How worried should retirees be about future inflation?
By way of an answer, ask yourself another question: Would you be interested in an annuity that pays you 3% less each year, with the result that your annuity income in 24 years would be half what it is today? Put that way, of course, your probable answer is “of course not.”
Yet this situation I describe is not hypothetical. It is “real,” as in inflation-adjusted. If upon retiring at age 66 you purchase an immediate annuity, and inflation averages 3%, the guaranteed income stream you will be receiving at age 90 will be worth half as much.
Unless, that is, the annuity you purchase carries inflation protection, automatically increasing payouts by a cost-of-living adjustment.
Should you purchase one? Even having the option is relatively new. When I last wrote about annuities in October, for example, several of the experts I interviewed thought that inflation-indexed annuities — real annuities, as they sometimes are called — weren’t available.
They are, though only to a limited extent. David Blanchett, head of retirement research at Morningstar, recently compared prices for a hypothetical 65-year old unmarried male buying a $100,000 annuity. He was able to obtain price quotes from 21 companies for a traditional annuity that provides a guaranteed level payout in nominal terms; 14 price quotes for an annuity that provides for a guaranteed increase in payouts of 2% a year, but only one with payouts indexed to inflation.
That’s probably a good estimate of the relative availability of these various types of annuities.
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Blanchett concluded his well-reasoned analysis of these various annuities that the real (inflation-indexed) annuity was way too expensive. And, given the low rate of future inflation he assumed when calculating the value of each annuity, his conclusion makes perfect sense.
What if inflation in coming years is a lot higher than currently assumed? Then the real annuity becomes more valuable. According to financial planner, actuary and retirement researcher Joe Tomlinson, the real annuity is a good deal once you assume that future inflation averages more than 3.57%. That’s significantly higher than what the markets currently are betting inflation will be over the next 30 — which is 2.12%, according to the Cleveland Federal Reserve.
To appreciate what an annuity provider must insure against when pricing a real annuity, consider what its annual payout would need to be in 30 years relative to what that payout rate is in the first year.
•If inflation averages 2.12%, then the payout in the 30th year would need to be 1.9 times as much.
•If inflation averages 3.57%, then the 30th year payout would need to be 2.9 times as much.
•If inflation averages 7.25%, as it did in the 1970s, then the 30th year payout would need to be 8.2 times as much.
Insuring against that kind of uncertainty is not cheap. But the alternative is to buy a nominal annuity and run the risk that the inflation-adjusted value of your payments in 30 years is worth only 12% as much.
In other words, according to Jeffrey Brown of the University of Illinois at Urbana-Champaign, there’s inflation risk with either type of annuity. Brown, who is dean of the Gies College of Business at the University of Illinois at Urbana-Champaign and director of the Retirement Research Center of the National Bureau of Economic Research, has devoted much of his research over the years to analyzing annuities. In an interview, he pointed out that there is no way around incurring that inflation risk — each type of annuity is making an implicit bet.
On the one hand, if you bet that inflation will be high and go with a real annuity, you run the risk of seriously overpaying if inflation turns out to be low. On the other hand, if you bet that inflation will be low and therefore choose a nominal annuity, you run the risk of inflation being much higher and receiving significantly more worthless payouts as your retirement years advance.
How likely is it that annual inflation will average just 2.12% for the next 30 years? No one knows, of course. But it’s worth pointing out that, historically, inflation has been mean-reverting. (See accompanying chart.) That means that periods of low inflation are typically followed by periods of high inflation, and vice versa.
That in turn suggests inflation over the next several decades may be much higher than the market currently expects. Brown conjectured that many retirees are not putting enough weight on the risk of higher inflation in coming decades.
Historical inflation trends have been widely analyzed, of course, and not all researchers have reached the same conclusion. But two academic studies that found evidence of mean reversion are: “Threshold, smooth transition and mean reversion in inflation: New evidence from European countries,” by Shyh-Wei Chen and Chi-Sheng Hsu, and “Mean reversion of inflation rates in 19 OECD countries,” by Chien-Chiang Lee and Chun-Ping Chang.
Remember, as Brown quickly added, just because inflation protection is a good idea doesn’t mean it’s a good idea at any price. And the lack of widespread competition for real annuities is a major impediment to better pricing.
Brown also pointed out that there are other ways of insuring against future inflation besides a real annuity. One way is to purchase a nominal annuity with a portion of what you otherwise would use to buy a real annuity, and invest the balance in 30-year TIPS. However, given the biases many retirees have against annuities in the first place, he believes it will be doubly difficult to persuade them to invest in a combination of annuities and TIPS.
This is one reason why Social Security is such a valuable part of the retirement puzzle. It in essence is an inflation-indexed annuity. And merely by postponing your retirement from age 66 to age 70, you can increase the amount of your inflation-adjusted payout by 8% a year. Deals that good aren’t available anywhere else.
The specific calculations for determining whether a real annuity is a good deal are quite complex, and are probably best left to a qualified retirement financial adviser. Since annuities have the bad reputation of being sold by commission-based brokers, it’s especially important to make sure he/she is providing advice free of a conflict of interest.
Regardless of the decision you reach in consultation with your adviser, however, never overlook the pernicious and toxic impact of inflation over periods as long as retirement, and don’t forget that you can’t avoid making an implicit bet on inflation no matter what you do.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com