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,
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
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).