Inflation happens when prices increase but the value of the dollar falls, meaning that your long-term investments start to lose their worth.
An annuity gives you the security of a guaranteed annual income, but there is no promise the money you receive 10 years from now will carry the same purchasing power as it did on the first day you invested, due to inflation.
Inflation is the increase in value of materials, goods or services without a corresponding increase in the value of currency. Consider a loaf of bread. A year ago, the cost of that loaf of bread at the grocery store was $2, but now the same loaf of bread is $2.50. As a result of inflation, your $2 cannot purchase the same goods as before.
Likewise, inflation can drastically reduce the value of your annuity.
For example, an immediate annuity purchased in 2003 guaranteed you $1,000 a month for life. That was good enough to cover rent and utilities on your condominium. It might even have provided enough leftover funds for groceries. Fast forward 10 years: Inflation increased the cost of rent, utilities and groceries, but you’re still getting $1,000 a month from the annuity. You can cover the rent and utilities, but there is nothing left for groceries. Inflation wins, you lose.
The U.S. inflation rate is based on the Consumer Price Index (CPI), a system of pricing consumers are charged for various products and services. According to the CPI, the current 2017 U.S. inflation rate is 2.2 percent. The U.S. Bureau of Labor Statistics determines the average annual inflation rate by calculating the percentage change between two given years.
For example, from 2003 – 2017, the cumulative inflation rate was 33.66 percent. Therefore, a product that cost $100 in 2003, costs about $134 in 2017.
If you stretch that period out to 20 years — a reasonable goal for someone who retires at age 65 — you can see how inflation can take a chunk out of an annuity.
You can prevent your assets from losing value over time by investing in inflation-adjusted annuities or an inflation rider. Both options help to protect your investment from losing value over time by adjusting your payout each year based on inflation. For inflation-adjusted annuities, this benefit is built-in. Others can purchase an inflation rider as an add on.
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You can also avoid losing annuity value by building your portfolio through diversifying and considering stock and security options to account for long-term needs.
Annuity issuers offer special annuities with long-term advantages. Inflation-adjusted annuities are based on a fixed percentage or a variable increase. The variable increase, for example, might be tied to the Consumer Price Index or might increase by 3 or 4 percent each year. These increases do incur a cost to you, which are taken out of the monthly payouts received the first several years.
If a 65-year-old man purchased a $100,000 annuity with inflation-adjusted protection, it would yield $167 less a month the first year than without protection. The monthly payouts would break even after approximately 15 years. Depending on your age when purchasing an annuity and accepting payments, this method might pay-off for you.
Pre-retirees can purchase Treasury Inflation-Protected Securities (TIPS), bonds issued by the government to hedge against inflation risk. These are also tied to the Consumer Price Index. A portion of the value increases with inflation, while part of it stays fixed over time.
Another strategy for preventing losses focuses on making sure to diversify your portfolio.
Including conservative, stable investments along with higher risk stocks gives you a chance to experience growth with minimal impact from losses.
Some financial experts recommend relying on home equity or purchasing gold as safeguards against inflation. Evaluating where the market is at the time of purchase as well as projections for the future can help show how risky these investments may be.