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Financial Planning Insurance Products

The Truth About Annuities and Inflation

While there is no annuity strategy that perfectly solves for inflation, specific types of annuities can lessen its sting.

by Stan Haithcock | March 2023

Those of you expecting fancy charts, backtested numbers, future projections and an equity-like mathematical analysis with this article will be disappointed. To my mind, those are all a colossal waste of time when it comes to annuity strategies. Annuities, regardless of type, are contractual guarantees between you and the life insurance company that issues the policy. Buying an annuity is like buying a plane ticket. You have to shop all carriers for the highest contractual guarantee for your specific situation and contractual goals. So, can annuities actually solve for inflation?

There are many types of annuities, and I always laugh when people talk about annuities as if one product type exists. When you hear people say that they “hate all annuities,” it’s like saying you hate all restaurants, all shoes or all trucks. Since inflation reared its ugly head again during the past two years, many people want to know if specific annuity types can actually solve for or combat inflation. Many agents and advisers might tell you that they have an annuity that perfectly addresses inflation. They do not. I always tell people that there are no perfect answers with annuities, just bad sales pitches. This statement holds true when it comes to inflation and the annuity category. Specific types can combat inflation, but none can perfectly solve for it.

Every single person who has a Social Security number already owns the best inflation annuity on the planet. It’s called Social Security. Yes, that is an income annuity issued by the U.S. government, and the increases to the income stream come from our friends in Congress who want to make sure Social Security recipients continue to vote for them. If you are a true annuity hater and don’t want to be labeled as a hypocrite, then contact your local Social Security office and decline the payments. The same thing applies to those of you who are fortunate enough to receive a pension. That is a lifetime annuity structure as well. It’s important to point out that the annuity category is the only financial strategy that can contractually guarantee an income stream for as long as you are breathing. Somehow the annuity industry hasn’t driven that fact home with consumers, and this marketing blunder will be studied for decades by business schools for a logical reason why.

So, let’s take a look at specific annuity types and how they actually can contractually work to address and combat inflation. Spoiler alert: Life insurance companies that issue annuities have the big buildings for a reason. They don’t give anything away. With that truth established, let’s dig into the brutal annuity facts that you need to know.

What Is an Annuity?

An annuity is a contract, purchased from a life insurance company, that provides for a set stream of payments or income for a set length of time, usually until the death of the annuity holder. Annuities are primarily used as a means of securing a steady cash flow during retirement.

See more financial terms defined at www.aaii.com/financial-term-dictionary.

SPIAs, DIAs and QLACs With COLAs

Single premium immediate annuities (SPIAs), deferred income annuities (DIAs) and qualified longevity annuity contracts (QLACs) allow you to attach a cost-of-living adjustment (COLA) at the time of application. You can choose a specific percentage amount that you would like the income to increase by every year for as long as you are breathing. Consumer price index (CPI) riders are currently not available for an attached increase to SPIAs, DIAs or QLACs, so COLAs are your only contractual choice for annual increasing income for as long as you live.

Most people choose a 2% or 3% annual increase to the contractual income stream. Before you get too excited, remember that there are no philanthropists at annuity carriers wanting to give things away to consumers. When you attach a COLA to a lifetime income stream annuity type, the annuity company significantly lowers the initial payout compared to the same annuity without a COLA attached. In some cases, the starting income amount can be lowered by 30% or more. Depending on your age, the breakeven point could be around six to nine years. Nothing is free in the annuity industry. Never forget that. The more “goodies and guarantees” you add to the policy, the lower the initial contractual guarantee. It’s really that simple.

Too many people think that with SPIAs, DIAs and QLACs, the insurance company keeps the money when you die. That’s called a “life only” structure, but it’s one of over 40 different ways to contractually structure your annuity payment. Most people choose a “life with cash refund” or “life with installment refund.” With these, the annuity company is contractually on the hook to pay as long as you are breathing but will never keep a penny of your premium under any circumstance. You can also structure the payment as “life with a period certain” to make sure your beneficiaries receive unused money.

