Are Inflation Adjusted Annuities Worth the Cost?

Inflation protection for fixed annuities would seem to be a sensible consideration given the fact that central banks around the world are doing everything they can to reflate in the wake of an historic deleveraging.

After all, the worst possible place to be if and when inflation does kick-in is on the receiving end of nominal (not adjusted for inflation) fixed payments, and most fixed annuities fit this description perfectly.

While the inflation protection makes sense in theory, it turns-out that inflation-protected annuities may not be so sensible in practice.

The reason is that the additional premium charged by insurance companies is too high relative to the amount of inflation protection that is delivered.

This insight comes from the noted actuary and financial planner Joe Tomlinson (an additional call-out to retirement income researcher Wade Pfau who published a paper referencing Joe’s work in this area).

Joe’s analysis focused on inflation-adjusted single premium immediate annuities (SPIA). Joe’s analysis involved the following:

• Payout rates for an inflation-adjusted SPIA
• The spread between the rates on regular Treasury bonds and Treasury Inflation Protected Securities (TIPS). This spread is a conventionally accepted measure of inflation expectations. This spread was 2 percent at the time Joe wrote the paper.
• Joe then looked at payout rates for a SPIA with a 2 percent annual increase or step-up--presumably with the intent of comparing the 2 percent inflation expectation with the 2 percent step-up.

Joe found that the payout rates for the step-up SPIA (5.03 percent) were considerably higher than the inflation-adjusted SPIA (4.11 percent).

Possible sources of this apparent arbitrage opportunity include insurance company margin protection, inflation hedging challenges for insurers and the fact that the market for inflation-adjusted annuities is small and undeveloped.

In any event, at the moment it appears that inflation protection for fixed annuities is not worth the additional cost.