Lack of inflation adjustment a problem for annuity holders

by Leo Almazora25 Sep 2019

Considering how long people can survive after retirement, it only makes sense to think about how inflation could affect their expenses through the decades. By extension, any financial plan that relies on guaranteed lifetime income through annuities should account for rising costs of living.

But as David Blanchett, head of retirement research for Morningstar Investment Management, recently wrote in a column for the Wall Street Journal, an overwhelming majority of annuities do not include a cost-of-living adjustment (COLA) to help account for inflation.

“[M]ost have payouts that are constant over time (commonly referred to as nominal)--even though nominal payouts can result in a significant decline in purchasing power for a retiree,” he wrote.

Annuities that do take inflation risk into account generally do it in two ways. Some explicitly consider inflation by having payments that are tied directly to inflation, ensuring that a retiree will always have some constant amount available to spend, in today’s dollars, throughout their retirement.

“Annuities linked to inflation are still relatively rare, though, with only about 0.2% of annuities quoted in 2018 including the option,” Blanchett said.

The other approach is to implicitly consider inflation through a “fixed” COLA. Annuities that favour this approach increase their benefit by some fixed percentage every year, he said, with 2% being the most common fixed COLA among annuities quoted today. Because fixed COLAs aren’t directly coupled to inflation, the growth in benefits associated with these annuities could differ materially from increase in expenses that one sees in retirement.

“Only about 4% of annuities quoted in 2018 included any kind of fixed COLA,” Blanchett said. “Taken together, less than 5% of immediate and deferred annuities quoted in 2018 included any type of cost of living adjustment.”

Noting that the percentage of annuities with COLA considered is “way too low,” he argued that higher initial payout rates could be a reason for the lack of uptake. Based on annuity quotes he prepared for a 65-year-old female on August 27, he said that the initial payout rate for a nominal immediate annuity topped out at 6.03%. In contrast, an immediate annuity with a 2% COLA had a maximum payout rate of 4.7%, and an immediate annuity with benefits linked to inflation had a 3.82% maximum payout rate.

“While the initial payout rate for annuities with COLA is clearly lower than the basic nominal annuity (with constant payments) that doesn’t mean COLA is a bad deal for retirees,” he noted. Retirees must be made aware of how factors such as life expectancy, realized inflation levels, and risk tolerance will influence the true value, and how well payout amounts satisfy what they are trying to accomplish.

“Modeling and discussing the implications of inflation is a critical component of a financial plan, since inflation can have a material impact on a retiree’s standard of living,” he said. “The fact that relatively few annuity quotes today provide any type of COLA is a point of concern.”