Inflation happens when prices of services and products increase, but the value of the dollar falls, meaning that your long term investments start to lose their worth over time as prices go up.
Inflation is a termite on investments. It quietly chomps away at the core, and when you finally realize how much damage is done, it’s too late to do much about it.
That is especially true with annuity investments. Inflation can eat them alive.
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.
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 provide 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.
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The U.S. Bureau of Labor Statistics determines the average annual inflation rate by calculating the percentage change between two given years. Its online calculator shows the annual inflation rate from 2003 to 2014 is 2.69 percent.
The cumulative inflation rate for those 10 years is 26.9 percent. Therefore, a product that cost you $100 in 2003, would cost about $126.90 in 2013. If you stretch that period out to 20 years — a reasonable goal for someone who retires at age 65 — inflation takes a chunk out of their annuity.
You can prevent your assets from losing value over time by investing in certain annuities and planning your portfolio by diversifying and considering stock and security options to account for long-term needs.
Annuity issuers offer special annuities with long-term advantages. This includes inflation-adjusted annuities, 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 percent or 4 percent each year. Increases come at a cost 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 rises 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.