Inflation-Protected Annuities: Part Of A Solid Financial Plan

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Two of the biggest gaps in your financial plan may be the lack of protection from inflation and the risk of outliving your assets. A little-known security called inflation-protected annuities (IPAs) (also known as real annuities or inflation-indexed annuities) can easily solve these problems.

While IPAs are common in other countries, most notably in the U.K., they are less well-known in the United States. In his article "Life Annuities and Uncertain Lifetimes", Jeffery Brown (NBER Reporter, Spring 2004) states that few financial assets outside of Social Security and defined-benefit plans are turned into annuities. This is surprising, given the innovativeness of the U.S. financial sector and the fact that baby boomers are nearing retirement (remember, these baby boomers lived through the inflationary roller coaster of the 1970s and early '80s).

In this article, we'll explain what these annuities are and show you why they make sense. We'll also discuss why IPAs are not yet popular in the U.S. and what it will take to make them so.

How They Work
An IPA is similar to a regular immediate annuity, but its payments are indexed to the rate of inflation. The Vanguard Lifetime Income Program is one of the few IPAs offered in the

U.S.

Although its annuity payments are linked to inflation, there is a cap: these payments can rise due to inflation a maximum of 10% per year. (To learn more about the different types of annuities, see An Overview of Annuities.)

Why They Make Sense
Unfortunately, Social Security does not meet most Americans' retirement needs. Its low payments and uncertain future make it nothing more than a supplementary vehicle for retirement. Ironically, however, Social Security is the most recognizable IPA available.

As the shift from defined-benefit plans to defined-contribution plans continues, the responsibility for funding one's retirement is moving from the employer to the employee. Unfortunately, with this shift come all kinds of financial risks to the employee - most notably inflation and longevity risk.

In their World Bank article "Annuity Markets in Comparative Perspective: Do Consumers Get Their Money's Worth?" (Nov 2000), the authors Estelle James and Dimitri Vittas claim that individuals tend to underestimate their life expectancy.

They tend to look at today's retirees as being representative of their own expected longevity. However, advances in health care have dramatically improved and will continue to improve life expectancies.

Inflation is also a silent killer threatening your retirement portfolio. All too often, investors focus on nominal returns rather than real returns. In fact, real returns are all that matters to your investment portfolio.

Why They Are Not Yet Popular
Considering how simple IPAs are and how well they suit the needs of investors nearing retirement, you would think these investment vehicles would be as popular among retirees as condos in Florida. But, as we mentioned earlier, this is not the case. Poor relative pricing and lower initial payments have been the IPA's downfall.

Lower demand translates to weaker relative pricing when compared to regular immediate annuities. According to Brown, couples naturally offset some of their longevity risk by pooling their assets together and avoid liquidity constraints by avoiding annuities. Liquidity constraints become an issue when expenses such as large medical bills suddenly appear - an event that is on every retiree's mind. It all adds up to lower sales levels for IPAs, and higher margins are demanded by vendors to make up for the lower demand. These higher margins are then passed on to consumers in the form of higher prices.

IPAs will mean lower initial payments, too. As the money invested will increase in value with inflation and compound at least annually with inflation, initial payments will be significantly lower than the latest payments. With the Vanguard annuity, payments can be initially 20-30% lower than those of a regular immediate annuity. This is a difference that many people have difficulty accepting. An alternative to investing in IPAs is to buy an annuity that gradually increases in payment between 1-5%.

Another problem is the lack of inflation-protected securities (IPS) out there. Insurance companies need these IPS because they invest in them to offset the risk inherent in the IPAs they issue. (For further reading, see Inflation-Protected Securities - The Missing Link.)

IPS have existed in the

U.S.

only since 1997, and they were not originally popular with the investment community. Insurance companies also need a variety of issues with different maturities to properly hedge their inflation exposure, yet the overwhelming majority of IPS are issued by the federal government. This minimizes credit risk for the insurance companies, but it also eliminates any additional yield spread pickup that they would have received otherwise by investing in non-government bonds. As an alternative, insurance companies can use the CPI futures on the Chicago Mercantile Exchange for that insurance protection. (CPI futures are derivatives that increase or decrease in value in perfect correlation with the Consumer Price Index, which is a measure of inflation, thereby providing risk managers and insurance companies with a hedge against inflation.)

Inflation protection does come at a price, however. According to James and Vittas, the price one has to pay for that insurance protection through IPAs varies from country to country depending on the supply of IPS. The present value of annuity payments from IPAs tends to be less than the present value from regular immediate annuities. James and Vittas have determined that the price of this protection can be anywhere from $0.10 to $0.20 on the dollar in some countries.

Pricing could improve if governments offered IPS securities with a longer duration and kept inflation stable, which would mean less risk to the issuers of IPAs. While annuities can last up to 40 to 50 years, the IPS with the longest duration currently offered is only 30 years. An inability to match assets with liabilities will add risk to an insurance company's balance sheet. Furthermore, it can take an insurance company up to 20 years, according to James and Vittas, before it knows whether or not it has made a profit on an annuity.

What Will It Take for Them To Become Popular?
First of all, baby boomers have to start thinking more about their pending retirement. Certainly, a period of bad inflation would be beneficial for the IPA market. The

U.S.

government could also increase the depth and liquidity of the IPS market.

But there are also a few more innovative solutions to consider. One suggested by William Goetzman, in his article "More Social Security, Not Less" (Yale International Center for Finance, April 2005), is to create a government agency like Fannie Mae to develop the IPA market in the same way that the

U.S.

government developed the mortgage market. Fannie Mae and Freddie Mac helped baby boomers finance their mortgages - perhaps a new government agency could help them finance their retirement. Finally, Zvi Bodie, professor of finance and economics at Boston University School of Management, suggests in his paper "Applying Financial Engineering to Wealth Management" (July 2003) that a product that combines a lifetime annuity with a long-term care insurance policy could also appeal to retirees' desire for peace of mind.

Conclusion
IPAs are not yet priced competitively when compared to regular immediate annuities, but their ability to eliminate inflation and longevity risk certainly makes them seem attractive.

Although they aren't that popular today, it is only a matter of time before IPAs are ready for prime time. Insurance companies and financial planners would be well advised to start preparing for that day.

by Investopedia.com , (Contact Author | Biography)

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