Does buying an income annuity with an inflation rider make sense? And if so, what kind of rider is best? The short answer – inflation is a significant risk, but you’re probably better able to protect against it with other assets in your portfolio than you are with an inflation rider on your income annuity.
What An Inflation Rider Does & Doesn’t Do
An inflation rider provides valuable protection from the risk that the value of your lifetime income decreases over time. Rising inflation reduces the purchasing value per dollar. If you are considering using an income annuity to create a lifetime income stream, inflation can be a considerable risk.
Insurance companies allow you to purchase a rider to protect you against this risk – to some extent. There are three key things to keep in mind though:
- First, no company will protect you against inflation risk during the deferral period. If you’re purchasing an immediate income annuity, you don’t have to worry, but if you’re purchasing a deferred income annuity, this should be an important consideration.
- Second, unless you’re purchasing an inflation rider that is tied to an actual consumer price index, the payout will not go up in lockstep with actual inflation. Most companies have 1%, 2% or 3% inflation riders, but chances are annual inflation will never be exactly that amount. AIG is one of the only insurers that offers a “CPI” inflation rider, meaning it adjusts payouts based on what measured inflation actually is.
- Third, the insurers generally try to profit from riders and there’s a good amount of evidence indicating that inflation riders are not quite “actuarially fair.” We explore what that means below.
Implied Cost Of An Inflation Rider
To determine the value of the inflation rider, we charted the payouts available with and without inflation riders for a policy. The payouts allow us to determine approximately what rate of inflation the insurance companies are currently forecasting in their payouts.
The payout for the policy with CPI-U rider in this example provides a payout between the 2% inflation rider and 3% inflation rider option. The implied inflation rate for the CPI-U payout if we did a linear interpolation between the 2% and 3% amounts is approximately 2.75%.
No matter how you look at this, 2.75% implied inflation seems expensive. Why? Well, the Federal Reserve, the body that determines interest rates, targets a long-term inflation rate of 2.00%. And recent auctions of Treasury Inflation Protected Securities (TIPS) imply a 10YR breakeven inflation rate of 1.54%.
Our view? Foregoing monthly income on your annuity purchase to include an inflation rider is not cost effective given the current implied rate. Why not use your equity portfolio to hedge your inflation risk? Or maybe even buy TIPS? Rather than doing it with an annuity purchase, creating an inflation hedge through your market-based assets will almost always make more sense.
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