In my opinion, it makes more sense to own an SPIA, DIA or QLAC without a COLA. I know that doesn’t fulfill the dream of increasing income to combat inflation, but it’s just not mathematically in your favor. I’m sure there are those of you reading this who can point to longevity within your family, but none of us can predict the future. There are “no U-Hauls behind hearses,” so I would recommend maximizing that income stream so you can enjoy it right now.

Multi-Year Guarantee Annuities

Multi-year guarantee annuities (MYGAs) are the annuity industry’s version of a certificate of deposit (CD). Don’t make your analysis any more difficult than that. It’s not an annuitized income strategy like an SPIA, DIA or QLAC. Rather, it’s a principal protection strategy. You lock in a guaranteed annual interest rate for a specific time period that you choose. Current durations offered can be as short as two years and as long as 10 years. MYGAs typically and historically offer the highest interest rates if your time frame is three years or more. If it is less than three years, you should probably buy CDs and/or Treasurys. It is really that simple.

MYGAs have no annual fees, no moving parts and the built-in commission to the agent is very small. Some MYGAs have liquidity provisions that allow you to take out money on a monthly or annual basis. That contractual liquidity can allow you to take out the interest, or a 5% or 10% free annual withdrawal. These liquidity features allow you to combat inflation by having the ability to take out money if needed. Most MYGA owners are choosing to protect the principal and just “peel off” the interest for additional income. At the time of this article, most durations contractually offered annual yields of over 5%. I list offerings for specific states on my website at www.stantheannuityman.com/myga-rates.

Multi-Year Guarantee Annuity Rates

Multi-year guarantee annuities (MYGAs) are the annuity industry’s version of a certificate of deposit (CD). The rates below are for the state of Illinois and are guaranteed for five years. Providers, rates and yields to surrender vary by state. Current rates can be found at www.stantheannuityman.com/myga-quote/quote-full.

Multi-Year Guarantee Annuity Rates, example IL 5 years

Source: Stan The Annuity Man. Data as of 2/1/2023.

Income Riders Attached to Indexed and Variable Annuities

If you attended an annuity bad chicken dinner seminar, you have probably heard the “too good to be true” sales pitch that your income stream increases when the accumulation value increases. As they say in Vegas, when you can’t pick out the sucker at the table … it’s you! Don’t be that person. If you go to one of these annuity food seminars, just swallow the food and not the sales pitch.

Just like with COLAs attached to SPIAs, DIAs and QLACs, any time there is a contractual or potential increase to the income stream, the annuity carrier will drastically lower the initial payment amount to make up for that future increase. Once again, the annuity company doesn’t give anything away. Don’t be swayed by a backtested number proposal or PowerPoint presentation. Make your decision solely on the contractual guarantees of the policy.

For full disclosure, I do not offer variable annuities because the income rider guarantees are historically higher with fixed index annuity income riders and the fees are drastically lower for these contractual guarantees as well.

Be careful with these income rider sales pitches because the non-guaranteed numbers you will be shown always look very attractive, but historically they have never materialized. Just remember that you should always own an annuity for what it will do, not what it might do. “What it will” do equates to the contractual guarantees of the policy. Don’t buy the dream, because you will always own the contractual realities of the policy.

An Overview of Different Types of Annuities

Deferred income annuity (DIA): Accumulates value on a tax-deferred basis with perhaps a guaranteed period for payments that could extend beyond the annuitant’s death. Can be exchanged, on a tax-free basis, for an immediate annuity once a given amount has accumulated.

Fixed index annuity (FIA): Returns-based and limited with an index call option and the guarantee that no losses will be incurred. These are fixed annuities, not variable, and should be compared with multi-year guarantee annuities.

Multi-year guarantee annuity (MYGA): Provides a guaranteed fixed interest rate for a specific time period from two years up to 10 years. These are similar to certificates of deposit (CDs) but pay higher interest rates and are not insured by the Federal Deposit Insurance Corp. (FDIC).

Qualified longevity annuity contract (QLAC): Eligible to be held in a 401(k) or an IRA. These annuity contracts provide a guaranteed lifetime income stream with payments deferred for as long as age 85 and can lessen the size of future required minimum distributions (RMDs).

