturity TIPS available matures in April 2032. Because the current real yield on TIPS is historically very high, it's likely the coupon rate will be less when they mature in 30 years or less and you need to reinvest the principal.

For a 65-year-old, an annuity is more attractive. The safe withdrawal rate jumps almost a full percentage point (from 5.70% to 6.61%). Taking a 6.61% withdrawal from a stock/TIPS portfolio has only a 68% chance of surviving 20 years. A retiree taking a withdrawal that large would be broke in less than 20 years in one-third of the 20-year pay out periods examined.

Conclusion

For younger retirees, annuities tend to "lock-in" close to the worst case results that could be expected from holding an investment portfolio in retirement. Certainly retirees age 45 and younger will find little of benefit in an annuity.

For older retirees who need to maximize their inflation-adjusted annual pay outs and have no desire to leave money to their children or a charitable organization after their death, an annuity may be attractive.