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**Fixed vs. Inflation-Protected
**

A Cost Comparison

Felix Schirripa, FSA www.elmannuity.com April 2009

© 2009 ELM Income Group, Inc.

and In the April 2009 interest rate environment.02% For example. Second:2/1/1915 thru 1/31/1945. we cannot guarantee the accuracy or completeness of this material. Although we worked diligently to produce accurate information. there appears to be little difference between the fixed and the “real” interest rates insurers may be using to price income annuities. The findings and conclusions expressed in this paper reflect the environment in April 2009.02% *Geometric average based on CPI-U All Urban Consumers (Source: Bureau of Labor Statistics) • Average Annual CPI-U 4% 3% 2% 1% 0% 19 25 19 75 19 15 19 35 19 45 19 65 19 55 Beginning of 30 Year Averaging Period First: 1/1/1915 thru 12/31/44. 2 . etc. It is not intended for individuals seeking financial guidance nor tax advice. Neither is it an offer to buy or sell annuities. the 30-year forward average annual rate of inflation for the period 1/1/50 to 1/1/80 is 4. An historical review of inflation during retirement periods dating back to 1915 is provided in the appendix and summarized in the chart below.Executive Summary We find that an analysis of historical inflation during periods of retirement indicates that retirement income plans should anticipate inflation rates of at least 4%. Please note that this material is not advice. Last: 1/1/1979 thru 12/31/2008 Important Disclaimers ELM Income Group prepared this material for educational purposes only. We illustrate that an inflation-protected income annuity may provide more value than the traditional fixed income annuity in the current environment. Forward Average Annual Inflation Rate* (30 Year Forward Averaging Periods) 6% 5% 4. The key factors leading to this conclusion are: • The disadvantage of the lower starting payment from the inflation-protected annuity begins to disappear quickly after adjusting for taxes (non-qualified purchases) and inflation.

000 $2.56. the straight line shows the pre-tax monthly income payments for a 65-yearold male would be $635.000 Real purchasing pow er if inflation runs at 4%/year $4. of course. In the typical fixed immediate annuity. or $7. Note that the real pre-tax purchasing power of the annuity in this example declines by about 35% in 15 years.000 $7.000 $2. more retirees (93%) reported that inflation was the cause for the decline in their confidence to live comfortably in retirement than those who cited the current economic uncertainty (89%) or the decrease in their savings (35%). Although the immediate annuity is an effective hedge against longevity risk and market risk for the assets allocated to it. This guarantee is. The curved line shows pre-tax erosion of purchasing power over the year due to the assumed effective annual inflation assumption of 4%.000 Income (Pre-Tax) $8. the issuing insurance company guarantees a constant amount each month for as long as the annuitant lives.elmannuity.626. Many noted economists have documented the wisdom of doing so (Babbel. Chart 1 illustrates the nominal and real “pre-tax” payment stream from an immediate fixed annuity.72 per year (using April 1.351 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Payment Year In the EBRI/Greenwald 2009 Retirement Confidence Survey. 3 . With an initial premium of $100.All Immediate Annuities Hedge Longevity Risk Retirees can hedge away longevity risk and market risk by allocating some assets to fixed income annuity contracts. Merrill 2007). subject to the credit of the insurance carrier. Chart 1: Income from Fixed Immediate Annuity (Pre-tax) Nominal (Fixed) $12. inflation can erode the real purchasing power of the payments as the annuitant ages. assuming an effective annual inflation rate of 4%. 2009 rates available at www.com ).000.000 Real (Purchasing Power) $10.627 $6.

