Thursday, April 8, 2010

Annuities and Inflation

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.

6 comments:

  1. Is this what you're looking for? :-)

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  2. Patrick: I don't think so. If I understand what this is, its price would swing up and down as interest rates change. So, the investor looking for guaranteed payments with constant buying power wouldn't get it.

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  3. Hi Michael,

    The idea would be to buy a bunch of this fund, and live off the distributions. You don't touch the original investment, so you don't care about fluctuations in its market value. The average duration of the underlying bonds is about 16 years, so beyond that timescale, you're indifferent to interest rate fluctuations. The fund is paying about 2.5% right now (which makes its .35% MER seem a touch high).

    It would be handy if they reinvested the inflation portion of the bond interest, and distributed the coupon. Then you'd have pretty much what you were looking for. Unfortunately, they actually distribute both the inflation portion and the coupon portion. I think that means if you want to keep up with inflation, you'll need to continually buy additional units each year in proportion to the inflation rate (CPI).

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  4. I always thought that an annuity was designed to benefit the salesman, not the buyer.

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  5. Patrick: I see your idea. I'll have to take some time to read up on exactly how the fund works.

    Mark: Sadly, I think you're right in most cases. I'm trying to figure out if it is all cases.

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