EDITOR'S NOTE: This article was originally published in the August 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.
Immediate annuities are attractive because they promise a guaranteed level of income for life, no matter what happens to the stock market or interest rates. But your fixed payout will buy less when the cost of living rises.
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To combat that concern, several companies are starting to offer immediate annuities that increase the payout to keep up with inflation. Some raise payouts automatically by 3% or 5% a year. Others tie payouts to changes in the consumer price index. But this feature comes at a big cost: The payouts start much lower than they do with the fixed version.
For example, a 65-year-old couple who invests $100,000 in a New York Life joint-life immediate annuity could receive $7,219 a year for the rest of their lives. Or they could buy a version that increases payouts by 5% a year, but their first check would only be $4,293.
Michael Gallo, senior vice-president of retirement income for New York Life, says that because of this difference, most people buy the fixed payout. "They're concerned about income today," he says.
But the longer you live, the more you'll benefit from the rising payout. With a 5% increase, the annual payment would grow to $11,389 by age 85 and $18,552 by 95. Meanwhile, the fixed annuity will continue to pay only $7,219 a year.
Your first check will be a bit higher if you increase payments by 3% a year, which is closer to recent inflation figures. The 65-year-old couple would receive $5,368 in the first year, and the annual payment would grow to $9,695 by age 85 and $13,029 by 95.
Is the Inflation Adjustment Worth It?
It takes about ten years for the annual payout on the annuity with the 3% increase to reach the level of the fixed payout -- $7,219 in the above example. You'll come out ahead with the inflation rider if you live beyond your life expectancy -- perhaps in your mid eighties. If you buy a joint annuity, a 65-year-old couple has an 85% chance that one spouse will live to 85 and a 36% chance that one will live to 95.
The importance of the inflation protection also depends on how much your regular expenses will grow, whether you have other sources of inflation-adjusted lifetime income, such as a pension, and how much money you have invested elsewhere.
If you're considering an immediate annuity, first add up your essential expenses in retirement, such as your mortgage, food, insurance premiums and utilities. Then subtract guaranteed sources of income, such as Social Security and a pension. Consider buying an annuity to fill in any shortfall.
A fixed-payout annuity may be fine if your biggest expense is a 30-year fixed mortgage and most of your income is from an inflation-adjusted pension and Social Security. Your other investments could fill in any gaps. The adjustment is more valuable if most of your expenses rise with inflation and you don't have an inflation-adjusted pension.
If your expenses tend to rise at the same rate as inflation, you may want to consider an immediate annuity that adjusts with the consumer price index. These products are more expensive than the payouts that rise by a set percentage; the insurer must make complex investments to be able to guarantee the payout. "You need to have a hedge of some kind, which adds a cost to the product," says Bret Benham, president of TIAA-CREF's life insurance company, which only offers fixed-percentage riders.
Vanguard offers one of the lowest-cost versions of the CPI-adjusted annuity. A 65-year-old man investing $100,000 in an annuity could get an annual payout of $8,784 for life, or he'd start with $6,768 if the payments increase by 3% a year. If he bought an annuity adjusted for changes in the CPI, his initial payout would be $6,576. If you think inflation could rise by more than 3%, then the $192 initial difference is a small price to pay to know that your payouts will keep up with rising costs.
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