Advertise

In this Section:
ANNUITIES

The Case Against Inflation - Preserve Your Client's Retirement With A Smart Annuity Mix.

As a result of the recent economic collapse, inflation rates have tumbled downward and interest rates are at historical lows. Inflation is said to be running well below the Federal Reserve's targets. And the Federal Reserve has even expressed concern about the risks of a deflationary spiral. Given this backdrop, are advisors unconcerned about inflation? Certainly not! As federal spending achieves record levels and as the Federal Reserve pumps unprecedented liquidity into the monetary system, advisors and their clients are worried that inflation will not only accelerate, but also may be difficult to contain. At the same time, many investors have reduced their appetite for investment risk out of concern that they may lose principal. The result is that retirees and those nearing retirement want guarantees of both principal and income in retirement.

So what should advisors do to deliver guaranteed income solutions that can address increased expectations of inflation, as well as fears of loss of principal? One solution that a large number of advisors have successfully deployed is an indexed annuity (IA) with an income rider that can provide guaranteed withdrawals for life. The indexed annuity is also appealing because it contains a minimum guarantee on the amount of principal and interest that will be available for distribution. However, the guaranteed withdrawals of the IA with an income rider are not directly related to inflation. Furthermore, in order to keep up with annual inflation, the interest credited to the account value would have to replace the prior withdrawals, plus cover inflation after any fee for the rider is taken into account. So let's assume that the fee for the rider is 0.4 percent, withdrawals are guaranteed at an annual rate of 5 percent and annual inflation expectations are 3 percent. This means that interest credited to the FIA would have to consistently meet or exceed 8.4 percent (0.4 + 5 + 3) per year once withdrawals begin. This would be a very unrealistic expectation given the methods used to determine interest credits on IAs.

How then should an advisor deal with inflation? The answer lies in the manner in which retirement income needs are determined for a typical retiree. In particular, the income needed by the retiree can be separated into two parts: an essential income need and a discretionary income need. It is the essential income need-the income that is necessary to cover the essential expenses of living-that is exposed to inflation. As the essential expenses increase, the essential income needed to offset them also increases. An additional consideration is that most retirees will also qualify for a Social Security retirement benefit that is adjusted for inflation, so Social Security needs to be accounted for. For example, let us take a look at the example of 65-year-old John, who has accumulated $280,000 of assets in CDs for his retirement. John is concerned about taking market risks. He needs $2,375 per month in retirement, of which $1,500 is for essentials and $875 is for fun, but is very worried about the impact inflation might have on his lifestyle. He qualifies for a Social Security benefit of $1,000 per month, and he is fortunate that his employer provides for his health and long-term care at no cost to him. Some advisors faced with this situation might be tempted to put $250,000 into an IA with an income rider that pays a 10 percent bonus on the income base and guarantees a 6 percent withdrawal. The pitch would be that the guaranteed withdrawals of $1,375/month (6 percent of 110 percent of $250,000 divided by 12) together with the Social Security benefits of $1,000/month would produce the total $2,375 of monthly retirement needed-problem solved-and $30,000 is left over for other purposes. Well, no cigar yet! John's inflation concerns have not been addressed, except by the Social Security income. How could this case be more effectively solved to address John's concerns?  

The answer lies in adding an immediate annuity to the mix. Here's how it would work:

1. The essential income gap-the difference between the essential income need of $1,500 and the Social Security income of $1,000-is $500 per month. It is this gap that needs to be inflationprotected. Purchasing a SPIA with a lifetime consumer price index (CPI) adjusted income of $500/month would cost about $117,000.

2. Of the remaining $163,000, $159,100 could be put in the IA to generate the $875/month (6 percent of 110 percent of $159,100 divided by 12). Since this is not required to keep pace with inflation, the problem is more effectively solved. In addition, the client has 58 percent ($163,000/$280,000) of the original assets available in case of an emergency. And of that, about $4,000 is free and clear-not used to purchase either annuity-so John can take that vacation trip he always dreamed of to start retirement.

We can now congratulate ourselves for doing a better job of addressing inflation for this client. Many advisors are familiar with the power of IAs but may be unfamiliar with the power of SPIAs, and CPIadjusted SPIAs in particular. They are not cheap. There is a reduction in initial income payments with purchase of a SPIA with a CPI adjustment rather than a SPIA with no adjustment. For example, at age 65, the SPIA with a CPI adjustment pays about 25 percent less starting income as shown in column four of the table. Column five shows what the COLA would have to be on a SPIA with a fixed annual increase in payments, regardless of the actual level of inflation-when the client is age 65, a CPI-adjusted SPIA would be about the equivalent price of a SPIA with a fixed COLA of around 3 percent. Advisors may therefore also consider SPIAs with fixed annual increases as an alternative to a CPI-adjusted SPIA.

Finally, in addition to the flexibility of addressing inflationary expectations, there are other reasons to combine a SPIA with an IA purchase for more power in the income solution:

• In some cases, the income base on the IA could be allowed to roll up by delaying the start date on the IA and bridging the time gap with a periodcertain SPIA (but this may not be as effective in low-rate environments).

• In the above example of John, the SPIA could have been purchased with nonqualified assets to take advantage of the high tax exclusion ratio on the income, while the qualified funds could have been placed in the IA to continue tax deferral.

• Instead of a life-only payout, which is typically illiquid, a SPIA could be purchased for a period certain and life thereafter. This would guarantee payments to the heirs in the event of John's premature death (although this option would be more expensive).

Garth Bernard is a CEO of Thrive Income Distribution System LLC. “The Thrive” Income Distribution System is designed to help clients achieve three critical goals for their retirement: inflation adjusted guaranteed income, high internal rates of return, an [email protected].


More from InsuranceNewsNet