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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.
Money earlier is worth more than money later. The level option pays more than the COLA option early on, so it should make sense that the level option looks more attractive in real figures than it does in nominal figures.
Mark, you did a good job with a tough problem. Your numbers were very close to ours with the exception of the $100,890 value. Was that a PV calculation of the 30 year stream of $7,000 at 2.5%? That would get close to the $100 K value.
I think your insight about insurance companies is correct. What would be their incentive to sell two similar products, but one with a 63% higher value? Why would anyone buy the level version?
PV is a powerful tool but not always intuitive. I make many mistakes and find I have to check my work and really think it through. I guess it’s fortunate I’m a nerd who enjoys the challenge.
Rick, looking back over my scribbles and notes, I think I’ve possibly found my mistake. I mixed up figures from two different calculations.
In an earlier attempt, I discounted the total 30-year sum ($210,000) as if it were a single lump sum received at year 30, rather than discounting each annual payment individually. I then accidentally used that wrong figure in the article instead of the correct calculation, where each year’s payment is discounted separately.
What a rookie error. I’m such a turkey, which I guess is appropriate for the time of year! Happy Christmas. (I got your message from Bogdan)
Mark, no worries. A wise man once told me that the only people who don’t make mistakes are liars, and those who never try anything. Jonathan used to check my articles carefully and often found errors, as have any number of readers. Bill Perry kindly saved me from a major tax faux pas when i was considering tweaking my mortgage from our primary home to our vacation home. This kind of respectful interaction is one of my favorite parts of HD. Merry Christmas.
I love this post. I love the time value of money. Finance would be so boring without unknown futures and human emotion that we (try to) synthesize into interest rates. It’s like romance that we turn into dating or marriage or running for the hills!
First, this highlights one of the most important aspects of life – what looks best now may not be best long-term. I want to do another romance metaphor, but I’m already in hot water around here. 🙂
Second, and insignificant is that the correct COLA annuities are..
Year 10: $4,950 x 1.03^9 = $6,458.63 (post is correct)
Year 20: $4,950 x 1.03^19 = $8,679.85 (post shows $8,440)
Year 30: $4,950 x 1.03^29 = $11,665.00 (post shows $11,020)
Third, it’s time to get a visual on the comparison..
Fancy Graph™ (with an unexpected conclusion!).
Langston, I had done a similar analysis earlier today and matched your numbers at 10, 20, and 30 years for the COLA SPIA. Did you consider calculation the PV of the 30 year stream of payments in today’s (or when payments start) dollars? I took each annual payment and discounted it back to the starting point using the 2.5% inflation factor in the original post. I found that the “real” value, or PV of the level SPIA was about $150K and the COLA adjusted PV was about $159 K. The COLA SPIA shows a higher real and nominal accrued value at about 23 years, in agreement with your curve. It would make sense that they would be fairly close – I doubt an insurance company would sell 2 similar products with a very large difference in value.
Some Thoughts on Present Value at the behest of the honorable Sir Rick.
It’s the way we compare apples to apples when dealing with future cash flows. We have a choice between two future cash flows: a fixed annuity and one that starts out lower but includes a COLA provision.
Promised future money (oranges) isn’t as valuable as present money in our hands (apples) for many reasons. The risk we might not get paid and competing opportunities top the list. We deal with these issues by discounting the future cash flows to a lesser amount using interest rates.
The fascinating thing is that two people correctly evaluating the exact same data will usually come up with different discount rates. Why? Because one person may have less confidence in the future cash flows, or they may have opportunities the other person doesn’t have, or they may need the money they have on hand more, etc.
Vanguard’s VMFXX money market is paying about 4%. Shiller says the stock market has averaged around 9% since 1871. Opportunities. Risk. Inflation. Mortality. Time without use of the money. Other stuff.
The discount rate turns those oranges into apples so you can make a decision.
Below is a link to a table of present values of the promised future cash flows from those two annuities. Same company, so risk is equal. Same upfront cost. The same effective rate of return — if you stay alive for 30 years. Still oranges and apples, because one pays more initially and the other pays more later.
If a lower discount rate is chosen, future money will be more valuable in the present, thus favoring the COLA payments once they exceed the fixed payments. If a higher rate is chosen, the future money will count less, thus favoring the fixed payments.
This is an extremely low-risk type of investment that is reasonably thought of as insurance. Expecting a higher rate of return would mean you’d have lower confidence in those future cash flows — not appropriate, though I included a 7.5% discount rate for fun. I also chose 2.5% on the low end, along with the actual returns.
I also show present values of each of these if you die earlier — in 20 years or 10 years. In those cases, you’d almost always be better served staying away from annuities and taking on more risk to avoid losing the bulk of your initial investment. IMO. No two people are alike. Some may value the reliability of an annuity so much that it’s a good deal no matter when they die. People are human, and that makes finance fun!
Annuity Present Value Table
Don’t read this and don’t click on the plot!
