Prices do rise, and a marginal rise in the price of goods is often considered a healthy practice by economists. But, it becomes unhealthy when the price rises exponentially; especially, for the people who are in their/planning for their retirement.
Inflation in the US has hit a 30-year high, exhibiting one of the biggest price surges in the entire US history. This state of inflation is concerning, and we must be well aware of how to manage our investments to sail through times as such.
This article will explain how a retiree could protect himself from inflation risk through Annuities and other investment vehicles.
US Inflation hits a 31-year high! And it is not transitory!
The Consumer Price Index (CPI) data, which measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, showed that the CPI rose to 6.2% in October – a 31-year high on a year-on-year basis.
While the Fed keeps on saying that inflation is “transitory,” we are very well aware that prices have been rising for a while now. The global supply chain challenges, covid19 aftershocks, and the low-interest-rate environment will further fuel inflation.
Inflation is the biggest enemy of retirees who are on a fixed income. During high inflationary periods, the fixed-income of retirees remain the same, while the prices of the commodities keep increasing – this forces the retirees to decrease their standard of living.
Retirees who buy Annuities think that their retirement can be sufficiently funded by Annuities; Single Premium Immediate Annuities (SPIAs) are the most common annuities chosen by retirees today – but these annuities are not sufficient to fund retirement during inflationary pressures.
Why does a regular single premium immediate annuity (SPIA) doesn’t protect you from inflation?
The payments that arise from an SPIA are fixed in nature. But the prices of commodities increase significantly during the inflationary period. So, even if the retirees’ lifestyle is not improving, they will need to shelve out more monies with each passing year. In cases of high inflation, there is even a chance that the retiree may outlive his income a lot early, even if protected by an annuity.
Let’s consider a simple example to understand this.
Victor (65) retired last year and happens to own an SPIA that will start remitting a fixed income of $5000 per month from this year onwards. Victor lives a budget-conscious lifestyle and believes that his expenses will always remain under $4000 per month.
On the face of it, it seems well-planned and solid. But the strategy fails to incorporate the effect of inflation. Let’s see what happens to this strategy when we assume a 3% annual inflation.
At just a 3% inflation rate, the retiree ran into a deficit into his eight-year of retirement. Now, if the inflation rate is more, it would have an even adverse effect on retirement.
Now, let’s assume a scenario where the inflation rate is 6% instead of 3%.
When the inflation rate is increased from 3% to 6%, we have an even adverse effect. The retiree ran in deficit in just the 5th year of his retirement. By the age of 80, he was in a major deficit, where the deficit was larger even than the original target living expense.
This is how inflation adversely affects a person who is living on a fixed income.
Even a seemingly smart financial plan can be shattered by the adverse effects of Inflation, which is why planning for inflation is important.
How could a retiree protect himself from inflation risk?
There are several ways through which an investor could protect himself from Inflation. But only a handful of these ways are appropriate for a retiree who plans to live off a fixed income strategy. Below, we discuss how an investor could protect himself from inflation and whether these strategies are suitable for a retiree.
- Stock Portfolio – Stocks are one of the best hedges against inflation. In a period of inflation, earnings increase, and thus the overall market value of the stock market. But, the stock market is risky and may not be a suitable avenue for most retirees. However, certain industries (healthcare, consumer staples, etc.) within the stock market are less risky and are a good hedge against inflation. Retirees who don’t mind taking small risks could benefit from investing in stock markets.
- Inflation-Protected Annuities (IPA) – Inflation-Protected Annuities are very similar to a conventional SPIA – the difference being that, unlike an SPIA, an inflation-protected annuity guarantees a real rate of return above inflation.
However, Inflation-Protected Annuities has this one major drawback: the initial payouts that these annuities offer are very low compared to immediate annuities (SPIA). This is the reason why these instruments failed to gather retirees’ interest when the inflation was low.
As a result, no company today offers any Inflation-Protected Annuities (IPAs). Principal was the last company to offer Inflation-adjusted annuities that stopped offering inflation-adjusted annuities in the second half of 2019.
The above two methods of hedging against inflation are not the best methods for a retiree to follow. They are either too risky or are discontinued. The methods discussed below are a more practical approach for retirees to create an inflation-protected retirement plan.
- Treasury Inflation Protected Securities (TIPS) – TIPS are a type of US Treasury bond that has a set value that is adjusted for inflation. The value adjusts for inflation to ensure the bond retains its real value over time. TIPS is one of the best hedges against inflation, especially when the expectations of inflation are high.
A retiree could create a fixed and predictable stream of inflation-protected income by laddering TIPS. The only drawback of TIPS is that they do not protect a retiree from longevity risk – If a retiree has laddered his TIPS for 30-years, he will only be protected from inflation for 30 years; if the retiree lives more than 30 years, he faces a risk that he will outlive his income.
- Annuities with Income Riders – Income riders are another good way of protecting yourself from inflation risk. Many annuities offer additional free or paid income riders that enable the annuitant to earn more than the standard terms of the annuity. Many of these riders help the annuitant protect themselves from the cost of living adjustment and inflation risks. American National Strategy Indexed Annuity Plus, Athene Agility Annuity, F&G Accelerator Plus, American Equity AssetShield, and Nationwide New Heights select are some of the annuities that offer additional income riders that can enhance the annuitant’s income and provide some hedge for inflation.
While a moderate level of inflation is healthy for an economy, high levels of extended inflation can become an enemy of a retiree who is living on a fixed income. For these individuals, in this case, there is often no way out other than to reduce the standard of living.
Fortunately, there are some ways to reduce this inflation-induced risk. One potential approach is to ladder a series of TIPS in such a way that they provide a fixed and predictable stream of inflation-protected income. Another way is to include additional income riders in your regular annuity, which can protect you from cost-of-living and inflation adjustments.
For retirees willing to take somewhat higher risks, a portfolio of less risky stocks, generally in the healthcare, energy, or consumer staples industries, may prove to be a good choice to hedge against inflation.