Using Fixed SPIAs and Investments to Create an Inflation-Adjusted Income Stream
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Considerable research argues that retirees benefit from creating guaranteed income streams through single-premium immediate annuities (SPIAs). The research finds higher success rates (not running out of money), along with higher average spending, higher minimum spending and greater utility with at least partial annuitization. I have referenced several papers that discuss this finding, and Pfau (2013) does a succinct and thorough literature review that covers the evolution of this topic.
This paper analyzes one aspect of this discussion – whether or not to use inflation-adjusted versus fixed SPIAs, and how a retiree can create inflation-adjusted income using fixed (nominal) SPIAs alongside an investment portfolio. Pfau (2013) finds that an efficient frontier for retirement income includes stocks and SPIAs, but not necessarily inflation-adjusted SPIAs, variable annuities (VAs) or bonds. Pfau states, “[F]ixed SPIAs dominate inflation-adjusted SPIAs in the retirement portfolio.” He references a comment by Joseph Tomlinson that “either because of a lack of competition or because of the difficulties of hedging inflation risks, inflation-adjusted SPIAs are not priced competitively with fixed SPIAs.”
One conclusion is that retirees who want inflation-adjusted income should purchase fixed SPIAs and “invest the difference” in order to protect against inflation by drawing down an investment portfolio as needed. My analysis tests that assertion. I consider various return and inflation paths to determine an appropriate asset allocation that would enable annual inflation adjustments for fixed SPIAs. I find that if retirees are willing to accept some probability of failure – perhaps less than 10% – they can create their own inflation adjustment and leave additional funds for liquidity needs or a legacy. However, risk-averse retirees who choose to use SPIAs may decide that inflation-adjusted SPIAs are worth the additional cost for their guaranteed inflation adjustments.
Methodology and assumptions
I start by looking at current payout rates for a 65-year-old married couple for a 100% joint and survivor SPIA. These rates are based on the current average quote provided by Vanguard Annuity Access powered by Income Solutions (quotes provided based on payment start date of April 1, 2016). Based on a hypothetical $100,000 deposit, the couple could get $3,884 per year from the inflation-adjusted SPIA. Alternatively, they could choose to use only $69,670 to purchase a $3,884 fixed SPIA, which had an average payout rate of 5.575%. If the fixed SPIA option were chosen, it would free up $30,330 to be invested separately.
I want to determine how this $30,330 could be invested among stocks and bonds in order to make up for the lack of annual inflation adjustment in the fixed SPIA. In order to analyze this, I ran a bootstrapped simulation that created 10,000 different return streams of stocks, bonds and inflation.