Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 5 – What about Inflation?

In the previous lesson, I showed you a quick and dirty method for estimating the lump sum you would need in order to finance a comfortable retirement. The method we used was to determine the purchase price of an immediate fixed annuity that would provide you with the periodic payments you desire. The problem with this calculation and, indeed, the problem with immediate fixed annuities is that we’ve completely ignored the problem of inflation.

So what about an inflation-adjusted annuity? This refers to an annuity which pays the indicated amount in the first month and then adjusts the payment in subsequent periods for increases in the Consumer Price Index (CPI). There are a couple of problems. First, very few insurance companies offer this option. Second, they cost anywhere from 30% to 70% more than a traditional fixed annuity, depending on the expected remaining life of the purchaser(s). Our 70-year-old Tampa resident who could have purchased a straight annuity for $154,183 would have needed $211,143, according to my rough calculation, to have payments that adjusted for inflation, a 37% increase. Our 65-year-old couple in San Diego would have to go from $801,912 to $1,197,129, an increase of 49%. (Sorry, the information I used to estimate the cost of inflation-adjusted annuities is not as readily available online. You can get a rough idea by comparing the annuities of the Principal Financial Group with and without the inflation protection rider here. Other insurance companies should show a similar relationship between the two.)

In the last lesson, however, I indicated that the lower cost annuity should be sufficient to buy inflation protection. How so? Well, consider that the insurance company must have a reasonably reliable way to make more money than it is promising to pay to the annuity purchaser. This involves, of course, investing a large portion of the premium received in growth investments. But if purchasers are willing to take on some of the volatility from the insurance company, they may be able to share in that growth. This can be achieved through an immediate variable annuity. Such an annuity can guarantee payments for life, but with the amount of each payment varying based on the performance of the underlying investments.

Let me explain how these work. (Once again, I am not recommending these.) Instead of purchasing a fixed annuity, let’s take a look at what our Tampa widow could purchase from American General. She wants $1,007 in the first month and chooses a 3.5% Assumed Investment Return (AIR). This means that her income will remain the same if she is earning exactly 3.5% per annum on the underlying investments in her account, but will go up or down to the extent that the account earns a higher or lower return. Such an annuity would have cost her $155,317 at the time I ran the numbers, which is virtually identical to the cost of the fixed annuity.

But this version can grow with inflation: 3.5% is an extremely modest rate, and even a conservative portfolio can be expected to do better over time. But we’re trying to cover inflation, so she’d have to invest the funds aggressively enough to earn 3.5% plus inflation. And how does she manage that? Next lesson.