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Is It Time to Invest in Inflation-Protected Annuities?

Low unemployment, moderate wage growth and the Federal Reserve's decision to raise the federal funds rate are key markers of the economy's continued recovery. While those are positive indicators, a strengthening economy may trigger an uptick in prices, resulting in higher inflation.

Since hitting 0.8 percent in July 2016, inflation has been climbing steadily. The inflation rate reached 2.7 percent in February, before dipping back to 2.4 percent in March. With energy prices expected to rebound after being depressed for much of 2016, the inflation rate is likely to remain at or near current levels in the coming months.

For investors, rising inflation can prove problematic if returns are unable to keep pace with rising prices, says Cathy DeWitt Dunn, president and CEO of DeWitt & Dunn in Dallas.

"It's necessary to understand how powerful the effect of inflation can be on a retirement plan," DeWitt Dunn says.

[See: 20 Awesome Dividend Stocks for Guaranteed Income.]

A 2016 LIMRA study found that when inflation reaches 3 percent, retirees may see their purchasing power erode by more than $117,000 over a 20-year period. Even at 2 percent, the inflationary impact creates a shortfall of nearly $74,000.

Purchasing an inflation-protected annuity may offer an opportunity to hedge against the effects of inflation and safeguard your retirement outlook.

"Inflation-protected annuities are designed to help mitigate both inflation and longevity risks to a retiree's income," says Justin Fort, a certified financial planner and president of Fort Wealth Management in Austin, Texas.

These annuities, sold by insurance companies, offer guaranteed fixed-income payments, either over a set period of time or for life. Unlike other types of annuities, the payments are typically indexed to inflation based on an annual cost-of-living-adjustment factor, which is determined when you purchase the annuity. This allows for periodic increases in the annuity benefit amount as inflation rises.

Ken Nuss, CEO and founder of AnnuityAdvantage in Medford, Oregon, says investors must be considerate of where they set the bar in terms of the COLA factor.

"In some years, the [income] increases will outpace inflation and in other years, it will fall short," Nuss says. "Choosing a COLA factor which is near the average historical inflation rate will work on the average to offset increasing costs in retirement."

Nuss says investors should be aware that the benefit increases that are built into inflation-protected annuities often come at a premium.

"The benefit increases in these contracts are guaranteed and to that extent, they're very effective," Nuss says. "This is mailbox money, meaning it's going to show up every month for the rest of your life."

The drawback, Nuss says, is that the extra cost for these additional benefits is borne by the policy owner. He gives an example of a 65-year-old man who purchases a $100,000 level annuity, with an expected monthly benefit of $512. To get that same benefit the first year and receive a 3 percent COLA increase each subsequent year, the purchase price would rise to $137,089.

Dawn-Marie Joseph, founder of Estate Planning & Preservation in Williamston, Michigan, advises investors who are considering an inflation-protected annuity to consider how much they're willing to pay for the security of guaranteed retirement income.

"The features and benefits inside these annuities do come at a cost and the consumer should educate themselves," Joseph says. "Consumers aren't naive in thinking that there's such a thing as a free lunch. Every month, they look at their brokerage statements or bank statements and see how much they pay in fees for having someone take care of their money and the same holds true for annuities."

When purchasing an annuity, it's important to weigh the value of the long-term benefits against the upfront expense. While inflation-protected annuity offers a measure of security in the form of steady payments, you may be able to realize higher returns by investing elsewhere.

[See: 10 ETFs That Pay Sky-High Dividends.]

Fort says in a low interest rate environment, it may be difficult for inflation-adjusted annuities to keep up with actual inflation. If the Fed moves forward with additional rate hikes as anticipated, that could quell inflation to a degree but investors should still be thinking about ways to minimize inflation's impact.

"Alternatives may include purchasing an inflation-protected annuity ladder over time, waiting until interest rates rise to purchase [an inflation-protected annuity] or using fixed payment annuities along with other assets like dividend-paying stocks, Treasury inflation protected securities or real estate to offset inflation," Fort says.

Nuss says it's important to review the finer points of any inflation-protected annuity offering before entering into one of these contracts.

"Carefully consider the company's financial strength and ratings beforehand," Nuss says. "While the contracts are guaranteed by policy language, those guarantees are only as good as the company standing behind them."

Your overall health and life expectancy are additional factors that come into play when determining whether an inflation-protected annuity makes sense.

"Annuity companies don't field underwrite health or life expectancy when investors purchase these contracts," Nuss says.

Critically evaluating your health, life expectancy and family history of longevity can help you determine whether you have a decent chance at living longer and collecting an increasingly larger monthly income, Nuss says.

How the company offers inflation protection is also something to look at, according to DeWitt Dunn.

"Some companies offer inflation adjustments based on the consumer price index for all urban consumers, while others offer income that increases based on other metrics," DeWitt Dunn says. "Neither is inherently better or worse, but it's important to understand what drives the inflation protection within a contract."

Where you are on the path towards retirement may also factor into your decision to pursue inflation-protected annuities.

[See: 9 of the Market's Best Growth Stocks.]

"Annuities may not be what you're looking for starting out of the gate but they could be a terrific addition to your plan as you get closer to retirement," Joseph says.

Finally, DeWitt Dunn says investors should consider the liquidity factor when contemplating whether to purchase an inflation-protected annuity.

"Annuities are long-term vehicles and typically limit the amount of liquidity available to [an investor]," DeWitt Dunn says. "It's important to consider them as part of an overall plan and make sure that they work well within your portfolio. Look at annuities like a tool: a hammer is very versatile but it won't help you inflate your tires."

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