Inflation is the great killer of long-term retirement dreams. Inflation is also a great unknown. When it will hit, how hard, and for how long is difficult to predict. This can add significant complexity to retirement planning. Many of us want to simplify, not add complexity and cost.
Eliminating Retirement Income Inflation Risk
Also, maintaining a steady income out of a TIPS or I-Bond portfolio can mean constant monitoring, selling, and buying as bonds mature.
Finally, a retirement income plan based on TIPS and I-Bonds usually involves periodic liquidation of principal, not just living off interest. This means that there is a potential for outliving your income.
Using Inflation Indexed Annuities
One strategy for completely eliminating inflation risk from your retirement is to supplement Social Security (which is inflation protected) and TIPS/I-Bond income with an inflation indexed annuity.
What is an inflation indexed annuity? It is a single premium annuity that provides income to the beneficiary for life. Most single premium or life annuities are sold as fixed-income products. The income that you receive each month never changes. This can be a serious problem because of inflation. An annuity that is inflation indexed adjusts the monthly payment upward based on the annual inflation rate.
I will give you one significant example from our baby boomer years. During the period 1973-1982, our calculated cost of living increased 130%, with inflation averaging 8.7% each year. If we were to experience a similar period during our retirement years, a $1000/month fixed annuity income could fall to $420 in purchasing power in just ten years. Ouch.
Many sellers of life income annuities offer inflation indexing options. These options include automatically increasing the income each year by a fixed percentage, often between 1%-5%.
A better and more secure option is to index the annuity income amount to an inflation indicator, such as the Consumer Price Index as determined by the Department of Labor. Most such annuity products will increase the monthly payment each year based on a CPI increase during the prior year but not decrease the payment if the CPI declines. Instead, a decrease in CPI will be used to offset any future annual increases.
Obviously, a life income annuity that is indexed to inflation will either have a higher premium or lower initial payout compared to a non-indexed annuity.
To give you one example of comparative annuity income payouts, a single life annuity from the Principal Financial Group with a $100,000 premium will pay $570/month for life if purchased today by a 60 year old male. If that income is indexed to inflation, the initial income payout amount drops to $402/month. But with an extended run of inflation, the income could grow easily to exceed the income paid by the non-indexed annuity.
Final Thoughts on Inflation Indexed Annuities
Ideally, we would all know how exactly much money we will need to live on in retirement and where it we are going to find it. Nothing is for certain in the retirement income calculation, but eliminating inflation goes a long way. Combining Social Security, inflation-protected securities, and a life income annuity indexed to inflation could be a smart strategy for accomplishing that goal.
Image credit: Gregor Rohrig