Market not interested in inflation protection?

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thx1138
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Market not interested in inflation protection?

Post by thx1138 »

Appreciate anyone's thoughts on this. However, please don't bother posting things like "what about TIPS?" without reading a bit more first :happy

It would seem that for individual retirees some sort of reliable inflation protection would be very desirable. SS provides that, but you can only "buy" so much. There are a few inflation protected annuity options but the market is tiny. TIPS and I bonds exist of course but their utility is constrained a bit.

But really, it seems like for whatever reason the "market" just isn't very interested. I say this thinking of a few things in particular:

- There are very few inflation protected annuities, the market is tiny.
- The true "liability matched" security is a TIPS zero coupon bond, for which no market exists despite the treasury provided the mechanism for it.
- Many pensions are not inflation adjusted despite being a center of labor negotiations.

So far I've thought of two reasons to explain the apparently tiny market for inflation protection for individual retirement accounts:

- Institutional investors (e.g. pension funds) are less sensitive to inflation because they have continuing contributions to go along with their distributions. In other words a pension is not at all like an individual retirement account and so the giant institutional market doesn't drive demand for securities more appropriate for individual retirement accounts.
- People stink at understanding the effects of inflation, there is a behavioral error here. This is in fact one of the reasons for steering monetary policy towards modest inflation, it helps in down turns because of behavioral errors like "nominal wage stickiness". As a result individual investors are drawn to the seemingly higher nominal returns of nominal securities and this restricts the market for inflation protected products.

There is of course a third possibility, which is that perhaps people think there are other combinations of assets provide equivalent inflation protection with higher real returns. I'd consider this a bit suspect though, most of these schemes include lots of equities and history shows equities can do poorly for long periods of inflation which makes them not at all appropriate for inflation protection of a distribution portfolio.

Anyway, I'd appreciate people's thoughts on this. Why do you think the market for such products is so small? Or am I all wet and the market is somehow thriving in some way I'm not seeing? Or I'm all wet and inflation protection isn't a risk worth protecting against for individuals?
Beliavsky
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Re: Market not interested in inflation protection?

Post by Beliavsky »

I think it's primarily irrationality about inflation. If forced to offer a rational explanation, I would cite data showing that real spending by retirees tends to fall as they age. Having real spending power decline by 2% annually may be OK, until the necessities threshold is reached. People in their 80s are less likely than people in their 60s to travel abroad, buy cars and second homes, remodel their homes, etc. My parents are in their mid 70s. Their health is gradually declining, so they sold their second home in another country and now travel very little.

It may be rational for people in their 60s, still healthy, to spend a good bit on things they may not be able to enjoy in their 80s. Of course, this raises the chance of their money running out. There are trade-offs.
Last edited by Beliavsky on Tue Jul 29, 2014 1:40 pm, edited 1 time in total.
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Re: Market not interested in inflation protection?

Post by chaz »

The TIPS fund is my protection from inflation.
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Dale_G
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Re: Market not interested in inflation protection?

Post by Dale_G »

I think the problem is that no one has the slightest idea of what inflation will be over the next 10, 20, 30 or 40 years. Not the feds, not the insurance companies and not the potential investors.

Over a wide geographical area and over time, the incidence of floods, hurricanes, tornadoes and forest fires can be reasonably projected. Inflation is much more uncertain. There is little in the way of "meeting of the minds" in terms of pricing, hence volume is low.

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dodecahedron
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Re: Market not interested in inflation protection?

Post by dodecahedron »

I agree with the forgoing. Inflation protected annuities are scary and uncertain things for insurance companies, which are inherently conservative, to offer. They aren't insuring against natural disasters. They are insuring against a government disaster. Also, folks in general may not value the benefits as much as the insurance companies project the likely costs to be.

In addition, inflation protected annuities represent a perfect storm of adverse selection for the following reasons:

1) Adverse selection is a big problem for annuity markets in general because annuities are differentially more attractive to folks who have reason to believe they can expect to live longer than average. (This would not be a problem if insurance companies knew as much about your relative risk of living longer than you do and could bake that information into the price. However, they don't always know as much as you do about your expected longevity (e.g., because you are privy to more of your family and medical history than they are) and even when there are factors that they DO know about, they are not always allowed to factor that information into the price they charge you. (E.g., they know that certain ethnic groups are apt to live for shorter or longer periods, but they would never be allowed to offer a price schedule that differentiated along those lines.)

2) Adverse selection in annuities gets more severe the more you "backload" the annuity by weighting more of the annuity payments later in time.

3) Because inflation is likely to be positive, an inflation-adjusted annuity can be expected to be inherently backloaded and thus differentially even more attractive to those folks who have reason to believe they can expect to live longer than average, further exacerbating the adverse selection problem.

Put it all together and you can see that market failure/inefficiency/inadequacy due to information asymmetry and adverse selection is apt to be more severe for inflation-adjusted annuities than for nominal fixed annuities.
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Re: Market not interested in inflation protection?