Single premium immediate annuity (SPIA): The original annuity design. These annuities provide a pension-like lifetime income stream. Income is paid for the duration that the contract was set up for.

Variable annuity: Allows the investor to choose from a family of subaccounts that include geographic, sector and broad index stock funds, which can fluctuate in value. They also have a fixed account, which typically has a fixed interest rate that resets at certain intervals such as five years.

Laddering Income

An efficient way to address current and future inflation is to have income starting at different future dates. You can do this a couple of ways. The first strategy would be to buy multiple income annuities at the same time, each with different income start dates in the future. For example, you could buy an SPIA with income starting in one year, a DIA with income starting in two years, an income rider with income starting in five years and a QLAC (using IRA assets) with income starting at age 80 or 85.

The second strategy is what I call MYGA to SPIA. You buy different duration MYGAs (the annuity industry’s version of a CD, as I previously explained), and at the end the duration you transfer it (a nontaxable event) to the highest-paying SPIA available after shopping all carriers. For example, you would buy three-year, five-year and seven-year MYGAs that would be transferred to SPIAs at the end of each one’s duration. This is an efficient way to control the asset and have the option of not transferring the money to a SPIA if income is not needed or if your situation changes.

Gap-Filling Strategies

The best way to solve for inflation, in my opinion, is to fill in the income floor gap at the time that extra income is needed. In other words, keep your powder dry until you need income and then look for the highest contractually guaranteed SPIA income available after shopping all carriers. I always tell my clients to use as little money as possible to fund the annuity in order to achieve your specific contractual goals.

For example, you can run SPIA quotes to “reverse engineer” the quote to solve for the monthly income needed. You can also run that quote using a lump sum, but I really like the reverse-engineered strategy. So, if your specific inflation number rises, you simply reverse engineer another quote to fill in the needed income gap.

You can also purchase an SPIA that pays for a specific period of time. These are called “period certain” SPIAs and can be contractually structured for terms as short as five years and up to 20, 30 and 40 years of guaranteed payments. For example, this type of strategy is used for a person who wants income between age 60 and age 70 in order to bridge that income or inflation gap before they turn on their Social Security payments.

Inflation Solutions Are Personal and Customized

I recently read that over 60% of adults in the U.S. have less than $400 in their checking account, so let’s all put things in perspective when worrying about and trying to solve for inflation. Knowing there is no annuity product on the planet that perfectly solves for inflation, you are just trying to contractually eat into that specific dollar number you need.

Not only is inflation personal to all of us, but so are the numerous customization strategies of how you structure that specific annuity type. Since my two daughters are now out of the house, inflation hits such as gas (taking them to dance), milk, eggs, clothing, etc., do not apply to me like they do to a young family. The same type of specific annuity analysis applies to you as well. Stop listening to cable news and start sharpening your pencil. How are you really being affected by inflation? What’s the real number or income gap that you need to fill?

Annuities Are Commodity Products

If you are considering the purchase of any annuity type, remember that they are all commodity products. You need to shop all carriers for the highest contractual guarantee available for your specific situation. Don’t let an agent or adviser say that they have “found the best one.” The best one, in my opinion, is the carrier that provides the highest contractual guarantee. Obviously, carrier ratings and their claims-paying ability are part of the decision-making process, but it all starts with quoting for the highest contractual number.

Remember that SPIAs, DIAs, QLACs and income riders for lifetime income are primarily priced on your life expectancy with interest rates playing a secondary role. The older you are, the higher the payments, and vice versa. It’s the same analysis you make when deciding to turn on your Social Security annuity payments.

Annuity Inflation Reality

I know that threw a lot at you, so just remember that there is no specific annuity strategy that perfectly solves for inflation. No annuity carrier has figured out how to price that moving and unknown target. But understand that annuities can contractually combat and lessen the sting of inflation, whatever that means to you. 

