What Does Inflation-Protected Annuity Mean?
An inflation-protected annuity (IPA) is an annuity that guarantees a real rate of return at or above inflation. The real rate of return is the nominal return, less the inflation rate, thus protecting annuitants and beneficiary investors from inflation.
How Inflation-Protected Annuities Work
An annuity contract is a written agreement between an insurance company and a customer outlining each party's obligations in an annuity agreement. Such a document will include the specific details of the contract, such as the structure of the annuity (variable or fixed), any penalties for early withdrawal, spousal and beneficiary provisions, such as a survivor clause and rate of spousal coverage, and more. More broadly, an annuity contract may simply refer to any annuity.
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 rise in the inflation rate.
Inflation is simply rising prices and is the enemy of retirees on a fixed income. Since most pensions are not indexed to rise with the general inflation rate and Social Security increases have tended to be less than general inflation, there's a real risk that older people will outlive their money. That's where IPAs come in.
Inflation-protection is not free, however. 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, so initial payments will be significantly lower than later payments - perhaps as much as 20% to 30% less than a regular immediate annuity.
These investments haven't been popular in recent years because inflation has been under 3% annually since the financial crisis of 2008-2009.
There are other ways to protect against inflation as well. These include Treasury Inflation Protected Securities (TIPS), which are government bonds that are indexed to inflation to protect investors from the negative effects of inflation. Dividend-paying stocks are another good hedge because the dividends tend to rise with general inflation. Hard assets such as commodities and gold also tend to gain more value when inflation is higher.