Inflation-Linked SPIAs Are a Bad Deal

May 20, 2019

by David Blanchett
I recently traded emails with someone who is provably smarter than me. He was very interested in
buying a single-premium immediate annuity (SPIA) with payments linked to inflation, which is also
called a real annuity. In the finance literature, real annuities are often depicted as perfect for a retiree.

But after obtaining some quotes and running an analysis, I concluded the idea was “nuts.” I’ll explain.

I’m not against annuities. I’m generally a fan of guaranteed income for retirees. Guaranteed income
can significantly simplify the incredibly complex retirement income decision process and ensures1 a
retiree always has some minimum level of lifetime income. Most retirees would be better off with more
guaranteed income.

I’m all for linking annuity payments to inflation, in theory. An annuity with benefits linked to inflation has
been talked about lovingly by retirement researchers for decades. It’s the Holy Grail to help mitigate
retirement consumption risk.

The problem with real annuities is the inflation cost of living adjustment is super expensive relative to
plain vanilla nominal annuities and those with a fixed increase (e.g., 2% per year). You can overpay for
anything, and at current prices people are overpaying for inflation protection. In other words, my
criticism is about market realities, not about theory. Let’s dig in.

Annuity payouts

To explore payouts for annuities, I pulled some quotes from CANNEX on April 28, 2019. The annuitant
was assumed to be a 65-year-old male buying a $100,000 annuity with annual payments that begin
immediately, and no period-certain or cash-refund rider. (A period-certain rider limits the payout period,
usually to between 10 and 20 years, while a refund rider pays a beneficiary the difference between
what was paid in and paid out to the annuitant.) Only about 25% of annuities purchased are life-only,
but focusing on life-only benefits simplifies modeling.

I obtained three sets of quotes for SPIAs: a nominal annuity (where payments are constant for life); an
annuity with a 2% fixed annual compound cost-of-living adjustment (or COLA, meaning the payment
increases by 2% per year); and a real annuity (where benefits are linked to inflation, defined as the
Consumer Price Index for All Urban Consumers, CPI-U). You can see how the payments differ for the
three annuities in the charts below. The payments for the real annuity are based on expected inflation,

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but the actual future payments are obviously uncertain.

For the nominal annuity, there were 21 companies offering quotes from ranging from $6,113 to
$6,643. This is a reasonably tight spread, where the best quote is only 5.73% larger than the smallest.2

For the 2% fixed COLA annuity there were 14 companies offering quotes ranging from $4,866 to
$5,168.

For the real annuity there was only one company offering a quote with a payout of $4,449. The same
insurance company offering the real annuity also offered quotes at $6,244 for the nominal annuity and
$5,030 for the 2% fixed COLA. Neither of these quotes was the best for the respective annuity type,
but I mention it here and include the insurer in the analysis for reference purposes.

We would expect the real annuity payout to be lower than the nominal annuity payout, since the
payments will increase with inflation. What is surprising is that the real annuity pays out significantly
less than the best 2% fixed COLA annuity quote (where the payout rate is 16.16% higher). This
suggests the real annuity isn’t a good deal, but it’s worth running some numbers to quantify the exact
costs.

The value of an annuity

To determine the value of an annuity, I calculated the mortality-weighted net present value for each
type (nominal, 2% fixed COLA and real). I used mortality rates from the Society of Actuaries 2012
Immediate Annuity Mortality table with improvement to 2019, discount rates based on the Treasury
High Quality Market (HQM) Corporate Bond yield curve (as of March 2019), and expected inflation

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from the Cleveland Federal Reserve (as of April 2019).

In the Exhibit below I provide an example of how the calculations work for the nominal annuity at five-
year intervals.

The 20th payment, at age 84, would be $1. The payment is nominal, so it does not increase at all (i.e.,
it shrinks in purchasing power over time). There is a 66.9% probability that the annuitant survives to
age 84 (column D). This means an insurance company would only need to set aside $0.669 for each
$1 of expected payments (assuming a large pool of annuitants) for that age. Given a discount rate of
4.37% (column E), which I assume can be invested in zero coupon bonds for 19 years,3 the $0.669 is

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reduced to $0.296 when you factor in assumed investment returns. If we add up all the nominal factors
(column F), to age 120, the total factor for the nominal annuity ends up at 14.55.

