Income Annuities, Cost of Living Adjustments, and Inflation Protection
I'm often asked by customers whether they should buy additional inflation protection to guarantee the purchasing power of their annuities. Most of us have heard about Cost of Living Adjustments (so-called "COLAs") that can be added to an income annuity contract.
If you're wondering whether such a COLA rider is worth the cost, the answer may be yes, but only in specific situations. Most income annuity buyers would likely not benefit from buying a COLA. I'll tell you why, but first, let's review how a typical COLA rider works.
An introduction to COLAs
The term COLA (Cost of Living Adjustment) is used by insurance companies to refer to one of two types of annual increases in the monthly payment--
(a) A "level" percent increase. This is when the COLA percentage does not change for the duration of your contract. The most commonly selected percentage is a 3% per year adjustment, but you can select another rate of increase. Most companies permit level increases from 1% to 6% per year, though one carrier even permits 10% a year.
Most insurance companies increase your income on a COMPOUNDING basis. This means each year's monthly income level is increased by the fixed annual percentage, and this new higher number becomes the base for next year’s increase, and so on for each year of your contract.
A few companies offer you a choice of SIMPLE vs. COMPOUND increases. The simple increase method uses your first year's starting income level to determine each subsequent yearly increase. Your income always increases faster under the COMPOUNDING than under the SIMPLE method.
(b) A few companies also offer a true Bureau of Labor Statistics (‘BLS’) derived Consumer Price Index ('CPI') adjustment. This percentage is recalculated January 1st of each year. Your income can either increase or decrease for that year based on the government's reported change in the CPI index.
With the first kind of COLA increase, the “level” type, you at least know you will receive the rate of increase you paid for regardless of the percent change declared by the BLS. That is not true for a CPI based COLA. With that type your income is dependent on the government's calculation of the rate of inflation. A figure you may disagree with.
On the other hand, a CPI-based increase gives you unlimited upside adjustments if we encounter a hyper-inflationary period down the road, and that’s a very big “if”.
For your information, the average CPI increase reported by the BLS during the past 60 years is around 3.00%. This includes the hyper-inflation period of the late 1970's. You also need to know that with a CPI-indexed annuity your monthly income amount can decrease in years when the CPI goes negative. With a fixed level percent it always goes up, year after year.
One additional point about CPI-based COLAs
Many people believe the government systematically under reports the true rate of inflation in our economy. Besides the political incentives for having the public think inflation is "under control," the CPI has a salient impact on the costs of operating the government since all Social Security payments and Federal employee salaries (including the military) are pegged to this same CPI number.
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So if you bought a CPI-indexed annuity, your monthly payments would not necessarily keep up with "true" inflation. In fact, most of my clients who bought inflation protection opted for the level type simply because they did not want to rely on the government’s calculation to determine their annual percent increase.
COLAs reduce your payments in the earlier years
Regardless of which type of inflation protection you consider, your first year's monthly income is always reduced from what you otherwise would receive without the COLA/CPI. This happens because the insurance company must "make up" the difference between the potential income increases you receive in later years against the fixed amount of your initial premium. In other words, the COLA/CPI IS NOT A FREE BENEFIT. You are paying UP FRONT for increased income in the later years by giving up income in the earlier years.
So, you’re probably wondering whether it’s worth giving up income in the earlier years to receive more income in the later years. To answer this question objectively you'll need to consider it from an actuary's point of view.
An Actuary's opinion on COLAs
In general, it takes an amount of time equal to half the number of years remaining in your life expectancy, for the monthly income level of an annuity with a COLA to reach the monthly income level of the same annuity without a COLA.
Think about this: Assume your life expectancy is twenty years and you selected a single life annuity. It would take ten years (half of your remaining life expectancy) for the annuity with the COLA rider to reach the monthly income level of that same annuity without a COLA option. Even after ten years, it takes the annuity with the COLA option another ten years (the remaining number of years in your original life expectancy when you bought the annuity) to make you whole with the same total dollar amount you would have received from the annuity without the COLA option.
More on the economics of COLAs
So the real question is, if adding a COLA rider makes sense to you emotionally, but it doesn't make economic sense, should you add a COLA to your annuity? Perhaps only if you are very very sure you’ll live past the life expectancy estimate an actuary calculates you’ll live. That’s because you will not break-even on the cost of the COLA rider until you at minimum reach your normal life expectancy.
Now if you selected a non-refund annuity (one that does not make any guarantees to a beneficiary), it's also possible that you may pass away before you reach that breakeven point. Remember, you must live AT LEAST as long as your normal life expectancy to just breakeven with a COLA rider. Otherwise buying a COLA does not make actuarial sense.
Do-it-yourself annuity inflation protection
Only a small number of my clients add a COLA to their annuities. They're the ones who believe they have longevity genes or that we're on the threshold of a long period of hyperinflation.
What do my other clients do about protecting their purchasing power? Some of them set aside money in inflation-linked assets. Think gold, silver, oil, or other natural resources stocks or funds. If there is a runaway inflation, those assets should increase in value much faster than the actual rate of inflation.
Theoretically, they will be able to buy much more annuity income with their fully-grown side funds when interest rates are also a lot higher than today. Plus, they’ll be many years older, which will further enhance the amount of monthly income they can buy at that time.
A COLA reality-check
Trouble is that anyone who followed the inflation protection approach I describe above has been sorely disappointed the past twenty years since interest rates continue to drop.
Also, any consumer who added a CPI-based COLA rider to their annuity in the last twenty years probably overpaid for that protection. Those riders were priced by the insurance companies to cover the risks of a much higher rate of inflation than actually occurred.
The bottom line is that the question of whether or not you should add a COLA to your annuity is very difficult to finesse. Even the experts have been wrong all along about the direction of interest rates and inflation.
More Coverage: US Bureau of Labor Statistics