Something that a lot of investors have a hard time understanding is the effect of inflation upon annuities. Many people avoid this kind of investment because they think inflation can destroy its value.
There is some truth to this belief but the threat is greatly exaggerated. The truth is that inflation can undermine the value of some annuities but there are products with built in defenses to protect against this menace. A person who buys the right kind of policies and plans carefully should be able to avoid this pitfall.
The big danger is that inflation will destroy the buying power of the regular income payments from an annuity. An investor can usually avoid this scenario by buying variable or indexed policies. These increase in value at a faster rate than inflation allowing the payments to retain their buying power.
Inflation and Fixed Annuities
Since a fixed annuity earns money at a fixed interest rate it can be very vulnerable to inflation. If the rate of inflation exceeds the interest rate, it is entirely possible for a person not to make any money from such a plan.
The person would not lose his or her principal but he or she could much smaller payments from it. Inflation is a danger with products that have a low interest rate such as 5%. The current rate of inflation is quite low but it could increase in the future.
This means it might be a good idea to get fixed annuity rates with a higher rate of return. If a person could get one that paid 10%, the plan’s growth could outpace inflation.
Part of the danger is that annuities grow through compound interest. This is interest that is constantly reinvested in the plan in order to keep the funds growing. If inflation eats up the interest the growth could stall and the buying power of the funds in the product could shrink.
Annuities that Beat Inflation
There are two different annuity products that are designed to beat inflation by providing a much higher rate of return. These plans do this because part of the funds are invested in equities such as stocks which have historically increased in value faster than the rate of inflation.
The first product is a variable policy in which a percentage of the money put up is invested in a portfolio of stocks or bonds chosen by the plan’s owner. This allows a person to invest part of the money in high growth areas to help offset inflation risks.
The second is an indexed annuity in which part of the funds are placed in a portfolio of stocks designed to match an index such as the S & P. The concept behind this is that the stock market historically increases in value faster than inflation. By investing in such an index, the plan is designed to grow several times faster than inflation.
Such plans can still be vulnerable to inflation because the majority of funds will still be invested in a fixed rate annuity. The idea behind this is to guarantee the bulk of a person’s investment so they will not lose everything in the market.
Should You Worry about Inflation?
Investors should definitely be concerned about inflation but it shouldn’t be the primary factor to consider when picking an investment. The risk of losing funds should the paramount concern.
Unlike many inflation beating investments annuities are insured so their holders will get their money back. The average person who buys one will receive a stream of income in keeping with the terms of the contract. Persons who need a secure source of income for retirement often turn to an annuity.
Individuals should be worried about inflation but they shouldn’t let it affect all of their investment decisions. Instead they should use it as one factor of many when planning for retirement or the future.