It’s just retired guy fun. It’s theoretical. Not something I’ve ever seen anyone else do, which is a warning. 🙂
But. The concept of Present Value for comparing different future cash flows is not at all theoretical. It’s the gold standard. Apples to apples. IF you pick the correct discount rate for YOU.
The following plot simply takes the 30 year present values we already calculated, places them where they should be – at time zero – and then applies compounding at the assumed discount rate. This allows you to see relative differences over time at a discount rate of your choice.
In effect it’s beating a dead horse because PV already gave us the answer, but I love graphs.
Annuity Present Value Plot
Langston, I must admit our idea of fun is radically different, but I find your obvious enthusiasm uplifting. Thanks for your excellent engagement and analysis of my article. Have a great Christmas.
And the COLA numbers..
COLA Annuity Table
It appears that you’re only allowed one link per post, so here are the numbers for the fixed annuity..
Fixed Annuity Table
Redundant post removed
the COLA option is essentially paying to protect against inflation risk, even though it costs significantly in the early years
Agreed. I knew my CCRC expenses would exceed my Social Security benefit even with delayed credits to age 70, and historically the SS COLA has lost a little ground to inflation each year.
Thus, after retiring in 2021 in good health, a year later I purchased a SPIA to narrow the gap so I’d need to draw less from my portfolio. To offset inflation I chose a SPIA with 5% (the largest available) compound annual increase in payout. Very happy with that decision; it allows me to sleep worry-free.
Do you mind sharing where you are getting that 5% COLA?
I used Income Solutions to provide quotes from multiple companies for the SPIA. Income Solutions is at this link. Lots of parameters to specify exactly what I wanted, lots of information included with each quote. Then for the company I chose, they provided and processed all the forms with that company, online as much as possible and with phone help as needed. The SPIA is with Mutual of Omaha.
I also used Income Solutions to purchase a QLAC (deferred income annuity from my tIRA) from a different insurance company, to start in 2034. No annual increase was available for any deferred annuities.
Completely satisfied with their service each time.
You can get quotes for annuities with COLAs that range from 1%-5% at immediateannuities.com. You do have to provide your email address.
I’m a 77 year old male and National Integrity gave me a quotes for $100,000 annuities of $930/month for no COLA and $667/month for a 5% COLA ($720 for 4% and $774 for 3%).
Thanks. I might have to do some math! 😉
A 5% COLA on your SPIA is excellent, I’d always assumed COLAs weren’t available with US annuities.
I think of COLA as tied to the inflation rate. My SPIA is not that. The 12 monthly payments are the same for the year and then increase by 5% for the next year, and so on, no matter what the current inflation rate is. So I called it a 5% “compound annual increase” to avoid using the term COLA.
Like parkslope, I did not find any SPIAs available with a “COLA that adjusts for annual changes in inflation.”
There are no annuities that I know of that will pay you a COLA that adjusts for annual changes in inflation. They used to be offered but I think they disappeared 8-10 years ago.
I searched briefly on fixed COLAs when interest rates were high and I couldn’t find any above 3%. It appears that some major insurance companies are now offering larger COLAs.
Yikes Mark, are you joining the ranks of the spreadsheeters?
From my perspective you can’t beat annuity income in retirement. An employer pension is ideal, but getting rare, a do it yourself annuity can fit the bill though as you described.
Unlike Kathy I knew my pension did not and would never have a COLA from the day I was hired in 1961. But the message was clear, I had to find another way to deal with inflation-can you say 401k + ? Those of us with both are few in the private sector, but fortunate.
I’m definitely not diving into nerd spreadsheet territory, that analysis was about as complex as I can handle on my own! My wife Suzie is fortunate to have both a substantial 401k and a government pension with a strong COLA that kicks in next year when she turns 60. It also includes a 50% survivor benefit.
Which is why I complain about US company pensions not having COLAs. Mine is worth half what it was twenty five years ago, when it was frozen when I reached 30 years service.
I was wondering, when you transferred your UK pension benefits to the US, did they not mention you’d be losing your COLA?
No, I don’t think they transferred in the sense you mean. I was on the UK payroll for about six years, and the UK company is paying their part of my pension – about enough for a good dinner out once a month. But it does have a COLA.
Thanks for this outside the box analysis of SPIAs, Mark, I never would have thought to take that extra step.
I’m a fan of SPIAs, though I do not presently own one. I have given thought to two other possible annuity strategies.
Interest rates are another consideration. Like certificates of deposit (CD), it’s better to buy a SPIA when rates are high, as they have been for a while now.
I suspect your post will generate a lively discussion, with many people condemning the product. Many people don’t understand the different types of annuities. The SPIA contract that we are discussing has no fees, in other words, they are not the variable products that can drain close to 3% per year from your investment.
They can also contain a return of premium rider in case one is run over by a bus at a young age.
I often ask Chrissy, please mam, can I have some more, when the popcorn bowl goes empty and the movie is only half over. But I digress, again.
I would have thought you’re at the perfect age for buying an annuity, especially with prices being so favorable right now?
I tried the “please can I have some more” approach earlier when Suzie was making gingerbread—it tastes amazing!