What’s An “Inflation-Protected” Annuity And Should You Have One?

"Inflation causes your savings and fixed income assets to lose purchasing power as time passes and the cost of goods and services goes up. Inflation can alter your standard of living and is especially problematic for retirees." – Eric Coons Many retirees are worried that government spending and budget and trade deficits have created a strong inflationary environment that may last for several years. For Americans who live on their savings, inflation is even more of a concern because it increases the probability that the cost of retirement will wind up being more than the growth of their accounts. A recent research study found that when inflation reaches 3 percent, retirees could experience a decline in purchasing power of over $117,000 in 20 years. Even a "normal" 2 percent inflation rate creates a retirement income shortfall of nearly $74,000. If you are at or near retirement, you need to manage inflation risk, and if you don't, you could run out of money before you die. Could "inflation protected annuities" help smooth out inflation risk? Generally, you shouldn't expect annuities to provide growth in guaranteed lifetime payments to offset higher-than-expected inflation. Still, annuities can serve as a financial cornerstone by providing a lifetime income stream. Having a reliable, predictable income stream in your matrix could reduce your anxiety if you need to invest in other assets with higher rates of return. It is also possible to purchase annuities with built-in cost-of-living adjustments or buy deferred annuities for growth. This type of annuity is known as an "inflation-protected annuity," or IPA. IPAs, also known as inflation-indexed annuities, increasing income annuities, or COLA annuities, are safe money products that guarantee a real rate of return that is not less than the inflation rate. In recent years, IPAs have gained popularity with seniors who want an opportunity to hedge against some of the effects of inflation and safeguard their retirement outlooks. These products can help mitigate both the inflation and longevity risks threatening your retirement. IPAs offer guaranteed fixed payments for a specified period or life. Unlike most other annuity products, the IPA's payments are usually indexed to inflation based on an annual cost-of-living adjustment (COLA) factor. The COLA is determined when you purchase the annuity, allowing for period benefit increases as inflation rises. Getting peace of mind with inflation protection inside an annuity has a few potential downsides. One potential disadvantage is that having the COLA feature reduces your initial payments by 20-30%, and it could take several years for inflation-indexing to pay off. However, some IPAs let you limit that initial reduction by choosing to limit your annual increase or by accepting a fixed increase of either 2% or 4%. There are other factors to consider as well. The bottom line: Inflation is likely to be a part of our economic landscape for the next few years, and no retiree will be able to escape its effects entirely. However, including an inflation-protected annuity product in your portfolio may provide a valuable approach to mitigating the negative consequences of prolonged inflation. Consult your local retirement income specialist to see if inflation-protected annuities will work in your unique situation.