What Advisors Miss When it Comes to Inflation and Annuities

The annuity purchase decision

Annuities are unpopular among retirees in the United States. There is a myriad of explanations for this effect and hopefully retirees and financial advisors will increasingly recognize the value of annuities and demand will increase.

While the decision to annuitize is more valuable than the precise method of annuitization (e.g., a SPIA versus a DIA), it is nevertheless important to be aware of the various considerations when making the purchase decision.

One such consideration is the extent payments account for future inflation. As previously noted, a real annuity is generally described as the ideal product for a retiree since it not only provides guaranteed income for life, but it also offers payments linked to inflation. This structure was built to help ensure that a retiree will not only have income for as long as he or she (or they) survives in retirement, but also have an income stream that is directly linked to changes in future expenses (i.e., moves with inflation).

While a real annuity explicitly considers inflation, an alternative approach to implicitly account for inflation is to purchase an annuity that includes a fixed COLA. With a fixed COLA, future annuity payments will increase by some pre-determined (fixed) percentage as long as the annuitant (or annuitants) survive. This approach only implicitly accounts for inflation because it subjects the retiree to the risk of inflation that is greater than the COLA adjustments. For example, if the retiree purchases an annuity with a 2% fixed COLA, benefits will increase 2% per year. If inflation ends up being exactly 2% a year (which is unlikely) the fixed COLA is a decent hedge. If inflation ends up averaging 4%, the inflation-adjusted income will decrease considerably over time.

Selecting the optimal annuity payout structure (i.e., with or without a COLA, and if with a COLA, which type) depends on a variety of factors such as the composition of the retiree’s wealth, spending goals, levels of risk aversion, etc. Some retirees may not need a COLA given their expected retirement needs. Regardless, though, a financial advisor should provide context around the pricing differences of different types of annuities.

To provide some perspective on pricing differences, I obtained life-only SPIA quotes for a 65-year old female from CANNEX on July 8, 2019, assuming a premium of $100,000 and annual payments that commence one month from purchase date. Three sets of quotes were run, one for nominal benefits (no COLA), one with a 3% fixed COLA, and one with a CPI-U COLA.

CANNEX Quotes for a 65-Year-Old Female

	Nominal
	(No COLA)	3% COLA	CPI-U COLA
Average	$5,810	$4,056	$3,953
High	$6,080	$4,264	$3,953
Low	$5,583	$3,854	$3,953
Std Dev	$139	$100	n/a
# of Quotes	21	15	1

Not surprisingly, the nominal SPIA had the highest average annual payment at $5,810. This is 43% higher than the 3% fixed COLA average payment ($4,056) and 47% higher than the CPI-linked COLA payment ($3,953). The higher payment for the nominal SPIA versus the COLA-linked SPIA can be attributed to the fact benefits are constant for life (i.e., are likely to decrease in real terms). This subjects the annuitant to significant inflation risk even if inflation is relatively mild, since benefits remain constant over the life of the annuitant.

If the retiree wants payments to grow in the future, she could purchase the 3% fixed COLA (or some other fixed COLA increase rate), which implicitly accounts for inflation, or the CPI-U linked COLA, which explicitly accounts for inflation. The 3% rate is higher than the expected inflation rate (e.g., 20-year expected inflation is 1.89% as of June 1, 2019, according to the Federal Reserve Bank of Cleveland²). However, she would still be subject to inflation risk (i.e., if inflation exceeds 3%, income would decline in real terms).

While 20-year forecast inflation is estimated to be 2%, it’s averaged about 3% historically in the U.S. and there have been 20-year periods where it’s exceeded 5%, on average. The higher the expected inflation and the more risk-averse a retiree is to inflation, the more benefit he or she (or they) will derive from a real annuity.

COLA usage

Let’s look at the popularity of the various COLAs today. To do this, I reviewed annual reports complied by CANNEX on annuity quotes. Roughly 98% of CANNEX quotes come from some type of intermediary sales channel according to a 2016 CANNEX report.³ Reports from 2011 to 2018 are available, and information on COLA utilization is included in the table below.