this relationship changes over time as inflation runs its course. The initial month’s benefit payable under these annuity forms at various ages is illustrated in the following table (using April 1. Chart 2 shows the comparison over time for our age 65 male example assuming annual inflation runs at 4%. But. before we consider the effects of income taxes. Issue Age (Gender) 60 (male) 65 (male) 70 (male) Initial Monthly Benefit ($) Fully Fixed Protected* $558 $392 636 470 742 577 “Cost" of Inflation Protection (% Reduction) 30% 26 22 60 (female) 65 (female) 70 (female) 525 588 672 360 423 509 31 28 24 * Adjusted annually for the cumulative increase in the cpi-u since purchase.com ). an inflation-protected life annuity guarantees “real” payments that start at 25% to 30% below the comparable fixed annuity.elmannuity. 4 . 2009 rates available at www.Measuring the Cost of Adding Inflation Protection* (Pre-Tax) to the Annuity The “cost” to an annuitant for the inflation protection feature is typically shown by illustrating the pre-tax difference in initial benefits payable under both a fixed and an inflation-protected annuity. in the current environment. The table indicates that. The benefit amounts shown are on a pre-tax basis.

the exclusion ratio for a fixed annuity without inflation adjustments is in the ballpark of 65% for a male age 65 (meaning that 65% of each payment is excluded from taxation until the initial investment is recovered.6 27 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Payment Year Chart 2 illustrates that the inflation adjusted annual annuity payments will start to exceed the non-inflation adjusted payments in year 9 when inflation runs at an effective annual rate of 4%. usually at life expectancy).297 Inflation-Protected Annuity @4% CPI Income (Before Taxes) $16.000 $6. $7 . All annuity payments received after the investment is recovered are fully taxable.000 $2.Chart 2: Income from Immediate Annuities (Pre -Tax) Fixed Annuity $20.6 27 5 .641 $7 .000 $$5.000 $4. The investment in the contract is generally the gross premium. Measuring the Cost of Inflation Protection (Post-Tax.000 $10.000 $8.000 $18. As a general rule. income received from a non-qualified fixed annuity is considered to be in part a non-taxable return of premium. In the current environment. For fixed annuities. expected return is based on IRS tables. for “non-qualified” annuities) Income taxes reduce the “cost” of adding an inflation rider to an immediate annuity purchased with non-qualified assets. The exclusion ratio is applied until the investment in the contract is fully recovered.000 $18. The expected return is generally the total amount that the annuitant can expect to receive. the exclusion ratio is determined by dividing the total investment in the contract by the total expected return. The insurance carrier calculates an “exclusion ratio” according to IRS regulations and notifies the annuitant of the amount of the annual payment that is excluded from gross income because it’s considered a return of premium. The remainder of the annuity payment is included in gross income for the year received.000 $12.000 $14. and in the case of life contingent annuities.

In the current environment. For example.com for a free interactive “calculator” that shows the year-by-year post-tax relationship.000 $8.On the other hand. For buyers in high tax brackets (e. all payments are fully taxable).000 $6. until the investment in the contract is recovered. and annuity prices. inflation rates. regardless of future inflation rates.000 $2. 35%). on an after-tax basis. for inflation-protected annuities purchased with non-qualified funds. key assumptions can be changed by the user to estimate the impact using different issue ages. $4 . The dollar amount of exclusion is held constant. assuming a 35% tax bracket and annual inflation at 4%. ELM Rates as of 4/1/09) Fixed Annuity $12. In the calculator.543 6 .000 $6 . In effect. all the inflation adjustments are fully taxable. the exclusion from gross income is determined based on a fixed dollar amount (not a fixed ratio)..893 Income (After Taxes .000 Inflation-Protected Annuity @ 4% CPI $11. the difference in starting payments (post-tax) is closer to 17% in our example. Chart 3: Income from Immediate Annuities (Post -Tax) ($100. Refer to Chart 3 to see this relationship for the age 65 male example used above. As payments are increased for the effects of inflation a larger and larger portion of each payment is taxed. The difference in the way the “exclusion” amounts are calculated for these two types of immediate annuities impacts the economics of buying inflation-protected annuities with non-qualified funds.000 Premium. Male Age 65.7 08 $4.9 57 $5.g. (For annuities purchased with qualified funds.000 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Payment Year Please email me at felix@elmincomegroup. the difference in starting payments is far less than the 25% to 30% mentioned earlier.35% Bracket) $10. roughly 95% of the first year’s payment would be excluded from taxation.

