Inflation and Fixed Indexed Annuities

This forum thread is a continuation of a conversation that began as a comment and can be found here:

The comment came from Phillip Hawley and is as follows:

Thank you Tom for your balanced and insightful articles and commentaries. Gladly, I recommend your website to every one of my prospective clients.

It is my understanding that in very simplistic and general terms, inflation has varying effects on the equity markets. At low and stable levels there is no correlation between the rate of inflation and market volatility as recent events seem to confirm. At moderate to moderately high rates of inflation, market activity is typically depressed, making indexed annuities not an attractive proposition. However, a super-inflationary cycle typically finds the markets in lockstep with consumer prices, making the indexed annuity an interesting alternative to some other asset classes.

It seems that the attractiveness and indeed the suitability of indexed annuities for the typical middle-income retiree depends on 1)how high the rate of inflation climbs, 2)the duration of intermediate inflationary cycles in relation to the selected crediting method and 3)the term of the annuity in relation to the overall period of inflation. In short and in general, indexed annuities are attractive in the first and third condition and very unattractive in the second. Sound about right?



Again, thanks for the comments Phillip.

First, at a very high level I think the idea of recommending or, at a minimum, discussion inflation protection features/riders with clients is completely necessary.

From there, I have a feeling that there would be no conclusions even if we were able to assemble a room full of renown economists and asset managers to discuss/debate the relationship between inflation and equity markets.

That said, some thoughts are as follows:

- different asset classes (e.g. commodities, fixed income, equities) would likely perform differently in a highly inflationary environment.

- the relationship between inflation and interest rates is typically pretty clear--rising inflation = rising interest rates.

- rising interest rates would likely crush the bond market.

- rising interest rates increase the discount rates that are used to value all equity-related cash flows, so those equity asset valuations would likely decrease.

- I assume that there will always be some very attractive businesses that have pricing power and little in the way of fixed costs, capital expenditures, etc. These relatively rare equity assets could benefit in an inflationary environment.

- the above said, I have a feeling that a highly inflationary environment would be tough for the broader equity markets.

- I also find it highly unlikely that equities in general would perform well in a super inflationary environment. It would be worth trying to find some evidence which would likely have to come from market history outside of the U.S. unless we consider the 1970s to be super inflationary. Is there a study, etc that underlies the assumption about very high rates of inflation as a positive for equity markets?

- with the exception of brief periods, we have always lived with moderate rates of inflation, so we certainly have evidence there in terms of the impact on equity markets.

Overall, the threat of high rates of inflation is a very tricky one for recipients of fixed income of any form. Education and hedging (commodities, TIPS, inflation riders) are critical. High rates of inflation are also tricky for owners of annuities that have some variable component to their payments (i.e. variable, fixed indexed).

As you indicate in the last paragraph, much depends on: a) the level of inflation, b) the duration of the inflation, c) product structure (e.g. crediting periods, term of annuity, etc).

Hope this is somewhat helpful--happy to continue the discussion.