Annuity Quotes With and Without a Cost Living Adjustments (COLAs)

% of Total
	2011	2012	2013	2014	2015	2016	2017	2018	Avg
no COLA	95.6%	96.6%	96.7%	92.6%	92.9%	93.2%	92.7%	95.7%	94.5%
with COLA	4.4%	3.4%	3.3%	7.5%	7.1%	6.9%	7.4%	4.3%	5.5%
% of Total (COLA Types)
	2011	2012	2013	2014	2015	2016	2017	2018	Avg
CPI-U	1.1%	0.8%	0.7%	0.6%	0.6%	0.6%	0.8%	0.2%	0.7%
Up to 1%	0.1%	0.1%	0.1%	0.5%	0.5%	0.6%	0.7%	0.5%	0.4%
> 1%, up to 2%	0.5%	0.4%	0.5%	3.9%	3.8%	3.1%	2.7%	2.0%	2.1%
> 2%, up to 3%	1.9%	1.5%	1.6%	2.1%	1.8%	2.1%	2.5%	1.4%	1.8%
> 3%	0.8%	0.6%	0.4%	0.4%	0.4%	0.5%	0.6%	0.3%	0.5%
% of COLA Types
	2011	2012	2013	2014	2015	2016	2017	2018	Avg
CPI-U	25.9%	24.0%	21.3%	7.6%	8.8%	8.6%	10.9%	4.0%	12.3%
Up to 1%	2.3%	2.1%	3.3%	6.1%	6.9%	9.4%	10.0%	11.9%	7.0%
> 1%, up to 2%	12.1%	12.3%	16.1%	53.1%	53.4%	44.6%	37.4%	45.7%	38.5%
> 2%, up to 3%	42.6%	44.6%	47.7%	28.1%	25.4%	30.7%	33.9%	31.6%	33.6%
> 3%	17.2%	17.0%	11.6%	5.2%	5.5%	6.7%	7.8%	6.8%	8.6%

Historically, only about 5.5% of quotes included a COLA, with a minimum of 3.3% in 2013 and a maximum of 7.5% in 2015. There’s no discernable trend in the use of all COLAs over the period (i.e., there’s no evidence whether COLAs are becoming more or less popular); however, there was a notable decline in the popularity of CPI-U COLAs over the period, decreasing from 25.9% of all COLAs in 2011 to only 4.0% of all COLAs in 2018. It is not clear why this trend is occurring. The 2% fixed COLAs appear to be the most popular COLA, followed by 3% fixed COLAs.

Overall, these figures strongly suggest advisors aren’t considering COLAs when providing annuity quotes. This causes me to question whether their clients fully understand the implications of a pure nominal income benefit, especially over retirement periods that are continually lengthening. Even if we assume most retirees are better off with any type of COLA, the fact that only roughly 1 in 20 quotes include them would suggest retirees aren’t given the option to purchase an annuity with a COLA. That is alarming.

What gives with low COLA usage?

While the optimal approach used to incorporate inflation risk into annuity selection will vary by advisor (i.e., fixed COLA versus CPI-U COLA), the relatively low utilization of COLAs in general is shocking. Here are some potential reasons for this effect.

Including any type of COLA reduces the initial payment (potentially significantly). This was noted in actual quotes obtained from CANNEX, covered previously (which were approximately 45% lower). This reduction in benefits could be a significant behavioral barrier when it comes to including a COLA. The annuity decision is already a difficult one and getting as much income as possible likely eases the annuity purchase decision. Individuals are not very good at incorporating the value of future payment streams, so having more now is obviously appealing.

Inflation expectations have been relatively low over the period of analysis (2011 to 2018). The 20-year expected inflation rate ranged between 1.71% and 2.28% from January 2011 to December 2018 according to the Federal Reserve Bank of Cleveland⁴, which is a relatively tight spread and well below historical long-term averages. It could be that advisors and their clients are less concerned about inflation in the future.

Lastly, other client assets may exist to partially hedge inflation. The vast majority of Americans receive Social Security retirement benefits, or some other public pension, that is directly linked to inflation. This reduces the need for the annuity payments to grow with inflation, especially depending on the role of these annuitized monies when it comes to funding retirement consumption. Other assets, such as portfolios, real estate, etc., can mitigate inflation risks, but typically aren’t a perfect hedge.

What’s a financial advisor to do?

Modeling and discussing the implications of inflation is a critical component of a financial plan. Inflation can have a material impact on a retiree’s standard of living, especially given increasing life expectancies. The fact that relatively few annuity quotes provide any type of COLA is a point of concern. At a minimum, financial advisors should help clients understand the differences in payouts for different types of benefits (i.e., with and without a COLA) to make the most effective decision.

I’m not suggesting that all (or even most) annuities need to include a COLA. But retirees need information to make optimal decision. While the allure of higher initial income is a difficult behavioral obstacle when making the purchase decision, it is imperative advisors provide this information to clients to ensure the best decision is made.

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 Something I wrote here, a follow-up by Dirk Cotton and Zvi Bodie here, and another piece by Joe Tomlinson here

² ://www.clevelandfed.org/our-research/indicators-and-data/inflation-expectations.aspx

³ http://www.cannex.com/wp-content/uploads/2016/09/Income-Annuity-Buyer-Study-2016.pdf

⁴ https://www.clevelandfed.org/our-research/indicators-and-data/inflation-expectations.aspx

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