Are Annuities a Good Idea in a High-Inflation Environment?
While some annuities offer inflation protection, it may not be worth the cost. Here's why.
Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Many retirees view annuities as useful tools for replacing income with a fixed payout during retirement. But are those fixed payouts vulnerable in a period of rising inflation? Joining me to discuss that topic is Christine Benz. She is Morningstar's director of personal finance and retirement planning.
Hi, Christine. Thanks for being here today.
Christine Benz: Hi, Susan. Great to see you.
Dziubinski: You've written a bit about annuities in the past, and you said that you often prefer the very basic annuity types. So, let's talk about those and what you like about them.
Benz: Sure. I like the very basic single premium immediate annuities where you give the insurer a bucket of money and say, send me a stream of income for the rest of my life, for some specific time period. There's a lot of transparency there. It's very easy to compare on costs, because, really, the costs are reflected in whatever that income stream is, assuming that you're looking at insurers that have similar levels of financial strength. Another annuity type that I think can be attractive for some retirees would be to look at a deferred annuity, a deferred income annuity, and that's basically where at, say, age 65, you purchase the annuity, and then it begins paying you a stream of income at a later date, say, age 85. And the virtue of a product like that is that it would protect you against having a really long life and outliving your assets. So, if you make it from 85 to 105, well, that's a good purchase for you to have made. I like those very basic, very vanilla annuity types. I think they're a good starting point for people who are interested in annuities.
Dziubinski: Christine, some of those basic annuity types are the ones that can be very vulnerable in the face of inflation. Let's talk a little bit about that.
Benz: Right. That's a big reservation about these annuity types right now. These annuity types give you a fixed stream of income. It's not going to change. And they are vulnerable in the face of inflation because inflation eats away at the purchasing power from that income. And by the way, this is not a problem exclusively associated with annuities. It's a problem with individual bonds, it's a problem with CDs, that if your return is fixed, that means that when inflation flares up, as it has been recently, that that does eat away at the purchasing power.
Dziubinski: When it comes to annuities, can you purchase some sort of inflation protection? What are the options that investors might have that would be interested in these annuity types?
Benz: Yes, you can purchase inflation protection. There are products that offer inflation guarantees that effectively attempt to make you whole when inflation goes up, attempt to reflect the Consumer Price Index changes. The issue is that there's a cost associated with that inflation protection because I think everyone would look at this and say, yes, give me the one with inflation protection. The problem is that in certain environments, like right now, when everyone is worried about inflation, the pricing of that inflation protection can get a little bit out of whack. So, unless inflation continues to be really high in perpetuity, you may have overpaid for that inflation protection. And then, another issue is sometimes these products, and it depends on how the contract is written, but sometimes, if inflation is negative in a given year and a series of years, that can take away from the inflation adjustments, the positive inflation adjustments, that you're later able to earn. So, you need to read the fine print. You need to know or at least have a sense of what you're paying if you're purchasing an annuity as well as some level of inflation protection.
Dziubinski: There are some annuity types, variable annuities and fixed indexed annuities, that are tied more to the stock market and the stock market's performance. Are those something investors might consider during inflationary times?
Benz: Well, certainly because there is that variability in your income stream as an investor, that's an attractive thing in the face of inflation. You're not wedded to a fixed payout. It seems that in an inflationary environment, you might be better off. The issue is that with, some of these products, the transparency is not there. I was talking about how I liked the transparency of the fixed annuity types. It's not there with these products. They can be very complex. They can sometimes be more costly. Certainly, variable annuities can be very problematic from a cost standpoint where you're often paying very high commission. So, even though they look better situated from an inflation-fighting standpoint, they may be less attractive on these other measures.
Dziubinski: Then, at the end of the day, Christine, how should retirees be approaching this? Should they be avoiding annuities entirely in a high inflation environment?
Benz: Not necessarily. But I do think a good thing to consider as a starting point, and really anyone who is conversant in annuities would say this--a starting point, if you're worried about lifetime income, if you want to try to maximize your lifetime income, the best thing you can do is to make smart Social Security filing decisions. Consider delaying filing. You can delay all the way until age 70, and you can enlarge your payout. And while you wait, the payout grows but also you're receiving those inflation adjustments on the payout. So, that's stop one before considering any sort of annuity. Then from there, if you decide that you want to add an annuity into your retirement toolkit--and I think that that's a valid thing to think about, kind of protecting your fixed cash flow needs through Social Security and then maybe some supplemental purchase of an annuity--from there, one idea is to look at some of these fixed annuity products but consider purchasing them over a series of years. And the virtue of that is that you're able to experience perhaps a range of interest-rate environments. So, when interest rates go up, you'll typically obtain a better payout. And you may also be able to better manage this inflation issue by buying it over a series of years. So, that would be my advice to consider making a staggered series of annuity purchases.
Dziubinski: Christine, thanks for your time today and for these insights and particularly some strategies that retirees can turn to when it comes to annuities. We appreciate it.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski for Morningstar. Thanks for tuning in.
Read more about it: Your Guide to Annuities