The idea of dedicating a portion of your retirement savings to an annuity can be appealing. Imagine that at retirement you buy an annuity guaranteeing payments of $3000 per month for the rest of your life. This would bring some peace of mind. You could then use what is left of your retirement savings for extras.
The big problem that could upset this tranquil scene is inflation. If the first ten years of your retirement are like the period from 1973 to 1983 in Canada, the purchasing power of your $3000 per month will drop to only $1220 per month! Suddenly, the annuity is bringing much less peace of mind.
By not taking into account inflation, retirees with fixed-payment annuities are effectively overspending in the early part of their retirements, possibly without realizing it.
It is possible to get an annuity whose payments rise by some fixed percentage each year (at the cost of much lower starting payments), but this requires guessing at the rate of inflation. If inflation is higher than your guess for several years, the purchasing power of the annuity will still erode.
An ideal solution would be an inflation-indexed annuity. The idea is that each year, payments would rise with the Consumer-Price Index (CPI) the way that Canada Pension Plan payments do. However, my attempts to find an inflation-indexed annuity in Canada have come up dry so far. Perhaps insurance companies don’t want inflation risk any more than retirees do.