Deflated Pensions

John Lim

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.

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