life annuities and inflation

Life annuities are ‘longevity insurance’ – protection from the risk of outliving one’s savings. Most annuities sold in the US – and in other countries – provide payments for a fixed number of years, so are not life annuities. A column published in Saturday’s New York Times recommends purchase of life annuities. The advice contains a fatal, though common, flaw: it ignores the risk of price inflation.

[M]any academic researchers have long advocated “fixed life annuities”: investment vehicles that pay a set amount each year until the investor — or, sometimes, a spouse — dies. ….

Imagine a 65-year-old single woman who has just retired with $100,000 in her retirement portfolio. According to actuarial tables from the Social Security Administration, she can be expected to live an additional 20 years. If she wanted to lock in a return [today’s Treasury yields] for that period by investing her $100,000 in Treasury securities of appropriate maturities, she could spend $578 a month ($6,941 a year) for the next 20 years ….

After 20 years, she would have no money left. Yet there is a significant probability that she will live for several additional years. In fact, there is a one-in-three chance that a woman aged 65 today will live until at least 90 ….

Fixed life annuities address this so-called longevity risk. If this same woman bought a $100,000 fixed life annuity today, she could not only lock in a higher return ($619 a month, or $7,428 a year) but also have it guaranteed until death ….

Mark Hulbert, “Beyond the Longevity Tables”, New York Times, 10 October 2009.

This hypothetical annuity is a nominal annuity – one that pays $619 a month, regardless of price inflation. A modest 2% annual inflation causes the purchasing power of this annuity to fall to $413 in 20 years. With 10% inflation, it would fall to $75. Full protection from the risk of falling into poverty requires indexed annuities, with periodic adjustments for changes in the cost of living. Inflation-adjusted annuities have low initial payments, so are not popular with consumers. Most public – and some private – pensions are adjusted for price or wage inflation, so can be thought of as indexed annuities.

Rather than purchase a nominal annuity, it might be better for a person to invest in indexed government bonds. These are issued by a number of governments, including the United Kingdom, Canada and, most recently, the United States. Indexed bonds do not provide longevity insurance, but they do guarantee that inflation will not erode the value of one’s savings. Inflation, arguably, is a greater risk than longevity for retirees. I have never understood why financial planners focus on the risk of longevity yet almost always ignore inflation risk.

Mark Hulbert is editor of The Hulbert Financial Digest. He writes regular columns on MarketWatch, a bi-weekly column for the New York Times and a quarterly column for the Journal of the American Association of Individual Investors.

For a humorous look at financial planning, see this post.

For a serious look at financial planning, go to a series of 3-minute webcasts recorded by Professor Zvi Bodie of the Boston University School of Management. I did not watch all of them, but was impressed with those I viewed. They are very informative and easy to understand. I also agree fully with the advice given. Professor Bodie does not ignore the dangers of inflation.

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2 Responses to “life annuities and inflation”

  1. Michael Littlewood says:

    I fear it’s a little more complicated than you indicate in your comments.

    Let’s assume I can find a provider who will sell me a perfectly priced inflation-linked annuity – impossible in most markets but bear with me for the sake of the example. I will obviously get less each year (at the beginning) than a similarly perfectly priced fixed annuity or, for that matter a perfectly priced term annuity.

    The important point is that all three will have exactly the same present value (the price I have to pay at the outset).

    Now the fun begins – the annual amount payable for a given purchase price is a function of:
    – The investment income the provider will earn on the capital;
    – The provider’s upfront and ongoing expenses;
    – The provider’s profit;
    – Mortality (except for the fixed term annuity, assuming it is not capitalised on early death);
    – Inflation, in the case of the inflation-proofed annuity.

    The guesses the provider makes about all of these things will be wrong – some in one direction; others in the other and the provider hopes it will all turn out OK. To increase the chances of that happening, the provider will probably pick a guess at the pessimistic end of the possibilities in each case. But that doesn’t affect the principal point. Of the available alternatives, the only way of increasing the annual amount payable is to reduce the value of the uncertainties faced by the provider. Again, however, that doesn’t change the point that the present value at purchase will be the same.

    I can actually help reduce the discount that derives from the application of the uncertainties. Given the probably pessimistic guess the provider will make about the cost of inflation proofing, and given a choice, I would probably pick a nominal annuity and recognise that the real value of that will diminish over my retirement; probably OK as my retirement expenses will usually be front-loaded (more at the beginning – less at the end). On the same logic, I should probably prefer a term annuity rather than a life annuity but on this, given the rest of my assets, I am probably prepared to pay more than I have to for both longevity insurance and also for insurance against the possibility that investment income will be less than expected.

    I agree that an inflation-proofed annuity will often (not always) be a preferable alternative to a fixed one but, given the risks involved, we will probably have to look to governments to provide the service, at market prices. Only governments can afford to take on the risk of insuring against unexpected inflation and, given governments have as one of their responsibilities, keeping inflation under control, there is some symmetry in that.

  2. Larry Willmore says:

    Michael,

    I agree that life annuities – indexed life annuities in particular – tend to be poor value, for the reasons you cite. Given multiple uncertainties, financial institutions tend to assume the worst when they price annuities. So, what is the consumer to do?

    First, it is absolutely essential for government to provide all citizens with an indexed pension, adequate at least to keep the elderly out of poverty. I think you would agree with me on this point. Shockingly, nearly all governments – even governments of affluent countries – fail to do this.

    From the perspective of the individual, you advise purchase of a nominal annuity, which is better value than an indexed annuity. You claim this provides insurance against both longevity (outliving one’s savings) and investment risk (because today’s yields are locked in).

    A nominal annuity provides insurance only to the extent that inflation remains low, or at least does not increase. If there is a surge of inflation, even modestly from, say 2% a year to 10% a year, the value of the annuity will quickly plummet. So much for insurance against longevity and so much for protection from investment risk!

    For this reason, I recommended purchase of indexed government bonds, to lock in today’s rates, but today’s real rates – not the nominal rates. Unfortunately, few governments sell such bonds. This is a disgrace, a disgrace almost as great as the failure to provide basic, indexed pensions to everyone. Absent capital controls, a citizen can always purchase the bonds of a foreign government, such as the US, Canada or the UK. This solution is not an ideal, since exchange rates fluctuate. But at least there is some protection against inflation, inadequate as it might be. Having lived most of my adult life in Latin America, I am exceptionally concerned with price inflation which, to my mind, is more likely than longevity to be the cause of poverty in old age.

    The actual decision – between purchase of nominal annuity and purchase of indexed bonds – depends on one’s country of residence, and on the extent to which basic needs are met with an indexed government pension. The investment choice of a resident of Argentina, for example, will no doubt differ from that of a resident of New Zealand.