If you buy an annuity right before interest rates go down, you’ll get a better deal. However, they might still not be a good idea if you think that inflation will rise a lot.
There have been a lot of stories lately telling us to buy annuities right away because interest rates are likely to drop a lot. This is important to note. One recent piece on the Advisor Perspectives website said that “now is the best time to act and secure elevated rates for annuities” because rates are going down. Brett Arends, a writer for MarketWatch, said the same thing.
This point of view is valid because the rates at which annuities pay out are linked to the interest rates that are currently in effect. So, if you were going to buy an annuity anyway, and interest rates drop from where they are now, you will get a better return rate if you buy the annuity now instead of after rates drop.
No insurance company offers annuities with payouts indexed to inflation.
Importantly, though, no insurance company sells annuities whose payments are tied to inflation. Even inflation rates that seem low can make an annuity’s payout much less valuable. If inflation stays at about 3%, which is close to the rate we’re seeing now, a pension payment that doesn’t change will be worth 60% less in 30 years. If inflation stays at 4%, the things you buy will be worth 71% less.
Other than Social Security, the only retirement plan I know of that automatically adjusts for inflation is a TIPS “ladder” plan. Allan Roth, founder of the financial planning company Wealth Logic, taught me about this plan.
Roth says that you should buy U.S. Treasury Inflation-Protected Securities with different maturity dates. This laddered method can support a steady inflation-adjusted payout rate over 30 years. This makes it much better than annuities in the event that inflation is much higher than what insurance companies think it will be when they price their annuities. Check out TIPSLadder.com for more information.
TIPS vs. annuities
How much inflation do you need to get a TIPS ladder to work and an annuity to work below that? As you might expect, it varies on a lot of factors, but researchers gave me answers that fall between 3% and 3.5%.
To say the obvious, no one knows what will happen with inflation in the future. Edward McQuarrie, a retired professor at Santa Clara University in California, says that investors should not focus on a single inflation prediction. Instead, he says that they should learn about the risks and benefits of different possible paths.
It’s also important to know that a TIPS ladder only pays out inflation-adjusted returns for 30 years before stopping. It doesn’t matter how bad inflation is over the next 30 years; a retiree who lives past those 30 years will have no income after year 31.
In an interview, McQuarrie said that a good middle ground would be for seniors to take some of their retirement income and buy a TIPS ladder with the rest. The annuity gives you money until you or your partner dies, and the ladder protects you against inflation.
As a general rule, he says you should spend half of the amount you have annuitised in a TIPS ladder. You could change these proportions to fit your needs based on what you think about future inflation, how willing you are to take risks, and whether your life expectancy is better or worse than normal.
Annuities that grow by 3% every year
Some commenters are bringing up the fact that some insurance companies offer annuities with payout rates that automatically go up by 3% every year. These contracts look like a good option, as long as the average rate of inflation during your retirement doesn’t go over 3%.
Roth said that these pensions that grow every year are risky. They are even more likely to go down in value if prices go up than annuities that don’t change every year. This is because the annuity that gives you a 3% yearly increase will pay out much less each year in the beginning than the annuities that don’t give you any adjustments, but they will pay out more each year later on.
But when you figure out their present value, those payments in later years are reduced the most. This means they will buy a lot less if inflation is higher than you thought it would be during that time.
In a strange way, this means that if you buy an annuity and inflation is higher than expected over the next two or three decades, you will have done better buying an annuity with no yearly adjustment than one with a 3% annual adjustment.
McQuarrie says that by carefully combining an annuity with a TIPS ladder, it is possible to make something that isn’t available in the financial markets otherwise: A life income that protects against inflation.
