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INFLATION IS BAD news for bond investors, but it’s really terrible for annuitants and those receiving company pensions. Bond investors can at least reinvest maturing bonds in newer bonds paying higher yields. But most income annuities and pensions pay a fixed monthly benefit for life. In fact, you can no longer even buy inflation-adjusted single-premium immediate annuities. Meanwhile, just 7% of all private-sector pensioners received automatic cost-of-living increases, according to a 2000 survey by the Bureau of Labor Statistics.
Just how big a problem would sustained inflation be for annuitants and pensioners? In recent months, inflation has averaged 6%, as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). If it remained stuck there, it would cut a pension’s purchasing power in half in just 12 years.
One pension, however, has near complete protection from the ravages of inflation. The Federal Employees Retirement System contains a cost-of-living adjustment (COLA) that raises payments annually. Here’s how it works: If inflation, as measured by CPI-W, is 2% or less, the COLA matches it. If inflation runs between 2% and 3%, the COLA remains at 2%. Most important, if inflation exceeds 3%, the COLA equals the CPI-W minus one percentage point. In other words, the worst-case scenario is that the COLA lags behind inflation by one percentage point in any given year.
If inflation spirals out of control at 10% a year, the COLA would add 9% to federal pension payments annually. If a federal worker’s pension were to lag inflation by one percentage point annually—remember, this is the worst-case scenario—its purchasing power would decline 26% after three decades. That’s not too bad, considering the alternative. An annuity or pension without inflation protection would have lost 94% of its value after the same 30 years.
Federal pensions are also backed by the full faith and credit of the federal government. That’s no small thing when you compare them to state pension plans. In aggregate, statewide pension plans were only 72.9% funded in 2019, near the lowest point in modern history. Given the current headwind of ultra-low interest rates, that shortfall is unlikely to narrow.
I’m certainly not predicting sustained 10% inflation. But even 5% inflation would drive down purchasing power by 77% in 30 years for those pensioners without a COLA. Worse yet, many economists feel that the official measure of inflation significantly underreports the true price increases we encounter in our daily lives.
Inflation is a huge risk for retirees, and it’s effects are felt even when inflation is relatively low.
There are a couple comments here about aiming for 100% income replacement as an inflation hedge. I’ve been doing the same, but for other reasons. The information that retirees on average spend at a rate equivalent to 70-80% of pre-retirement income is, I think, heavily influenced by the fact that many cannot afford to spend more… and the figures would be closer to 100% if people had their druthers. For people without such constraints I have seen figures more like 120-130% for the first decade of retirement (often involving travel and hobbies), dipping to 80-90% the decade after, and 60-70% the decade after that.
For this reason, I treat 100% income replacement as a base goal, and hedging against inflation as an additional goal beyond that… but I also realize that age is likely to slow me down a little, and with it my spending.
This is a good eye opener. I think if inflation is stuck at a high level for long periods it will be difficult for many types of assets. I am considering allocating a portion of my portfolio to fixed annuities but just a portion. Studies have been made where the mortality credits offer a different value to a portfolio than having only stocks and bonds. It seems the key is not to rely 100% on any single asset class be it stocks, bonds or an annuity.
I did not realize that only 7 percent of pensions have COLA’s. I retired from the Federal Reserve Banking System and we have the same COLA protection as Federal employees. We are very fortunate. Our pension is fully funded and I don’t anticipate any issues in my lifetime with the Fed’s guarantee of a pension. Wall street would throw a tantrum if the Fed ever mismanaged its pension program! As for Federal government employees (Fed Reserve employees are NOT Federal government employees, we are only quasi gov’t), their income over the years, depending on their job sometimes lags private industry. So having the COLA is an offset in some ways for lower pay than some equivalent private corporation jobs. The longer you stay with a Federal job the better off you are though in retirement. Having a COLA is a powerful inflation hedge.
Thank you. I have commented several times here recently that a SPIA with no inflation protection is a terrible buy, especially if you already have a pension with no COLA, but I kept meeting opposition. I moved to the US from the UK, where private sector pensions do have COLAs and it took some time for me to realize that in the US they do not. I was not happy….
The lack of COLA doesn’t make it a terrible buy, it just means you need to understand better what you are buying.
I’m definitely considering layered annuities that together can roughly imitate the rising cash flows you get with a COLA.
One of the reasons that I bought a Qualified Life Annuity Contract (QLAC) in my IRA was to handle the need for additional income later in life. If either my wife or I make it to age 85, the QLAC will kick in an additional $3000 per month of income. I’m planning on at least 2 per cent annual inflation over the next 15 years.
With a 26 trillion dollar national debt, you can imagine that the interest payments alone at 4 per cent is over a trillion dollars a year. US Taxpayers are in for a future shock.
Good post.
My state pension plan doesn’t have a COLA. I plan to delay Social Security until 70, to maximize the value of that COLA. I’ve also used 401k and IRA to accumulate funds to supplement the pension. I’ve been shooting for 100% gross income replacement, to give myself a buffer against 30 years of inflation eroding value of pension.
As someone whose entire financial life is based on a pension, tell me about it. Years ago when I managed the plan that provides my pension today we used to give adhoc increases when inflation took off. We did it seven times over 10-15 years, but I could no longer justify it once we added a 401k with match. Effectively we were then pre-funding inflation for future retirees.
Many of the states have COLAs too. I was always fascinated that government workers generally have a total compensation package higher than what the workers have who pay for their packages .
Of course, everyone who lives at least partially on SS has some inflation protection for a portion of income and the 4% rule does account for it.
I push the idea of a target retirement income replacement of 100% of base salary just to help with inflation over the years plus retirees should have non-retirement investments like dividend paying stocks and interest paying funds to tap as necessary, but otherwise reinvest.
I remember when our GIC in the 401k was paying 16% and I bought a house in 1987 with the interest at 9-3/4% Not exactly the good old days of inflation, but younger people haven’t a clue what can happen.
Rather than finding it problematic that many public employees have inflation-protected benefits I think it is more appropriate to view the lack of inflation-protection in most private pension plans as a major problem.
There is a big difference. Pension costs hit a company’s bottom line and hence earnings, stock value and ultimately consumer prices. Accounting for the expense is a major factor why private pensions have virtually disappeared.
Government pension costs are just buried in taxes and nobody sees the direct impact not to mention that many states simply ignore adequate funding for the obligations they create whereas the private sector doing the same violates the law. State pensions are driven largely and many times irresponsibly by the relationship between politicians and public employee unions.
My point was simply that the lack of inflation-protected private pension plans is a problem, which is different from the issue of the cost of funding pensions or the fact that politicians have often agreed to overfund public pensions.