Discussion

BARRY J from TX posted over 3 years ago:

I confess I did not read this article. As soon as I saw the words "truth" and "annuities" in the same sentence (the title), I knew I was being forewarned that this article's treatment of "the truth" was probably suspect. It implies that the topic of "annuities" has a reputation for not telling the truth from only one perspective. And this is certainly the historical record here. It is similar to when someone starts a sentence by saying "To tell you the truth, ..." you know the intent is anything but telling the truth from your perspective.


JOSEPH S from CA posted over 3 years ago:

I did read the article. He does a serviceable job of defining the 3 and 4 letter acronyms that are part of annuities. It does a service by using colloquial language to explain there is no free lunch, what trade-offs to look for. The article also leaves it to you as to whether these products solve a problem for you or not.


BERT M from AZ posted over 3 years ago:

Barry J: After I ACTUALLY READ the article it pretty much says what I have always thought about annuities. And explains the various types in easy to understand terms. As he says there are no free rides in the financial business, but certain types of annuities have a place in retirement planning. I once read the terms in variable rate index annuities and immediately dismissed them for their unachievable promises and complex language (as does the author). I found the article informative and worth the read.


RANDALL T from CA posted over 3 years ago:

I have had several conversations with the author over the past decade and have always found him to be very knowledgeable and logical in explaining the various types of annuities and the proper way to utilize them in sound financial planning. This an excellent article and well worth reading. Randy T


KEVIN V from NC posted over 3 years ago:

Article is worth the read, Barry. I read a contract for a recommended Variable annuity and all I saw were fees, so no go. But my question is about a QLAC. If purchased with 401k funds, that would reduce the 401k balance subject to RMDs. But aren't the payments from the annuity still taxed as regular income? It seems I forfeit flexibility, as I can always donate RMDs to achieve zero taxation if I do not need the funds. Also, if I need income as a SS bridge from 60-70, what does a SPIA accomplish outside of a guarantee against return sequence or market risk? After all, just withdrawing more from a 401k or brokerage for those 10 years would cost less than paying an insurer to be a middleman. I'm trying to understand what risk I am mitigating to transfer these decisions to an insurer.


RANDALL L from CA posted over 3 years ago:

To tell you the truth, Barry, I did not fully read your comment until AFTER I scanned the article as I find people from Texas are sometimes beset with beliefs that display prejudice and I wanted to get a sense of what this author was saying before reading more from a Texan. While I am not a fan of annuities this article did seem to be truthful (and even helpful) about some important aspects of annuities, at least for those interested in them. The article also pointed out the "no free lunch" aspect of life, including annuities, with reasonable balance. Still not a fan of annuities and particularly find some annuity sales people greedy and ignorant, but then I find some of every type of (sales) person greedy and ignorant - and we all have prejudices. Now I went back and read Barry response after scanning the entire article and find my prejudices remain. People from Texas ARE sometimes beset with beliefs that display prejudice and I am still not a fan of annuities, but Texas, and annuities, are loved by many people and both serve a purpose...so, to each their own and, sorry, Barry, but you should read before trashing, if you must trash, but since I started off my comment with "to tell you the truth..." I suspect you won't read this anyway.


JEFF S from MN posted over 3 years ago:

I think this was an useful discussion of annuities. I don't need them, but for those who do, this article helps provide some critical thinking about them. Thanks.


David H from CO posted over 3 years ago:

I wish it were possible to go back in time and allow all of today's prospective annuity buyers to have invested in equities instead. In the last three decades when the CPI went up 2.2 times, the cash dividend of the S&P 500 increased 5.3 times. I don't know a better way to "inflation-proof" your retirement income. I hope more people wake up and participate in the great American economy.


WAYNE W from WI posted over 3 years ago:

I have looked at many different annuity products and come to the same conclusion each time. I would not buy one, but I can understand why some of my friends have purchased them (and then regretted their decision.) My mom had annuities, and she sacrificed asset growth on the altar of "safety" even though she did not need to do that. Finally, I don't view Social Security in the same light as an insurance company annuity. I was not given a choice regarding SS. It was something I was forced to participate in. It is the only annuity I will ever own and it has performed very poorly, given how much I and my employers put into it. The one thing I can say for it is that it gives some people a false sense of security, even though that is in the name of the product.