In other words.543 $4. we reduce the income from the contracts to reflect the erosion caused by taxes at the assumed rate of 35%.5 28 $2.000 $3.000 Inflation-Protected Annuity Income (Tax & Inflation Adjusted) $10.000 $6 .000 7 .e. Chart 4 illustrates the after-tax purchasing power of the income from these two contracts (i. it represents the difference between the fixed annuity payments represented in Chart 4 and the inflation-protected annuity payments also in Chart 4. Chart 4: Income from Immediate Annuities (Purchasing Power after Taxes & Inflation) ($100. and by inflation at the assumed rate of 4%/year).000 $6.000 $5.For an alternate view. $1 .667 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Payment Year Chart 5 illustrates the annual difference in after-tax purchasing power for the same example. 4% CPI) Fixed Annuity $12..000 Prem ium .7 08 $8. Male Age 65. 35% Tax Bracket. ELM Rates 4/1/09.

the reduction in starting payments is 17% post-tax (instead of 26% pre-tax).000) 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 $(2.000) $(3.000) $(2. the inflation-protected annuity appears to provide good relative value if inflation runs at or above 4%/year.166 $- 1 $(1. the after-tax relationship can be quite complex. and an assumed effective annual inflation rate of 4%.000 $4.600 (5.000 Prem ium . thereafter the cumulative cost starts to diminish. Please note that by accumulating the yearly differences in the after-tax annuity payments.000 $2.000 Annual Income Delta (Tax & Inflation Adjusted) $3.000 $1. ELM Rates 4/1/09.Chart 5: Annual Difference in Purchasing Power (After Taxes & Inflation) Fixed minus Inflation-Protected Life Annuity ($100. we can calculate the cumulative cost of buying the inflation-protection feature. Male Age 65. That happens in year eight (see Chart 6).6% of the premium).000) $(5.000 $1. In our example.138) Payment Year As these Charts illustrate. 8 . In our example. accumulating the payment differences at an after-tax interest rate of 3%.000) $(4. For retirees seeking to maximize “real” purchasing power for life. eventually turning to gain. the maximum accumulated cost is $5. 35% Tax Bracket & 4% CPI) $5.

4% inflation. 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Payment Year However.000 Premium. Male Age 65. and the sensitivity to the inflation assumption is illustrated by Charts 7 and 8.000) $(15.000) $(25. 9 .000 Cumulative After-Tax Cost $$(5.000) $(45.000) $(40.000) $(20.000) Cost peaks at $5. ELM Rates 4/1/09) 35% tax bracket.000) $(35.6% of prem ium ) in year 8.000 $5.000) $(30. these results are quite sensitive to the assumed inflation rate.000) $(50. and 3% after-tax interest $10.000) $(10.Chart 6: Cumulative Cost of Annuity's Inflation-Protection Feature ($100.600 (5.

Male age 65.291 11 13 15 17 19 21 23 25 27 $(2.000) $(5.138) $(2.000 $- 1 $(10.000) Assumes 35% Tax Bracket 10 .000 Premium.000 2% 4% 6% Annual Income Delta (Tax & Inflation Adjusted) $4.000 $3.804) 1 3 5 7 9 Assumes 35% Tax Bracket Chart 8: Cumulative Cost of Annuity's Inflation-Protection Feature ($100.000) $(40.000) 3 5 7 9 11 13 15 17 19 21 23 25 27 31 $(20.166 $1.000 $$1.000) $(3.Chart 7: Annual Difference in Purchasing Power (After Taxes & Inflation) Fixed minus Inflation-Protected Life Annuity ($100.000) 29 31 6% 29 $(1.000) $(930) $(2.000 $1.000 Premium.000) $(30. Male Age 65. ELM Rates 4/1/09) Cumulative interest at 3% after-taxes 0% $20.000) $(50.000) $(4.000 2% 4% Cumulative After-Tax Cost $10.000 $2. ELM Rates 4/1/09) 0% $5.

