The drop in the unemployment rate, moderate salary growth, and the increase in the federal funds rate have become the key markers of the economy’s continued recovery. While these are positive indicators, a strengthening economy can also trigger a rise in prices, resulting in higher inflation.
Since July 2016, CNBC states inflation in the United States has climbed steadily after hitting 0.8%. As energy prices rebound after a massive drop for much of 2016, the inflation rate is likely to remain close to its current levels in the coming months.
Rising inflation can prove problematic for investors as investment returns are unable to keep pace with rising prices. More so for retirees, who fear investing as they lose purchasing power during this economic phase.
Inflation Affects Retirees More
A recent study by LIMRA revealed that when inflation reaches 3%, retirees may see their purchasing power drop by over $117,000 in more than a 20-year period. In fact, even at 2%, the impact of inflation creates a shortfall of about $74,000.
“Seniors or retirees face a different inflation environment than nonretirees,” said Matthew Drinkwater, an assistant vice president at the institute who participated in the research. As a result, inflation becomes one of the top things people fear most upon retirement.
Therefore, buying an inflation-protected annuity may offer an opportunity to avoid the effects of inflation while safeguarding your retirement outlook.
Inflation-Protected Annuities
“Inflation-protected annuities are designed to help mitigate both inflation and longevity risks to a retiree’s income,” stated Justin Fort, a certified financial planner and president of Fort Wealth Management in Austin, Texas.
These annuities, which are sold by insurance firms, provide guaranteed fixed-income payments over a set period of time or for life. Periodic increases in the inflation-protected annuities happen as its price rises along with inflation.
However, investors must be aware that the extra costs for these benefits are borne by the policy owner (i.e. a fee for the security of guaranteed retirement income) and the benefit increases that are built into the annuities often come at a premium.
Experts advise to weigh the value of the long-term benefits against the upfront expense before purchasing any annuities. While inflation-protected annuities may offer a measure of security through steady payments, investors may want to double-check other investment opportunities that may offer higher returns.
“Annuities are long-term vehicles and typically limit the amount of liquidity available to [an investor],” DeWitt & Dunn CEO Cathy DeWitt Dunn says. “It’s important to consider them as part of an overall plan and make sure that they work well within your portfolio.
In order to understand inflation adjusted annuities you first need to understand annuities. Annuities have two phases the accumulation phase and the distribution phase.
The Accumulation Phase
During the accumulation phase you pay into a fund and that fund is allowed to grow at some agreed upon rate or through some agreed upon method. Some annuities grow at a fixed rate others grow according to some index (such as a stock market index) while others combine both providing a market rate return during good years and a guaranteed minimum during bad years. The accumulation phase can consist of a single payment or multiple payments over several years.
The Distribution Phase
The distribution phase can begin immediately after a single payment or after the accumulation has been allowed to grow for a while. Once the distribution phase begins, the rules change and specific rules regarding the distribution will be in place. Since this phase may begin many years after the annuity was originally purchased, it is important to get the right provisions in place for this phase when you set up the annuity.
If structured properly, this can result in a steady income for the rest of your life (or for both your life and your spouse’s life, or for a specific number of years, or a variety of other variations, etc). While income for life is reassuring, if inflation is high (or you live a long time), the purchasing power of that annuity income can erode over time. That is why some people prefer the added peace of mind in knowing that their annuity income is protected by an inflation clause. In that case, in addition to their regular payment they will receive an inflation adjustment usually based on the U.S. Bureau of Labor Statistics official inflation rate.
In times of high current inflation the cost of this protection will be high but in times when inflation is low, the annuity provider might underestimate the cost of the inflation protection. And so counter-intuitively the best time to add an inflation rider to an annuity might be during times of low inflation.
Buying Annuities
Annuities are complex legal contracts with many different variations. Some are better deals than others. Annuities can be an excellent way to guarantee a steady income during your retirement years but they can also be a big rip-off depending on how the contract is designed. Unfortunately, annuities are often sold by pushy salesmen who do not have your best interests at heart. Before you buy an annuity be sure you understand what you are buying and compare several companies (this applies to both ordinary annuities and inflation protected annuities).
Other Ways to Invest During Inflationary Periods:
Aside from acquiring inflation-protected annuities, there are other ways to invest even when the market is challenged by inflation.
Traders are constantly watching inflation rates to get clues on investment falls and growth. In a normal trading atmosphere, inflation leads to the fall of a currency’s purchasing power, which affects many trading mediums. However, a rise in the prices of goods and services may still benefit traders if they consider trading currency, stated teramusu on its website. The process features the quotation of the relative value of a currency alongside the unit of another currency in the foreign exchange market. ‘Currency Pairs’ are known as a popular method of expanding investment opportunities and opening up more growth for traders. In a healthy economy, a rise in inflation points to a rise in interest rates, which in turn will favor the traded currency.
Trading commodities may also protect investors against inflation. Prices of gold and oil rise when inflation occurs, which may help in attempting to profit rather than just hedging against them.
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