Retirees often overlook the impact of inflation, though it represents significant risk to the long-term growth of their investments. Since 1925, inflation has averaged about 3% per year.[i] Compounded over time, price increases can eat into the purchasing power of your investment portfolio over time. And with life expectancies rising, inflation can hike your living expenses during retirement. Though inflation may not be much of an issue today, consider periods like 1974 through 1981 when the average year-over-year inflation rate topped 9%.[ii] In these instances, holding low-returning investments could mean losing purchasing power, which could prevent you from reaching your goals. Although we believe inflation is unlikely to reach these extreme levels any time soon.
Even 3% inflation can steadily erode your purchasing power during retirement. If you currently require $50,000 for annual expenses, you would need nearly $90,000 in 20 years and about $120,000 in 30 years just to maintain the same purchasing power.
So how can you protect your retirement income from inflation?
One option is to invest in annuities because they offer guaranteed income for life. One problem is that without costly contract addendums known as “riders,” these guaranteed payments typically don’t adjust the monthly payments or terms to account for inflation. Because annuity income typically isn’t adjusted for inflation, retirement payments tend to lose purchasing power over time and may eventually fall short of your needs. What benefit is guaranteed income if it stays the same as your expenses increase?
You can buy a rider that allows annuity payments to adjust for inflation (known as an inflation protection rider). However, these benefits generally come with fees. Additionally, to account for this feature, the annuity provider may set lower initial payouts into the contract—possibly 25 – 30% lower than a comparable unprotected annuity product.
If you are considering an inflation-protected annuity, it is a good idea to understand how inflation riders work. Generally, there are two types— those that raise payments by a fixed percentage each year, and those with a variable increase tied to an inflation indicator such as the Consumer Price Index (CPI) or similar index.
Even with an inflation rider, your annuity payments may not keep up with increases in your cost of living, which could lead to difficulty funding retirement. The CPI, a standard measure of inflation used to calculate many inflation riders, may not accurately reflect the price changes for the goods and services you may need. CPI tracks a “basket” of goods and services and how their prices change over time. This basket includes categories such as food, gas, housing, education, health care and so forth. As people age they tend to spend more on health care and other categories that have historically seen higher inflation than the broader CPI.
Annuities carry other characteristics and limitations that may present disadvantages in retirement.
Commission structure: An annuity is a contract between an investor and an insurance company. Similar to many insurance products, annuities typically pay commissions to those who sell them. In our experience, it isn’t uncommon for 4 – 8% of the contract value to be paid to the salesperson. Commission-driven annuity sales may incentivize salespeople to sell annuities that may be suitable for a client, but not necessarily in that client’s best interest.
Ongoing fees for inflation protection: The trade-off between exposure to inflation and the cumulative effect of ongoing fees for inflation protection is the erosion of invested capital. Whether this reduces purchasing power via inflation or “rider” fees, the effect is a reduction in returns.
Surrender charges: You can expect to experience unforeseen income needs in retirement. If you need to pull money out of an annuity too early or above an amount specified in the annuity contract, you may be subject to surrender charges that, in our experience, can be as high as 10%.
Other limitations and trade-offs: Fixed annuities may guarantee steady income but may yield smaller returns over time than other investments with more market risk exposure. If you require equity-like growth to achieve your investment objectives, income from fixed annuities may not be sufficient.
Indexed annuities aim to provide equity-like growth and downside insurance, but these annuities come with limitations that can make it difficult to actually achieve equity-like growth:
Some of these annuity features can potentially limit your ability to achieve any long-term equity-like returns at all. While you may receive a minimum return when equities are lower, you may be capped on years when they are up 15-20% or more—a hefty cost for downside risk. Those big up years can drive equities’ healthy long-term returns, and missing out on their full potential can hurt your relative returns. This is just one reason equity-index annuities may struggle to keep pace with their underlying indexes or other equity-indexed investments over the long run. Variable annuities can provide market-like returns, but they typically come with high fees and surrender charges. These include mortality and expense risk, administrative fees, death benefit riders, withdrawal benefit riders and fund expenses for underlying funds in a variable annuity.
When you factor in performance caps (monthly or annual maximum return), safety nets for loss and various fees, you may end up not getting the growth and income you need from annuities to offset inflation. Annuity payments that aren’t inflation-protected present risk to your purchasing power over time. Payments from inflation-protected annuities are reduced by fees and expenses. Either way, you end up with reduced income.
We believe there are better ways to cope with inflation when creating a retirement plan. Investing in stocks isn’t risk-free but can help provide needed growth for investors with long-term goals.
Annuities may not offer the returns you may need in your retirement years. If you are considering an annuity, think about whether the real costs of annuity benefits outweigh the opportunity cost of market growth and the cost of having more flexibility, freedom and control over your own money.
For more information on annuities and potential alternatives, contact Fisher Investments today.
[i] Source: Global Financial Data, Inc. as of 01/09/2018. Based on US BLS Consumer Price Index, 12/31/1925–12/31/2017.
[ii] Source: FactSet, as of 11/27/2018. Based on average monthly US BLS Consumer Price Index year-over-year growth, 12/31/1973–12/31/1981.