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Annuities with Fixed Cost of Living Adjustments Don’t Protect Against Inflation

A reader writes in, asking:

“I have been considering purchasing one of the “SPIA” annuities often recommended on Bogleheads. [Mike’s note: SPIA stands for single premium immediate annuity, and they are the most straightforward type of annuities — essentially just a pension that you purchase from an insurance company.]

I like the idea of inflation protection, but the ones linked to CPI are very expensive. What are your thoughts on buying one with an automatic 3% COLA [cost of living adjustment] every year as a compromise approach? It gives me some protection against inflation but not perfect protection.”

In short, I’m not a fan of annuities that use a fixed cost of living adjustment (rather than actually having the payout tied to the consumer price index) as a way to protect against inflation. The reason is that, as it turns out, they don’t actually protect against inflation! They just protect against a long life.

Let’s look at an example.

As of this writing the Income Solutions website (which I access via Vanguard) shows that a 65 year old male can get a fixed lifetime annuity paying 6.83%. Or, he can purchase an annuity with a 3% annual increase in the payout, with a payout that starts at 5.02%.* And, according to the SSA’s most recent period life table, a 65 year old male has a total life expectancy of nearly 83 years.

So, if the person buys $100,000-worth of each annuity, and there is no inflation over the person’s lifetime, then:

  • The fixed lifetime annuity will pay a total of $129,770 over the person’s expected lifetime, whereas
  • The annuity with the 3% COLA will pay a total of $126,087 (i.e., 97.2% as much as the annuity without the COLA) over the person’s expected lifetime.

But what if there is inflation? That’s what we really care about, after all.

If we assume annual inflation of 2% and we do the analysis in inflation-adjusted dollars:

  • The fixed lifetime annuity will pay a total of $108,859 over the person’s expected lifetime, whereas
  • The annuity with the 3% COLA will pay a total of $103,896 (i.e., 95.4% as much as the annuity without the COLA) over the person’s expected lifetime.

So in the scenario with higher inflation, the annuity with the COLA performs worse. (That is, it underperforms the non-COLA annuity by a greater amount than in the no-inflation scenario.)

But is that just a fluke? The table below shows other scenarios, with various ages at death along the left-hand side, and various rates of inflation along the top. The value in each cell shows the ratio of total inflation-adjusted dollars paid by the annuity with the COLA to total inflation-adjusted dollars paid by the annuity without the COLA.

So, for example, if the person lives to age 88 and there is 4% inflation over that period, the annuity with the COLA will have paid 99.5% as much as the annuity without the COLA.

0% inflation 2% inflation 3% inflation 4% inflation 5% inflation
73 83.0% 82.6% 82.5% 82.3% 82.1%
78 89.7% 88.8% 88.4% 88.0% 87.5%
83 97.2% 95.4% 94.6% 93.7% 92.9%
88 105.4% 102.5% 101.0% 99.5% 98.1%
93 114.6% 109.9% 107.6% 105.4% 103.2%

The key point here is that, the higher inflation is over this person’s lifetime, the worse the annuity with the COLA does as compared to the annuity without the COLA.

Why is this? It’s because the annuity with the COLA has a greater portion of its payout occurring later in the annuitant’s life (due to the fact that its payout starts lower, but climbs over time). And in a scenario in which dollars are declining in value over time due to inflation, the annuity that front-loads the payout (i.e., the annuity without the COLA) does better.

My point here isn’t that the COLA annuities are a bad idea. As you’ll notice, they do a better job of protecting against longevity than annuities without COLAs. (That is, the longer the lifetime, the better they perform.)

But annuities with fixed cost of living adjustments do not protect against inflation. Not only do they not keep up with high rates of inflation, they actually perform worse in the face of inflation than annuities without COLAs. If you want an annuity that provides true inflation protection, you have to buy one with payments that are tied to the actual rate of inflation.

*The payouts for females are slightly lower given longer life expectancies (6.35% for a fixed lifetime annuity and 4.58% for one with a 3% annual increase), but the analysis is essentially the same.

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