Inflation-Protected Annuities: What are they and How Do They Work?

Annuities can be great products to guarantee lifetime income. But what if annuity payments remain the same throughout your lifetime and inflation rears its ugly head? That's where inflation-protected annuities (IPAs) come in. They offer inflation protection, but come with a cost.

When insurance companies sell annuities, they guarantee payments throughout your lifetime or for a period of time that you select. Since most of these companies are financially sound, the risk of handing over a portion of your retirement nest egg is low. For retirees, one of the primary challenges of most annuity payouts is inflation risk.

Inflation protection is a unique feature of some annuities that increases your purchasing power when inflation rates are high because the product has annual positive adjustments that track with the inflation rate. These adjustments help you keep up with the cost of living, typically calculated by the consumer price index (CPI). The product can be a nice complement to social security payments, since both have inflation adjustment features.

The CPI consists of the weighted average of prices in a "basket" of consumer goods and services, like transportation, food, and medical care. It is calculated by taking price changes for each item in the basket and averaging them.

Let's take a closer look at IPAs and how they may, or may not, be a smart addition to your retirement plan.

Are (IPAs) Full Annuity Plans or Policy Riders?

The inflation protection feature is typically a rider attached to an annuity that is being annuitized (converted into a stream of payments) or with the purchase of an immediate annuity.

Before we dive into more facts about IPAs, let's review the types of annuities, focusing on the two core types, deferred and immediate.

With deferred annuities, you pay a premium to the insurance company today, and payments are deferred until a later date. In the meantime, your money earns tax-deferred interest, either a fixed or variable amount, depending on the contract you select. When it is time to begin receiving guaranteed payments, you "annuitize" your deferred contract. That's when you can choose to have an inflation protection rider attached to your annuitized contract, if it is available from your insurance company.

The word "deferred" in deferred annuities means you receive a future payout. Similarly, the term immediate in an immediate annuity means you receive a payout almost as soon as you purchase the product.

When you purchase an immediate annuity (also known as an income annuity), you pay a premium to an insurance company and your lifetime income payments (or payments for a period of time chosen by you) begin immediately. People usually buy this product when they are nearing, or in, retirement.

IPAs are designed to increase the monthly income payout each year based on a predetermined formula. As we mentioned, the increase is usually tied to changes in the consumer price index. However, there is a cost for this protection. When you opt-in for the IPA rider, your payments start out less than they would have been if you bought a traditional immediate annuity.

It could take 12 to 20 years for the real annuity payout to equal what a comparable non-inflation adjusted fixed annuity would pay. That's because the issuing insurer has to make a profit spread on the product long term and is counting on the fact that, historically, rates of inflation ebb and flow, and they will be liable for making sure they are paying you the adjustment as agreed. That's why they pay you less in the initial years of the contract.

Despite this "cost," IPAs can still be effective for retirement income planning. If you want to create a stream of income that maintains buying power if inflation rates spike, it may be worth the lower initial payout of an IPA. And the product can be a worthwhile component of a retirement portfolio, effectively creating a "personal inflation-adjusted pension."

Inflation-Protected Annuity Pros and Cons

Pros

IPAs are an effective hedge against inflation because they help you keep up with the cost of living. They help you create a "personal pension" with the added benefit of inflation protection

(IPA) Cons

Insurers make you "pay" for the inflation benefit by starting out your income payments lower than they would be if you bought an annuity without this protection. If inflation rates remain low, then your lifetime payout will be lower than with a traditional immediate annuity (this is the “cost” that we talked about earlier)

Is an Inflation-Protected Annuity Right For You?

Many people nearing retirement are worried that continued government spending and budget deficits will create a stronger inflationary environment in the coming years. For retirees who are living on their savings, that’s a significant concern because higher inflation increases the risk that retirement costs will outpace the growth of their assets. Including an IPA as part of a well-designed retirement portfolio may be a good idea if you have these concerns.

If you are not yet ready to use an annuity for retirement income, then direct-purchased Canvas annuities could be useful in building a foundation of pre-retirement savings that could then be converted into lifetime income. Canvas annuities are fixed annuities, meaning that rates are guaranteed for the term you select. Check out the Canvas competitive rates today!