The roller coaster ride of the stock market in the past five years has resulted in plenty of discussions regarding how to take advantage of the market highs while also protecting our savings against the market lows.
However, with our obsession with stock market performance, we may be overlooking the one silent killer that can slyly erode the purchasing power of our retirement savings.
Yes, I am talking about inflation. There are two big threats to our retirement savings. One is the risk of outliving our savings and the other is the risk of inflation.
The Fed tells us not to fuss about inflation, but The Fed does not subsist on fixed income.
The fears about inflation have certainly dropped below our radar. Yet the fact is that Inflation can potentially offset any gain from our retirement portfolio. Usually investors think about the nominal returns. What in fact should they be worried about are the real returns.
The real rate of return is the nominal rate of return minus the inflation rate. To explain to you how real returns have an adverse affect on our savings, let me share with you a scenario from the inflation nightmare of the 1970s.
During the period from 1973 to 1983, the cost of living increased 130%, with the annual inflation rate averaging 8.7%. If we were to experience a similar trend during our retirement years, a $2000 monthly income could easily plummet to $840 in terms of purchasing power in just ten years. Ouch.
So, how can I hedge my Retirement savings from Inflation?
Inflation-indexed annuities (IIAs), also known as inflation-protected annuities (IPAs) or real annuities, offer you a hedge against this dilemma.
Inflation-indexed annuities are similar to regular annuities. However, they give you an automatic increase in returns linked to the inflation rate (CPI) determined by the department of labor each year. Most inflation-indexed annuities are also designed to protect your savings from the risk of deflation. The returns of the annuities are adjusted for inflation but they do not decrease with the deflation.
But, with the inflation rate well under 3% should I even worry about this potential menace? Again, I have to answer in the affirmative.
I agree with the recent CNBC television interview of Mr. Jeffrey Lacker of the Federal Reserve Bank of Richmond that we should not be complacent about the adverse affect of inflation on our retirement savings.
To give you an example of the comparative advantage of inflation-indexed annuities, consider an annuity of $200,000 that promises to pay $1,140/month if acquired by a 60-year-old person.
If the annuity is indexed to inflation, the monthly payout from the annuity initially drops to $804/month. However, with the extended run of inflation of 3%, the real returns from Inflation-indexed annuities will easily exceed that from the ordinary annuity.
Final Verdict on Inflation Indexed Annuities
While IIAs are becoming common in other countries, particularly in the UK, they are less common in the United States. There are two main reasons for their obscurity. Most of us are gripped with the obsession of the stock market boom. Moreover, we are also not aware about the potential danger of inflation in eroding the purchasing power of our retirement savings.
It is implicit that we cannot predict how inflation will affect our retirement savings in the future. Nevertheless, we should be vigilant and try to limit the potential adverse effects of inflation on our retirement savings.
The balanced combination of inflation-indexed annuities, life equity-indexed annuities, and Social Security can go a long way in hedging our retirement savings from the menace of inflation.
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