Inflation-Linked SPIAs Are a Bad Deal

I recently traded emails with someone who is probably 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 the perfect product/investment 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 provides guaranteed benefits for a certain period, usually to between 10 and 20 years, while a refund rider pays a beneficiary the difference between the annuity premium and the sum of payments received by the annuitant.) Only about 25% of annuities quoted on CANNEX 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 for each $1 of initial payments. The payments for the real annuity are based on expected inflation, 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 Annuity payouts are also often quoted in percentage terms, which is the annual payment divided by the premium. The nominal annuity with the highest benefit ($6,643) would therefore have a payout of 6.643% ($6,643/$100,000=6.643%).

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