What Advisors Miss When it Comes to Inflation and Annuities
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There was a spirited debate recently in a few Advisor Perspectives articles1 regarding the potential benefit of purchasing a “real annuity.” To recap, there is relatively wide agreement among economists that the best product for retirees, in theory, is an annuity where benefits are tied to inflation, also called an inflation-indexed single-premium annuity (SPIA) or a “real” annuity. This product is seen as ideal, since it aims to hedge two notable risks faced by retirees: longevity and inflation.
The market for real annuities is relatively sparse, though, with only one company currently offering the products today (Principal). This lack of competition, along with other market forces (e.g., adverse selection and hedging considerations) has resulted in an implied “cost” (or load) for real annuities that is significantly higher than other annuities not directly tied to inflation (i.e., nominal SPIAs). The load of a real annuity is roughly 3.7 times that of the best nominal SPIA and 2.7 times the best 2% fixed cost of living adjustment (COLA) payout (based on my previously noted article).
This high (relative) cost of the real annuity led me to label them a “bad deal.” While inflation is definitely a key consideration in a financial plan, it represents just one of the many risks (and decisions) faced by retirees. A retiree who purchases a real annuity would expect to receive guaranteed income for life hedged to inflation, but would also have less money to tackle other retirement issues (e.g., purchasing a long-term care policy) than if a different annuity had been selected (e.g., a nominal SPIA with a 2% fixed COLA). Therefore, the potential benefits associated with real annuity must be weighed against the costs when determining the optimal product.
In theory, a retiree interested in any type of SPIA should be provided with a variety of quotes (e.g., with different types of COLAs) by the advisor to determine which is the best fit (obviously with guidance from the advisor). In reality, though, the vast majority of SPIAs and deferred-income annuities (DIAs) sold today do not include any type of COLA (fixed or CPI-U). For example, from 2011-2018 only 5.5% of annuities quoted by CANNEX included any type of COLA, and only 12.3% of those (0.7% of the total) were linked to inflation (i.e., real annuity quotes).
The fact only roughly 1 in 20 annuity quotes include a COLA suggests that advisors are not considering, and retirees are not being provided with, information that is essential for determining the optimal annuity benefit payment structure. While the relatively high implied load associated with CPI-U COLAs may explain some of this effect, fixed COLAs have implied loads similar to nominal SPIAs, which means this effect cannot be entirely pricing related. Overall, it’s critical for advisors to provide clients with pricing and context on the different types of COLAs (fixed and CPI-U linked) to ensure the client understands the tradeoffs associated with the different forms of guaranteed income (i.e., give annuity COLAs a chance!).