Buying an Annuity During Times of Inflation

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Inflation can throw a wrench into retirement plans. That’s because, over the long term, inflation erodes your income’s purchasing power. So even if you save and invest, your wealth may buy less and less with time.

Commercial annuities often pay a fixed monthly income. This fixed amount is susceptible to inflation. But if annuities are susceptible to eroded purchasing power, does that make them a poor retirement vehicle during inflationary times?

Understanding How Annuities Work

An annuity is a financial product sold by insurance companies. It provides income payments to an individual in exchange for a lump sum payment. Some annuities require a series of payments. Then, the insurance company invests the money you have paid.

You usually don’t receive payments from your annuity immediately. Stage one of an annuity is called accumulation. This is when you deposit the money into the annuity. Then, the account is annuitized at a point specified in your contract. This is when the money becomes the insurers. At this point, the insurer starts making payments to you.

Although this sounds simple, there are different types of annuities with different goals and nuances.

Types of Annuities

Although there are variations to these, there are three types of annuities: fixed annuity, variable annuity, and fixed-indexed annuity.

The fixed annuity has a guaranteed minimum rate of return. Your interest will not drop below that minimum rate during your initial contract term.

A variable annuity lets you choose sub-accounts in which your premium is placed. The sub-accounts each have different investments with different risk profiles. Your rate of return is determined by how well the investments perform. So, if they perform well, your rate goes up, but if they don’t perform, the rate goes down. You could even lose money.

The fixed-indexed annuity is the best of both worlds. It offers a fixed minimum interest rate. But you can also choose a market index to follow. Since your rate is tied to that index, if it rises, you benefit. But even if it falls, you will never go below the minimum rate.

Are Annuities Safe in a Recession？

The various annuities have different risks during a recession.

Variable annuities are a little more at risk during a recession, depending on what types of investments they are linked to. If the annuity is linked to a market sector that is not performing, the annuity can lose money. For example, stocks tend to be more volatile. Bonds are perceived as safer and may not change during a recession. It all depends on how aggressive you were when choosing sub-accounts.

Because of the fixed annuity’s guaranteed growth at a steady rate, they can protect you against adverse financial effects during a recession. A fixed annuity isn’t tied to market performance. So, they are therefore a low-risk option.

Fixed-indexed annuities are a mixed bag. They are partially tied to market performance. But because they have a guaranteed minimum rate, they can still have some growth during a recession.

Guaranteed Lifetime Income Rider

Some individuals opt for a guaranteed lifetime income rider. This option functions like a pension, and it is guaranteed for a retiree’s life.

This option is typically available for fixed indexed and variable annuities. The annuity still earns interest while the policyholder receives income. But does this guarantee income keep pace with inflation?

Can Annuities Keep Up With Inflation？

The one main benefit of an annuity is that it can provide you with a steady income stream. But they also can offer some protection against inflation.

A policyholder can choose a “level” income or an “increasing” income amount. The level income amount remains the same. It doesn’t increase or decrease. But an increasing income option is usually tied to the Consumer Price Index (CPI). As a result, it will increase at the CPI’s rate.

Because the level income option doesn’t increase with an index like the CPI, it won’t keep up with inflation. Inflation will erode your purchasing power.

But the effects of inflation are offset by the increasing option. It may even exceed the inflation rate.

Annuities That Hedge Against Inflation

Variable annuities and fixed index annuities with lifetime income riders can offer protection against inflation.

With a fixed-index annuity, you'll be able to earn a higher rate of return than a fixed annuity. And with the fixed-index annuity, you won’t risk losing your principal investment. This is because earnings are based on the performance of an underlying index, such as the S&P 500 Index. There is also a guaranteed minimum rate. You also can defer your income payments later or receive them immediately.

A variable annuity with a lifetime income rider can potentially grow your investment. The investment grows while you are receiving a guaranteed lifelong income. But your income payments are based on the performance of underlying investments. Investments could include stocks, bonds, and mutual funds. They offer protection against inflation, but are riskier. There isn’t a guaranteed minimum rate.

Annuities and Inflation

Annuities can help fend off inflation. But some options for fighting inflation incur risks. Talk to your financial advisor about annuities and whether they suit your retirement goals.

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