CHARLES M from VA posted over 3 years ago:

I hardly ever post on any site, but I can't help myself when the subject is annuities. You know, a dividend is kind of an annuity when you think about it, and it has an "inflation protection clause," but there is no complicated legal contract involved, and you know exactly what it costs - and what your are getting (a company that makes things) - to buy up front (nowadays commissions are said to be "free") so your cost is known when you decide to buy. And, in all likelihood, the companies paying you dividends during your lifetime will still be around after you die, allowing you to pass on your hard earned retirement investments to others. And, if you have a diversified portfolio of these dividend paying stocks, this diversification reduces your risk and likely affords the inflation protection inherent in "dividend growth stocks" AKA "investor-friendly stocks." Anyone contemplating an annuity today has probably missed the golden opportunity of having built a diversified dividend paying stock portfolio over time. I hear you. And, if I may say, it's a LOT EASIER to choose components of a diversified stock portfolio than it is to understand and compare annuities and their contracts. IMO, buying an annuity is NOT investing. It's a form of THINKING you are avoiding risk and getting a "guaranteed" income by buying a contract that most people probably don't even read. There are three main components of any annuity/type: the investment pool (think mutual fund, ETF, etc.) managing the income from product sales; the actuarial calculation of the purchaser's life, given her age; and all the costs associated with managing a complex product (promotion, advertising, chicken dinners, articles, office space/back office, commissions, regulatory compliance, etc.). And the underlying "pool" that is managed, after all the haircuts, is going to be INVESTED (primarily in - you guessed it - Bonds and Stocks). And finally there are the OUT clauses, that temper or even eliminate the "guarantees" you think you are getting. A good example is Long Term Care Insurance. When an insurance company makes a mistake in pricing its product and begins to lose money on it, they either have to raise rates, stop selling it, decrease payouts, or go belly up. These are real risks when you deliver large sums of money up front to one entity. No diversification (on your part) there. I really don't view buying an annuity as a true form of INVESTING. But that's just me. Yes, I can see where one can be useful in certain circumstances, but there is a huge "machine" at work hawking them to just about anyone who'll listen. I'll give the author credit for comments along this line. And everyone needs to earn a living, and so do commissioned sales people who represent these insurance companies (keep in mind they don't represent YOU). I'd rather see annuities compared with regular investment choices (stocks, bonds, real estate, commodities, etc.), but the trouble is that the insurance companies continue to take a very basic product and carve out all sorts of specialized bells and whistles that just make comparisons difficult. So the consumer is given a lot of choices of icing to consider on the cake. You can have vanilla, buttercream, or chocolate, but it's still added to the same basic cake, it just costs more. My clients have seen their dividend stock portfolios grow to the point where the dividend income is equal to or greater than their annual cost of living and the kicker is, their portfolios are still growing. But this is not an "oops, retirement is in 5 to 10 years, now what" moment. It is something to begin in one's 30s, 40s, maybe 50s, but preferably younger.


ANDREW S from NM posted over 3 years ago:

Some excellent comments here. I have to say, I only read the article because my elderly aunt told me someone suggested she buy an annuity. I expressed my dislike for them, but I don't know what direction she's taken at this time. When I was younger, I learned that it makes more sense to buy a term life insurance policy if you feel you need insurance (to protect a family or leave behind an inheritance) and invest the rest in an index fund, rather than buying a whole life policy. I think the same holds true for an annuity. It seems to me you basically making someone a loan - you give them money up front and then they pay you back incrementally. Maybe I'm missing something, but nothing I read in this article entices me to purchase an annuity for myself. Of course, the author would tell me I already have, with my Social Security account.


David L from AK posted over 3 years ago:

Stan's writing is easy to read, and to me, entertaining/educational. I thank Stan & AAII for the article. The AAII Journal offers a better level of insight than what the news-stand magazines offer. I don't see myself buying a commercial annuity but I also think being knowledgeable of them is prudent....even if only to be able to discuss the topic with a person who is smitten by their allure. Inflation and level of payout keep me worried about buying a commercial annuity.


