Latest / Inflation and Your Money with Fexingo: Protecting Purchasing Power and Beating Inflation / How Inflation Eats Your Fixed Annuity Income
Transcript
- Lucas: So, Luna, a fixed annuity is often pitched as the ultimate sleep-at-night retirement product. You hand over a lump sum, and you get a guaranteed check every month for life. Sounds great. But what happens to that check when prices keep going up? Luna: You mean, does the check keep up? Because I have a feeling it doesn't. Lucas: Right. And that's the quiet problem. I was looking at numbers this morning—CPI is sitting at 332.8 as of July, and the ten-year breakeven inflation rate is around 2.32 percent. So the market is pricing in roughly two and a quarter percent inflation over the next decade. But here's the catch: a typical fixed annuity right now might pay you four and a half percent, maybe five if you shop around. The spread between your payout and inflation is thinner than people think. Luna: So you're earning four and a half percent, but inflation takes two of that, so you're really getting two and a half percent in real terms. That's not exactly wealth building. Lucas: Exactly. And it gets worse if inflation runs hotter than the breakeven. Let's do a concrete example. Say you put half a million dollars into a fixed annuity that pays four and a half percent for life. That's twenty-two thousand five hundred dollars a year. After ten years of three and a half percent inflation—which is not crazy—that same income buys about fifteen thousand eight hundred dollars in today's dollars. You've lost almost thirty percent of your purchasing power. And that's just the beginning. Luna: Wow. And most people don't think about that because they're focused on the guarantee, not the erosion. Lucas: Right. The guarantee is real, but it's a nominal guarantee. The dollars are guaranteed, not the purchasing power. And the thing is, annuities rarely come with automatic cost of living adjustments. Some have a rider you can add, but that rider costs money—usually it reduces the initial payout. So you're paying extra for something that just gets you back to where you would have been without inflation. Luna: So it's like you're paying for a feature that should be built in, but it's not. And I guess the sales pitch doesn't emphasize that part. Lucas: No, it doesn't. The pitch is 'guaranteed income for life' and 'never outlive your money.' And those are real benefits. But if you're retiring at sixty-five and live to ninety, that's twenty-five years of inflation. Even at two percent, your purchasing power drops by about forty percent. At three percent, it's more than half. So the question isn't whether annuities have a place—it's whether you're using them for the right slice of your portfolio. Luna: So maybe you don't put your whole nest egg in a fixed annuity. You use it for essential expenses, and the rest goes to something that can grow. Lucas: That's the classic approach. But even then, you need to be aware of the inflation risk. I was reading about how the current rate environment—the fed funds rate is at 3.63 percent—means annuity payouts are actually higher than they were a few years ago. That's a silver lining. But it also means you might be tempted to lock in a higher rate without thinking about the long term. Luna: Right, because rates are high now, so the payout looks great. But inflation could pick up again, and you're stuck with that nominal stream. Lucas: And you can't get out. That's the other thing. Fixed annuities are illiquid. Once you hand over the money, it's locked in for the term—often ten years or more. Surrender charges can be brutal in the first few years. So if inflation spikes and you want to reallocate, you're paying a penalty to do it. Luna: So what should someone do if they're considering a fixed annuity? I mean, are there any red flags to look out for? Lucas: I'd say start by asking two questions. First, is there any cost of living adjustment, and if so, what's the cap? Some riders cap the increase at two or three percent, which might not be enough if inflation runs hotter. Second, what are the surrender charges and how long is the term? And third—and this is the one people forget—what's your inflation assumption? Run the numbers with two, three, and four percent inflation. See what your income is actually worth in ten or twenty years. Luna: That sounds like homework, but it's the kind of homework that saves you from a nasty surprise. And maybe you don't need a hundred percent inflation protection, but at least you know what you're giving up. Lucas: Exactly. And there's a middle ground. Some insurers offer inflation-adjusted annuities, but they pay a lower initial amount. Or you can ladder annuities—buy one now, buy another in a few years, so you have some flexibility. But again, that's more complex and you need to run the numbers. Luna: And I guess the point is not to say annuities are bad. It's to say they're not a silver bullet. They're a tool, and like any tool, you need to know its limitations. Lucas: Yeah. I was reading a study that showed the average fixed annuity payout is around four and a half percent right now. And core CPI is running at about three point three