IRA and 401k Retirement Income: Increase Security With an Inflation-Adjusted Annuity

I've previously written about immediate annuities as one way to provide monthly retirement income, no matter how long you live and no matter what happens in the economy. The most common type of immediate annuity has a fixed dollar amount, which means one unfortunate -- and critical -- disadvantage is that inflation can erode the buying power of your income.

To counter this disadvantage, you could buy an immediate annuity that's adjusted for changes in inflation as measured by the Consumer Price Index, or is increased by a set percentage each year. This can provide the ultimate in retirement income security -- by purchasing this type of annuity, you're guaranteed a given amount of buying power, no matter how long you live and no matter what happens in the economy. This feature does have a cost, however, because a given amount of retirement savings buys a lower monthly income. Let's take a look.

Suppose you're a 65 year-old single man who plans to use $100,000 of your retirement savings to purchase an annuity. Let's look at annuity purchase rates using Vanguard's Annuity Access program through Income Solutions. As of November 7, 2010, here are initial annual payout amounts from one of the insurance companies in their panel of companies:

$7,042 for a fixed annuity, which works out to be a payout rate of 7 percent
$5,300 for an annuity that increases 3 percent per year -- the payout rate is 5.3 percent
$4,980 for an inflation-adjusted annuity-- the payout rate is 5 percent

You might wonder why the payout rate for an inflation-adjusted annuity is smaller than the payout rate for an annuity that increases by 3 percent each year, when inflation is currently lower than 3 percent. The reason is that the insurance company is taking the risk that inflation might eventually be higher than 3 percent.

If you're a 65 year-old woman, based on the same information, here are the annual payout amounts:

$6,550 for a fixed annuity, or a payout rate of 6.6 percent
$4,818 for an annuity that increases 3 percent per year -- the payout rate is 4.8 percent
$4,493 for an inflation-adjusted annuity -- the payout rate is 4.5 percent

If you're part of a married couple, both age 65, then here are the annual payout amounts for a 100 percent joint and survivor annuity (this annuity continues payments as long as either one of you is alive):

$5,814 for a fixed annuity, resulting in a payout rate of 5.8 percent
$4,167 for an annuity that increases 3 percent per year -- the payout rate is 4.2 percent
$3,853 for an inflation-adjusted 100 percent joint and survivor annuity -- the payout rate is 3.9 percent

If you compare the above payout rates to the payout rate under the four percent rule that's typically recommended for investing and drawing down retirement savings on your own, you'll find that in most cases, the inflation-adjusted annuity provides higher retirement income than the four percent rule. The only time you'll receive a slightly lower retirement income than the four percent rule is if you purchase an inflation-adjusted 100 percent joint and survivor annuity.

So why not just put all your retirement savings in an inflation-adjusted annuity, instead of investing on your own and using the four percent method? After all, you'll get a higher retirement income, and you're guaranteed not to outlive your income. By contrast, the four percent method carries a chance, albeit small, that you'll deplete your retirement savings.

There are two very good reasons why you wouldn't do this:

With an immediate annuity, you leave nothing to children and charities. When you die and your named beneficiary (if applicable) dies, all payments stop. You don't get any part of your initial premium back. Contrast that with the four percent method, which offers a very high chance that you won't outlive your retirement savings, and most likely you'll leave a legacy.
You can't tap into an immediate annuity for emergencies or unexpected expenses.

So now you see the trade-off between these two methods of generating retirement income:

The inflation-adjusted annuity provides the security of lifetime purchasing power, at the cost of flexibility and the ability to leave a legacy.
The four percent rule provides lower initial retirement income and less income security, since there is a chance you might outlive your savings. But you have the ability to tap your savings for emergencies, and there's a good chance you'll be able to leave a legacy.

The inflation-adjusted annuity might be for you if:

you want to have a worry-free retirement where you don't have to be concerned about how long you live and what happens in the economy,
you want to maximize your inflation-adjusted retirement income,
you don't want to manage your retirement savings or pay someone else to manage them, and
leaving a legacy isn't important to you.

If, on the other hand, you can live with some uncertainty regarding your retirement savings, you like managing your retirement savings or can pay someone else to manage them, and you'd like to leave a legacy, then the four percent method might be a better choice for you.

If you want to hedge your bets, I'd suggest splitting your retirement savings between an annuity and the four percent method, as I've written about previously. Or phase-in your annuity purchases as you get older.

Generating lifetime retirement income from IRAs, 401ks, and retirement savings is a significant challenge, since there are many methods, each with their pros and cons. But if you give it your best effort, I'm sure you'll be up for the challenge!

More on CBS MoneyWatch
IRAs and 401ks: Maximize Retirement Income With Immediate Annuities
IRA and 401k Retirement Drawdown: Don't Die Broke!
IRA and 401k Retirement Drawdown: Tips to Make the Four-Percent Rule Work
IRA and 401k Retirement Income: How You Can Get Both Predictability and Flexibility

Steve Vernon

View all articles by Steve Vernon on CBS MoneyWatch»
Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.

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