I performed the same calculations for the 2% fixed COLA (where the payments in column C increase
by 2% per year) and the real annuity (where payments increase by cumulative expected inflation), and
got total factors of 17.79 and 17.56, respectively. The 2% fixed COLA has a slightly higher factor than
the real annuity because expected inflation is less than 2% until the 25th payment.

Next, I multiplied the specific annuity-type factors by the actual payouts available to estimate the
expected “value” of the various annuities. The value is the expected benefit the annuitant will receive
from buying the annuity (the higher the value, the better). Subtracting the value from the cost of the
annuity ($100,000 in this case) gives us an estimate of the “implied load” of the respective products.
The implied load is the average expected loss that is being incurred by the annuitant when purchasing
the annuity (the higher the cost/implied load, the worse for the annuitant). Those calculations are
below.

The least implied load is for the best nominal annuity payout, at $5,937. As a reminder this was also
the most competitively priced annuity, with 21 companies providing quotes. The implied load is greater
for the best 2% fixed COLA annuity at $8,060 but is still significantly less than the implied load for the
real annuity (at $21,851). The implied load for the real annuity is 3.7 times that of the best nominal
payout and 2.7 times the best 2% fixed COLA payout.

Other considerations

The analysis suggests that purchasing an annuity with benefits linked to inflation is incredibly
expensive compared to either a nominal annuity or even one with a 2% fixed COLA payout. It’s
preferable to have income that is guaranteed to rise with inflation, but the cost of doing so is
significant.

Why is this? The COLA annuity costs a lot more than the nominal annuity because those increases
compound over time. The rate of increase is set, but longevity causes the insurer greater uncertainty.
The real annuity increases the uncertainty of future inflation increases. Insurers are not being unfair,

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but that doesn’t change the purchase reality for consumers.

The good news is that consumers might not need inflation protection as much as they think. Consider
a few reasons that mitigate the need for an annuity that is perfectly tied to inflation.

For most retirees, any annuity purchase will likely represent only a fraction of their total wealth;
therefore, the marginal impact of benefits potentially declining in real terms (if inflation ends up being a
big deal) won’t be catastrophic. For example, Social Security retirement benefits have a near-perfect
hedge to inflation (since they are linked to it). If you want inflation-linked income (or guaranteed income
in general) delaying Social Security retirement benefits is the best place to start (and probably the only
thing that academics of all stripes agree). Homeownership and financial assets (like stocks and bonds)
have been decent inflation hedges4, especially low-duration fixed income and Treasury Inflation-
Protected Securities (TIPS).

While research commonly assumes retiree spending increases lockstep with inflation, this doesn’t
track reality. Actual retiree spending tends to decrease in today’s dollars throughout retirement based
on research I’ve done. For example, if we assume base inflation is 3%, retiree spending might only rise
by 2%, on average, throughout retirement. Retiree spending is also pretty flexible and retirees typically
have the ability to adjust spending if need be.

Lastly, even if you’re convinced inflation is not being correctly priced in the real annuity, there are
other, cheaper ways to exploit the mispricing. For example, you could buy the nominal annuity and add
TIPS.

Conclusions

The higher the effective cost of any type of income guarantee, the less attractive the guarantee
becomes. My analysis shows the effective cost of a real annuity today is 3.7 times the nominal annuity
with the highest payout and 2.7 times an annuity with a 2% fixed COLAs with the highest payout.
While a retiree would still bear inflation risk with the 2% fixed COLA, this could be an acceptable risk
for the vast majority of retirees. Other assets directly or indirectly linked to inflation can fund retirement,
and an annuity usually constitutes a small portion of one’s retirement income.

Therefore, while an annuity with payments linked to inflation (i.e., a real annuity) sounds highly
attractive in theory, its cost is significant, and does not make sense for the vast majority of retirees.

David Blanchett, PhD, CFA, CFP® is the head of retirement research for Morningstar Investment
Management LLC.

Opinions expressed are as of the current date; such opinions are subject to change without notice.
Morningstar Investment Management LLC shall not be responsible for any trading decisions,
damages, or other losses resulting from, or related to, the information, data, analyses or opinions or
their use.

1 Based on the claims paying ability of the insurance company.

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2 The spread widens significantly when you look at deferred annuities and can easily exceed 20%.

3 Payments are at the beginning of the period, which is why it’s not 20 years.

4 Past performance does not guarantee future results!

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