percent year-over-year as of July. So the real return, the money you actually get to keep in purchasing power, is maybe one point two percent. That's not nothing, but it's not the 'beat inflation' product some people think it is. Luna: So if you're in your forties, like me, and you're thinking about retirement, you probably shouldn't put a huge chunk into a fixed annuity. You'd want growth assets that can outpace inflation over the long run. Lucas: For sure. For a younger person, the opportunity cost is huge. You're locking in a rate that might look good today, but over thirty years, the equity market has historically returned more. The annuity is more of a risk management tool for people who are already retired and want to cover their base expenses. Luna: And even then, you might want to consider a TIPS ladder or a combination of Social Security and a pension if you have one. Lucas: Right. Social Security has a cost of living adjustment, even if it's imperfect. Pensions often have some inflation protection. Those are the base of the pyramid. Then you can add an annuity for the gap. But you don't want to rely on a nominal annuity for everything. Luna: And if you do buy one, make sure you understand the fee structure. I've seen annuities with hidden commissions that can eat into your returns. Lucas: Oh, absolutely. Commissions are a big deal. They're not transparent like a mutual fund expense ratio. A typical fixed annuity might have a commission of three to six percent baked into the payout. So you might think you're getting five percent, but the insurer is really paying you four and a half because they've already taken their cut. Luna: That's sneaky. And it's not something they put on the front page of the contract. Lucas: No, it's in the fine print, if it's disclosed at all. That's why I always tell people to ask for the 'accumulation value' and the 'income rider value' and see how they differ. And ask the agent to explain the commission. If they're not upfront, that's a red flag. Luna: So we've covered the basics: inflation eats the real return, lack of COLAs, illiquidity, and hidden fees. Seems like a lot of reasons to be cautious. Lucas: But again, not a reason to rule them out completely. I talked to a financial planner last week who said he uses annuities for about ten to twenty percent of a client's retirement income, but only after maxing out Social Security claiming strategies and building a diversified portfolio. He sees annuities as the 'floor' of the retirement income plan, not the whole house. Luna: That makes sense. And if you're going to use that floor, you want to make sure it's not crumbling underneath you. So run the numbers with inflation, read the fine print, and ask about riders. Lucas: Yeah. And remember, the current environment—with the fed funds rate at 3.63 percent—is actually a decent time to buy an annuity because rates are higher than they've been in years. But don't let that urgency blind you to the long-term inflation risk. It's a marathon, not a sprint. Luna: So, one more thing. You mentioned that the ten-year breakeven inflation is 2.32 percent. What does that mean for someone considering an annuity? Lucas: It means the market expects inflation to average about two point three percent over the next decade. If that's right, and you're getting a four and a half percent payout, your real return is about two point two percent. That's actually not bad for a guaranteed income product. The problem is if inflation surprises to the upside, like it did in 2021 and 2022, then your real return could turn negative. Luna: So the breakeven is the market's guess, but it's not a guarantee. You have to be prepared for the tail risk. Lucas: Exactly. And that's why I think it's smart to use a portion of your portfolio for inflation-protected assets, like TIPS or even gold, to hedge against that scenario. But that's a whole other episode. Luna: We could do that next. But before we wrap up, I want to say something about today's topic. It's been really helpful to think about annuities in this light. I know a lot of listeners might be considering one, and I hope they're not scared away, just more informed. Lucas: Absolutely. And you know, if today's conversation helped you think about your choices, that's exactly what we're here for. And if you find value in these episodes, you can support the show over at buy me a coffee dot com slash fexingo. It's the smallest thing, but it keeps us going. Luna: Yeah, and it really does help. We keep the podcast ad-free, and listener support is a big part of that. Lucas: So thanks for considering that, if it's your thing. But back to the annuities—the bottom line is, if you're evaluating a fixed annuity, treat it like any major financial decision. Understand the product, understand your own inflation expectations, and don't let the guarantee blind you to the cost. Luna: And maybe talk to a fee-only fiduciary, not just an insurance agent who earns a commission. Lucas: That's a perfect final point. You want someone on your side, not someone selling you a product. So do your homework, run the numbers, and make the decision that fits your retirement picture. We'll be here to help you think it through.