Fixed Annuity COLAs Fail Against Inflation

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While cost of living adjustments (COLAs) with single-premium immediate income annuities (SPIAs) are uncommon, they are often discussed as a way to provide inflation protection for retirees. But nominal COLAs with SPIAs can actually increase inflation risk because they place a greater strain on the portfolio earlier in retirement (due to the lower initial payout) and are less likely to result in more income in higher inflationary environments, especially if the retirement portfolio is designed with some degree inflation hedging. Therefore, while fixed COLAs seem like an attractive way to address inflation in retirement, they actually increase inflation risk, not reduce it.

Fixed COLAs

A fixed COLA provides a predetermined increase in the income benefit of an annuity for the life of the contract. For example, with a 2% COLA, if the initial income benefit (in the first year, assuming annual payment frequency) was $10,000, the next year it would increase by 2% to $10,200, and then that benefit to $10,404 and so on (i.e., 2% per year for life). The adjustment typically compounds over time, which results in a benefit that can increase significantly at older ages, but also means a lower starting benefit, as noted in the following exhibit, which includes the income benefits based on two quotes obtained from CANNEX on October 14, 2023, for a 65-year-old male life-only SPIA.