Inflation-Protected Annuities: Part Of A Solid Financial Plan

By Investopedia AAA

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 used to be less well-known in the United States, but that is changing. 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 more popular in the U.S

How Inflation-Protected Annuities Work
An IPA is similar to a regular immediate annuity, but its payments are indexed to the rate of inflation. However, oftentimes there is a cap, and investors don't receive payments beyond this percentage. (To learn more about the different types of annuities, see An Overview of Annuities.)

Why IPAs 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. (For more insight, see The Demise Of The Defined-Benefit Plan.)

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

In other words, they tend to look at today's retirees as being representative of their own expected longevity. However, advances in healthcare have dramatically improved and will continue to improve life expectancies.

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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. (Learn about how to reduce the impact of inflation on your portfolio in Curbing The Effects Of Inflation.)

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Why They Are Not More 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 caused challenges for the IPA's.

Lower demand translates to weaker relative pricing when compared to regular immediate annuities. In addition, 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, forcing vendors to demand higher margins. These higher margins are then passed on to consumers in the form of higher prices.

In addition, IPAs provide lower initial payouts to investors compared to other types of annuities. This is because 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 - perhaps as much as 20-30% less than 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%. (Learn more about immediate annuiteis in Immediate Annuities: Guaranteed Income At A Price?)

Another problem is the lack of inflation-protected securities (IPS) out there. Insurance companies need these securities 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.

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 before it knows whether or not it has made a profit on an annuity.

What Will It Take for Inflation-Protected Annuities Them To Become More 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.

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.

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