Risks are inherent in an investment. One large annuity risk is its length. With your money tied up for years, annuity inflation can make the actual worth of your money, and the investment, a loss rather than a gain.
Pretend you have an annuity that pays out $1,000 a month for your lifetime. The higher inflation is the less actual value the $1,000 has. Even small inflation, over the course of years will make one realize a steady decline of their purchasing power. (i.e. 1000<1000*[(1+K) ^n] where K is the inflation rate, and n is the number of years since the beginning of annuity payments).
Now, one could always think that if inflation did increase, one could just take ones money out of one annuity and purchase another more current annuity with a secured return more appropriate to current inflation. This method, however, does not account for all of the surrender charges one must pay to withdraw money early. Nor does it take into account the taxes one would have to pay on the money they withdrew.
Increasing Annuity
There are, however annuities that exist to help decrease, or eliminate completely, the risk of inflation. The increasing annuity is an annuity where, “payments increase at a fixed rate determined at the time of purchase.” This annuity can help maintain, or even increase one’s purchasing power over time, so long as the inflation rate remains below or at the rate increase on the annuity.
Inflation-Adjusted Annuity
Another annuity, to completely eliminate the risk of inflation to the annuity is the inflation-adjusted annuities. These annuities have, “payments that increase with the rate of inflation actually experienced.” This ensures that no matter what, the spending power you expect to have in retirement will remain, now matter high or low inflation.
Conclusion
For both the increasing annuity and inflation-adjusted annuity, there is a cost. The prices of such annuities are much higher than for a nominal annuity. Increasing annuities and inflation adjusted annuities have lower initial payments than the fixed annuity.
Annuities are for preparing for the future and ensuring for retirement or later in life income. It seems logical to also prepare for inflation as a risk and be accurately prepared.
By – Domenic Gabriella for RetirementSecurity.com