JOHN S from MI posted over 3 years ago:

Thank you, Charles M for giving us the best summation I've ever read of the annuity business. Its a sucker's game as far as I am concerned. John S from Mi


ROBERT A from NC posted over 3 years ago:

The author states: "When you hear people say that they 'hate all annuities,' it’s like saying you hate all restaurants, all shoes or all trucks." I disagree. It's more akin to saying I hate all shysters, grifters, and thieves. And H--L NO I'm not giving my SS back to the government! Just because SS is a raw deal doesn't mean I'm not trying to get every penny I can out of it. Once upon a time, I worked in the investment industry. I remember the absolute look of joy on the face of every salesman who closed a deal on an annuity. Annuities are enormously profitable to the salesguys. To the clients, not so much. And don't believe anything you hear about there being "no fees"! They're there, perhaps under a different name, but they're there! Through all the twists, turns, and acronyms of this article, I have yet to see an annuity I could recommend to anyone I cared about.


DAVE G from TX posted over 3 years ago:

Charles M. Good discussion. The only thing is insurance companies don't as a rule invest in equities. They are in the business of risk transfer, so they have to invest in fixed income such as bonds. When interest rates were near zero annuities were priced to deliver less compared to now with rates higher. I wouldn't touch any annuities except the SPIA or DIA.


Anthony C from IL posted over 3 years ago:

Great discussion. I am also not of fan of annuities for the same reasons expressed above. However if we get back to the high inflation rates we had in the ‘70s, will buying annuities look more attractive compared to when inflation is under control and down to historical averages?


BARRY J from TX posted over 3 years ago:

My screen says the date of the "Market Summary" at the top of the page is "February 14, 2023, 8:37 AM EST." Today is 3/12/23. What gives?


RICHARD J from WI posted over 3 years ago:

I really enjoyed the article, including the humor, and got a lot out of it. I understand annuities much better than I did before. Thanks!


ANDREW D from PA posted over 3 years ago:

I am 61 and trying to figure out how to best manage my portfolio for tax advantage and longevity, as opposed to being focused strictly on growth. I am new to AAII and am grateful for the combined wisdom of the members who willingly share a wealth of life experience to learn from. I suppose my greatest anxiety is that I no longer trust our government to keep any promises I.E. S.S. and FDIC, or even to maintain our nations credit rating. Great article, great discussion.


STEVEN H from CA posted over 3 years ago:

Overall, I commend the author's presentation of the complex subject and I learned from it. Thank you. However, there are two aspects I wish the author had more clearly treated and would encourage doing so in future articles. (1) I wish the author had explained the meaning of the column headings in the Illinois 5-year MYGA table example presented. Understanding and comparing the example information presented in the table requires understanding what the column headings are referring to. The meaning of some of the column headings left me, and I suspect others, wondering what was specifically being identified. (2) I also wish the author had defined an "Income Rider". While the article briefly mentions how adding an income rider adds cost or reduces the initial benefit, I had to find from another source (a Kipplinger article) that an income rider for an annuity is "Its sole purpose is to create a payout that is contractually guaranteed for the rest of your life (and possibly your spouse’s life as well), even if your original investment goes to zero.". I'm still somewhat confused because I understood that some annuities are already designed to provide income for the remainder of one's life. Apparently an income rider would not apply to such annuities and, instead, would only apply to annuity types that did not already provide for income for the remainder of one's life. I wish the article had explained this more clearly. Thank you. Steven


Andrew O from MD posted over 3 years ago:

Good artIcle presented well. As an exercise, I went to Schwab website after I read this and using their annuity calculator, I indicated I wanted $2500 per month lifetime single premium without any cash returned to heirs. I am 67. The results indicate I needed $370k to purchase this annuity. Instead, if you just take that sum of money and just assume 0% interest for now, and withdraw $30k per year (2500 per month) it would last 12.3 years without purchasing the annuity. So that would take me to 79.3 years old. If I had time I would add 4% interest (i.e. CD, MM) to see how many years that would add. But certainly into my 80’s. The security of annuities sound great but my example convinces me to stay away for now, as I can just withdraw the money on my own. As the author emphasizes, insurance companies do quite well and don’t give anything away.


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