“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man,” Ronald Reagan once famously said.
And the worst time to try to fight this formidable foe is when you are in retirement, living on a fixed income. Many people have some employment, or some involvement with entrepreneurship, for a stream of retirement income.
But chances are they don’t offer wage increases, or other inflation-countering benefits that you might have had in your working years, to help you keep pace.
Annuities are one of the few ways to obtain retirement income that is paid out as long as you live, making them a popular component of many retirement plans.
But if the annuity payout is fixed at the outset of the contract, by design it can’t be increased to keep pace with inflation. Should inflation rise 10% over time, for example, the buying power of a $3,300 monthly annuity payout erodes to $2,970.
This threat has the potential to affect a retiree’s lifestyle and could even require making unwelcome cuts in spending.
Receive Annuity Payouts for Shorter Periods
Annuities offer fixed-income streams over a lifetime. But there are other options when choosing an annuity strategy to address inflation. Period-certain annuities offer payouts for a predetermined duration, for example for 5 or 10 years.
The timing of Medicare and Social Security benefits can make as much a difference as hundreds of thousands of dollars in retirement income. And if you have another guaranteed income source with a pension?
While it doesn’t matter with some pension plans, choosing to delay when you start pension payouts could help further maximize your lifetime income. Of course, that assumes you opted for an annuity pension option over a lump-sum option.
These delay strategies could pose a cash-flow challenge for someone retiring early. How do you bridge the income gap while delaying these benefits? This is where a fixed annuity with a period-certain payout can come in handy.
Say someone wishes to retire at 62, but to claim Social Security benefits at 70. With advanced income planning, the following scenario could help them come out on top:
1. Buy an annuity that, starting at 62, pays a fixed monthly amount that covers their cash-flow needs for eight years until they have maximized their Social Security benefits at 70.
This strategy would build an “income bridge” between when they retired and starting their benefits at 70. And while living expenses may go up, the short timespan means the retiree shouldn’t be too exposed to increased inflation risk.
Purchase Annuities in Phases
Another strategy to combat inflation is an annuity-laddering strategy. This is a process in which several annuities are purchased over time.
The annuity contracts have different maturation dates and time-frames for penalty. So, your financial professional would need to time the purchases so you wouldn’t have any adverse effects from ill-timed transactions.
Just like before, let’s say your income strategy includes an annuity with a period-certain payout, say for 5 years. This could provide you with an income stream that starts immediately.
Meanwhile, you might eventually put a bucket of money into another annuity, which would let your retirement dollars grow at a tax-advantaged, compounding rate for future income. It might also benefit from other features, like annuity bonuses, that help boost growth potential.
Then, at the end of the respective payout period, the new annuity replaces the other’s income stream. Depending on the interest-rate environment, the new annuity might offer higher payouts that keep pace with the new cost of living.
How Annuity Laddering Can Help Your Retirement
A laddering strategy can be beneficial in a number of ways:
- More flexibility with multiple annuity purchases instead of committing to one large lump-sum annuity purchase
- Gives some contracts more time to mature and rise in value so you can have more income later on
- Reduces the buying risk that possibly comes with just one annuity purchase
- If there are any gaps created by lower interest rates, income-value bonuses or other bump-ups in income payouts with a new annuity can help offset the gaps
This sort of strategy requires advanced planning. Make sure that you work with an experienced financial professional who guides in your best interest.
Incorporate Inflation-Adjusted Annuities
Another option is to use “inflation-adjusting annuities,” which are often fixed annuities with some sort of inflation-adjusting rider. Some experts in the annuity industry call these “real annuities” because of how they are designed to increase payouts relative to overall cost-of-living increases.
While these contracts have a place in income planning, they might not necessarily be the most advantageous solution for you. Why is that? Because the insurance carrier takes on the risk of inflation itself.
This is reflected in the payout amounts you receive.
An inflation-adjusting annuity payout will be smaller than a fixed annuity payout from its beginning. And from there, it could take years before your real annuity payout equals out to what a comparable, non-inflation-adjusting fixed annuity would give you.
As Steve Parrish, Co-Director of the Retirement Income Center at the American College for Financial Services, writes:
“Research by Morningstar’s director of retirement research, Dr. David Blanchett, suggests that real annuities are ‘a bad deal.’ The concern is that research suggests the cost of a real annuity is expensive compared to a fixed income annuity. You get a lot less for a monthly benefit to possibly get more in the future. It may take 12 to 20 years for the real annuity payout to equal what a comparable non-inflation adjusted fixed annuity would pay.”
Anticipate the Issue During Your Accumulation Years
If you are in your late 40s or 50s, there is a real advantage to planning for your retirement now. Why?
Because you can start planning for the future impact of inflation while in the accumulation stage of your financial life. With more time before you need to start collecting retirement income, you can pencil out what your retirement spending is truly likely to be.
How will you know what level of income you need to receive – and protect from inflation – until you know your estimated monthly outgo?
When creating realistic future retirement spending expectations, it helps to keep in mind the three stages of retirement. Perhaps you have heard of something like this before:
- Go-Go years, 60-75: Finally, the retirement you have dreamed of begins! You are feeling fit and exploring hobbies, travel, and adventures
- Slow-Go years, 75-90: With all the kids and grandkids grown and living their lives, selling the house and downsizing might be attractive
- No-Go years, 90+: Happy to greet each day, living a close-to-home or assisted lifestyle
If further guidance would be helpful, check out this article, which discusses some ways of how to think about these life stages in the scope of your retirement financial strategy.
Create an Early Strategy to Counter Inflation Risk
This planning strategy gives you an idea of not only how much money you will need. There is also the source of the funding (and its tax status) that the annuity will need so you meet the spending demands of your future lifestyle.
Your current financial strategy can be modified with these expectations set.
You might start putting aside money in another new bucket to reach the amount of funding needed. Or you might divert some of your current retirement savings into a new bucket for your annuity policy – for future income growth.
Leave Behind the Bells and Whistles
Think about when you shop around for a car. There are plenty of opportunities to add upgrades and features.
But they aren’t going to get you to your destination any better than if you had kept that money in your pocket. The same is true with annuities.
The cost of annuity bells and whistles takes away pennies out of every dollar of premium toward other features or benefits that might not be income-related. Consider looking into fixed-type annuities with simpler features, or even deferred income annuities, to fuel your retirement cash-flow.
Explore Deferred Income Annuities
Deferred income annuities offer some level of accumulation during the surrender period. Then they can provide simple streams of income for you later when you retire.
You give a lump-sum payment to an insurance company. In return, it provides a guaranteed lifetime income that begins at a preset future date.
The insurance carrier calculates the payout on current economic conditions and its prediction of future conditions. Because of this, there is a risk of inflation eroding the purchasing power of the payout.
The advantage of a deferred income annuity is that insurers aren’t obligated to pay additional contractual benefits. So, they can pay a much higher monthly benefit. With less “expense drag” for the insurance company before a deferred income annuity’s payout starts, a higher payout may be available.
This strategy can serve to offset any inflation risk associated with a fixed payout. The inflation risk is also minimized, since the selected age to begin payouts is often later in life.
Creating the Right Income Strategy for You
In today’s financial marketplace, there are more annuities than hedge funds available. You might benefit from the help of someone who can review your unique situation and show you the available options that are appropriate for you.
An experienced financial professional will be knowledgeable of inflation risk, not to mention other potential hazards to your retirement income. They can help you explore various potential solutions that help you maintain your ideal lifestyle.
If you are ready for personal guidance, financial professionals at SafeMoney.com stand ready to assist you. Use our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.