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I was mulling over a thought recently. It seems that over the last nine months I’ve become so enamoured with the fixed income I secured with an annuity when first retiring that a little voice in my head keeps whispering to load up on some more.
At the moment I have a term annuity that lasts ten years and covers all my essential spending. Out of curiosity I decided to get some quotes for a single payment immediate annuity (SPIA). And although I’ve put the idea on the back burner until I’m older, probably mid to late sixties, the numbers looked quite good: 4.95% with a 3% COLA for my spritely 58 year old self. Alternatively I could have got a level annuity with a 7% rate.
Even though I’m not buying, it occurred to me that working through the figures would be an excellent example on the effects of long-term inflation on fixed income. The contrast is illuminating. That level annuity at 7% sounds good at first look—for every $100,000 I hand over, I’d receive $7,000 annually for life. Simple, straightforward, and the payout never changes. The COLA option at 4.95% looks anaemic by comparison, delivering just $4,950 in year one for the same premium. But then it gets interesting.
Fast forward a decade, and that 3% annual adjustment has compounded quietly in the background. By year ten, my COLA annuity would be paying $6,460 annually—still trailing the level payment, but the gap has narrowed considerably from that initial $2,050 difference. Another decade out, at year twenty, the COLA payment reaches $8,440 while that level annuity stubbornly sits at $7,000. The inflation-adjusted income has overtaken the fixed payment, and the crossover happened somewhere around year fourteen.
The real eye-opener comes when you extend the timeline to thirty years. That 3% COLA, which seemed almost miserly at the start, has compounded the initial payment to $11,020. Meanwhile, the level annuity remains frozen at $7,000—meaning the purchasing power of that payment has been steadily eroded by three decades of inflation. If we assume a modest 2.5% inflation rate over that period, that $7,000 would only buy what $3,360 purchases today. The COLA annuity, by contrast, has been climbing alongside inflation, preserving its real value.
When I tally up the total nominal payments over those thirty years, the level annuity delivers $210,000 while the COLA option pays out $237,877—a difference of nearly $28,000. But the real story emerges when I adjust those payments for inflation to compare their value in today’s dollars. The level annuity’s $210,000 in nominal payments is worth only $100,890 in real terms. The COLA annuity’s $237,877 holds its value far better, equating to $164,663 in today’s purchasing power. That’s a 63% advantage in real terms—the COLA option delivers substantially more actual buying power over the long haul, even though it started with those meagre early payments.
This analysis shows how the COLA option is essentially paying to protect against inflation risk, even though it costs significantly in the early years. It’s a good example of why not to underestimate the corrosive power of inflation when considering annuity and pension payments. It also helps to explain why some want to delay social security for the biggest possible base for future COLA increases.
I think I’d rather have a TIPS ladder.
Great to do the comparison with the COLA. I purchased a DIA (SPIA that pays out at a later date) w/o a COLA. Logic being the Social Security pymt has a COLA and the bulk of the assets (the portfolio) should provide an inflation hedge. The breakeven point as you point out, is down the road a
long while.
Mark, this is an excellent post. I bothered to read through all the comments, and see that the numbers in the main (first) post are not correct. Would it be possible to update them to be correct? Otherwise you have to read through the comments, in the correct order, to figure out what is going on. The problem with this is, of course, the comments then become meaningless.
Guys, I doff my hat to you both. Your expertise and rigour is an order of magnitude above my attempt to work through the numbers.
Rick, let me make sure I understand what you’re saying: when properly valued in present value terms, there’s no clear financial advantage to taking the COLA option over the level payment? That seems counterintuitive given how much the COLA grows over time. Am I missing something, or is the key insight that insurance companies have priced these to be roughly equivalent, and the choice is really about when you want the money rather than how much total value you get?
It’s a good reminder not to let an amateur like me start building spreadsheets without fully understanding the methodology. Appreciate you both tightening up my analysis.