From the Archives: Getting Going

The Inflation Protection You Can't
Get: In Search of an Indexed Annuity

By KAREN DAMATO
Staff Reporter of THE WALL STREET JOURNAL

A classic insurance product -- a type of annuity providing lifetime income payments -- has gotten a public-relations boost from the Bush administration in recent months.

In proposing to add personal investment accounts to Social Security, administration officials have called for some retirees to roll their personal-account balances into insurance contracts called "immediate income annuities." Regardless of the outcome of the president's proposal, though, annuities may play an important role for many of the huge numbers of people with 401(k) plans who are nearing retirement.

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But investors interested in acquiring a type of annuity that is part of the Bush proposal -- an income annuity where the payments rise in line with inflation -- may be in for a surprise: The inflation-indexed feature is rare in today's insurance products.

Insurers say that is because there are impediments to the development of such annuities, including a limited supply of inflation-indexed corporate bonds in which to invest annuity dollars. Investors also have shown little appetite for income annuities and may be unwilling to accept the lower initial payments provided by contracts promising higher inflation-indexed payments down the road.

One of the few inflation-indexed annuities today is a Vanguard Group offering backed by embattled insurer American International Group Inc. (AIG also offers the inflation feature on annuities it sells through other companies.) Another contract launched about five years ago -- partly as an experiment, by a proponent of private Social Security accounts -- is no longer available.

The attraction of inflation-indexed annuities is that they offer a way to preserve your purchasing power by providing a lifetime stream of payments that will rise in step with inflation. The Vanguard Lifetime Income Program comes close to a full inflation adjustment: Payments rise with the consumer-price index, but not more than 10% in a single year.

An inflation-indexed annuity can be a solution to two problems that loom large in later life -- the risk of outliving your financial resources and the risk of inflation steadily eroding your purchasing power. It "is arguably a product that people should want," says Jeffrey Brown, a finance professor at the University of Illinois at Urbana-Champaign. "I would want part of my portfolio to be in some form that is both annuitized and protected from inflation."

But sales for the Vanguard inflation-indexed annuity have been "fairly lukewarm" since the inflation feature was added in November. Vanguard principal Robert Nestor says that is largely because the inflation protection trims the buyer's initial income payment by 20% to 30%. Still, he says, "We believe in the concept" even though many investors "can't bring themselves" to accept the lower initial payments.

By putting a portion of your money in a standard immediate income annuity, you get the comfort of payments that will continue if you live far beyond your average life expectancy. And you will probably also get more spending cash each month than if you kept the annuity purchase amount and invested it yourself. That's because when you invest the money, you need to limit withdrawals in order to increase the probability that the money will last for your lifetime. Initial annual withdrawals generally shouldn't exceed 4% of your retirement nest egg, financial planners say. (A downside is that income-annuity purchases are typically irrevocable.)

Investors may very well need their retirement nest egg to last for decades. A healthy 65-year-old man will live to 85 on average, and has a 1-in-4 probability of living to 92. In a couple where the man and the woman are both 65 and healthy, there's a 1-in-4 chance at least one of them will survive to 97. (Similar figures for people from ages 50 to 79, derived from tables insurers use to price annuities, can be found on Fidelity Investments' Web site, search on "longevity risk" at www.fidelity.com.)

But over time, a standard income annuity's fixed payments will get you fewer and fewer goods and services with each payout. If prices rise 3% a year -- a historical average level -- items that cost $1,000 today will cost over $1,300 in 10 years and over $1,800 in 20.

There is another more limited inflation hedge available to people interested in the lifetime income offered by an annuity, but are worried about seeing a fixed monthly check eroded over time by rising consumer prices. A number of immediate annuities provide for the payouts to rise by a preset percentage -- say, 1% to 5% -- each year. As with inflation-indexed annuities, the initial payments are reduced.

Another option is to buy a variable income annuity, where your lifetime payments will fluctuate based on the performance of investment portfolios you select. Stock accounts are likely to beat inflation over time, but may take you for a wild ride. Accounts holding Treasury inflation protected securities, or TIPS, will fluctuate less, but are usually available only within annuities offered for individual retirement accounts and other retirement plans.

As for privately sold annuities, it may take years -- and a revival of inflation woes -- for consumers to warm to the idea of inflation-indexed income annuities. The now-popular TIPS weren't an immediate hit on their 1997 launch. With the aging of the baby boomers, there may be additional products offered down the road. And if interest rates rise, expect the initial payments offered by income annuities to climb as well.

• Jonathan Clements will return next week.