Male Age 65. an inflation-protected annuity appears to provide better relative value than the traditional fixed annuity.000) $(5.796) $(3.000) $(2. If inflation runs at or above 4%. For buyers in a 35% tax bracket. These points are illustrated in the next two Charts.000 $- 2% 4% 6% $1. Chart 7A: Annual Difference in Purchasing Power (After Taxes & Inflation) Fixed minus Inflation-Protected Life Annuity ($100. inflation well below 4%/year). ELM Rates 4/1/09) 0% $5.000 Annual Income Delta (Tax & Inflation Adjusted) $4. At 2% inflation.000 $1.000 Premium.000) $(3.634 $1.g.666) Assumes 15% Tax Bracket 11 .216) $(2.000) 31 $(1. the fixed annuity “wins” (post-tax) for a very long time. if purchased with non-qualified assets and assuming inflation runs at or above 4%. in the current environment.. the fixed annuity’s advantage disappears quickly. Similar results are seen at lower tax rates (for example.Major Conclusions In general.000 $2. the conventional fixed annuity can be expected to show an income advantage (in terms of post-tax purchasing power) in low inflation environments (e.000) $(4.688 1 3 5 7 9 11 13 15 17 19 21 25 23 27 29 $(1.000 $3. 15%).

000) $(40. Male Age 65.000) 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 $(20. ELM Rates 4/1/09) Cumulative interest at 3% after-taxes 0% $20.000 Premium.000) $(50.000) Assumes 15% Tax Bracket 12 .Chart 8A: Cumulative Cost of Annuity's Inflation-Protection Feature ($100.000 $- 1 $(10.000 2% 4% 6% Cumulative After-Tax Cost $10.000) $(30.

48%). In addition. and above 4% for 45%. Starting a new retirement every month beginning January 1915 produces 768 such periods in the intervening 94 years through the end of last year. because too many calculators often default to a “standard” 3% inflation assumption.S. Annualized Inflation Rates 30% 25% 20% 15% (1915 thru 2008 (Arithmetic Average of 3.48% from 1915 through 2008 Annual CPI-U 10% 5% 0% 19 25 19 35 19 45 19 55 -5% -10% -15% -20% However. We now find that the effective average inflation during these 30-year retirement periods would have been above three percent for 64% of the 768 periods. For example. let’s look at U.48%) Red line shows average annual inflation was 3. The following Chart illustrates that from 1915 through 2008 annual inflation rates in the U. have averaged well above three percent (actually 3. in part.APPENDIX Historical Inflation Rates & Retirement Income Planning Historical rates of inflation during retirement have been much higher than people may realize. the actual inflation rate experienced by a retiree planning on 30-35 retirement years could be very different from the historical average. to coincide with our retiree’s planning period.S. all of the 30 year periods at or below three percent actually began before 1939! 19 15 19 65 19 75 19 85 19 95 20 05 13 . inflation rates in thirty-year increments going back to 1915.

Here are these results in chart form: Forward Average Annual Inflation Rate* (30 Year Forward Averaging Periods) 6% 5% 4.02% *Geometric average based on CPI-U All Urban Consumers (Source: Bureau of Labor Statistics) Average Annual CPI-U 4% 3% 2% 1% 0% 19 25 19 75 19 15 19 35 19 45 19 65 19 55 Beginning of 30 Year Averaging Period First: 1/1/1915 thru 12/31/44. it would be prudent to base retirement income plans on an inflation assumption of at least 4%. Last: 1/1/1979 thru 12/31/2008 Conclusion If history is any guide. etc. 14 . the 30-year forward average annual rate of inflation for the period 1/1/50 to 1/1/80 is 4.02% For example. Second:2/1/1915 thru 1/31/1945.

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