Post by SpaceCowboy »

I think it's mostly the behavioral issue coupled with the benign inflationary environment of the last decade. If you look at the spread between 20 year nominal Treasuries and TIPS, the market is currently predicting inflation of only 2-2.5% over the next 20 years and that's held pretty steady over the last 10 years. To me that seems benign and unlikely, but I'm only one market participant. Personally I think inflation over 20-30 years is a substantial risk and happily take the other side of that bet.
However, due to recency bias and current economic conditions, most people just don't see inflation as a risk, when in fact inflation is a much higher risk to the value of long term nominal bonds than real interest rate risk. People are much more focused on the interest rate risk given all the attention that is paid to low interest rates and high bond prices. What many people forget is that nominal interest rates are composed of both a real rate and an inflation expectation.
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Chan_va
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Re: Market not interested in inflation protection?

Post by Chan_va »

I don't think the market is not interested in inflation protection. Most people already have 3 forms of inflation indexed assets - Social Security, real estate and equities.

So, what you are saying is that there doesn't seem to be much of a market for riskless inflation protection. I think there are a few reasons

1. Inflation indexed annuities are very expensive relative to nominal. Given that most retirees have SS and equities, they are not willing to pay the premium
2. Holding individual TIPS in taxable accounts is problematic.
3. There is no data regarding how TIPS will behave in a high inflation scenario. So there is some skepticism till we have some real world data
4. Most large insurers and lenders have nominal liabilities, hence they are fine hedging them with nominal bonds.
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Re: Market not interested in inflation protection?

Post by Oicuryy »

thx1138 wrote:Or I'm all wet and inflation protection isn't a risk worth protecting against for individuals?
This, IMO. Nominal yields are (usually) high enough to cover expected inflation and some part of the risk of unexpected inflation. Most individuals must think insurance against the rest of the risk of unexpected inflation is not worth the cost.
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Re: Market not interested in inflation protection?

Post by LongerPrimer »

Wrong.
Market is very concerned with inflation AND deflation, which is one of the why insurance-annuity cos are reducing benefits and projections. If not getting out of the business. The risks for inflation-deflation is more-

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Re: Market not interested in inflation protection?

Post by Epsilon Delta »

A market requires both buyers and sellers. It could be that nobody is interested in offering inflation protection that is remotely close to being fairly priced.

For my part SS offers a good chunk of inflation (and longevity) protection. If I want to buy more I can delay until I'm 70. Last I checked other inflation adjusted annuities are a lot more expensive. Does this mean SS is a give away, or the annuities are robbery, or that there are circumstances that allow the government to provide inflation protection cheaper than insurance companies? I don't know but I'm not buying at current prices.
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Re: Market not interested in inflation protection?

Post by heyyou »

The potential market is huge, but who is going to take the other side of the risk? What can an insurance company invest in that will pace inflation plus admin costs? Equities will outgrow inflation over multi-decade periods, but not during the inflation periods so the insurers would need deep pockets.

That is why there are so few products. If someone is selling them, they are high priced due to the risks. Life insurance is simple when compared with inflation insurance.

Private pension funds can barely manage to meet nominal payments. It takes a federal institution to offer 30-40 years of inflation protection on their own annuities.

As we look at 1966 retirees for worst case retirements, an insurance company would do the same for pricing inflation protected annuity payments. After free energy from perpetual motion is solved, expect more action on inexpensive, inflation protected retirement income.
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Re: Market not interested in inflation protection?

Post by Dale_G »

Epsilon Delta wrote:A market requires both buyers and sellers. It could be that nobody is interested in offering inflation protection that is remotely close to being fairly priced.

The problem is that no one has any idea of what is remotely close to being fairly priced

For my part SS offers a good chunk of inflation (and longevity) protection. If I want to buy more I can delay until I'm 70. Last I checked other inflation adjusted annuities are a lot more expensive. Does this mean SS is a give away, or the annuities are robbery, or that there are circumstances that allow the government to provide inflation protection cheaper than insurance companies? I don't know but I'm not buying at current prices.

Insurance companies are bound the the terms of the original contract. Government does not have a contract. It can change the rules at any time. It has done so in the past
Edit: Sorry about including my comments (in blue) within Epsilon Delta's quoted post.

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Re: Market not interested in inflation protection?

Post by #Cruncher »

thx1138 wrote:- The true "liability matched" security is a TIPS zero coupon bond, for which no market exists despite the treasury [ providing ] the mechanism for it.
It's not necessary that a zero-coupon form exist in order for TIPS to provide a known stream of dollars over a period of years -- which is what a "Liability Matching Portfolio" (LMP) is supposed to do. The reason is that a portfolio of TIPS can be constructed taking into account both principal and interest payments to produce such a stream. For example in its default setup, my TIPS Ladder Builder provides $30,000 in constant dollars every year from 2015 - 2029 composed of principal plus interest. And Wade Pfau does so also in a blog referenced in the thread, Wade Pfau's TIPS ladder guide.

Where zero-coupon TIPS STRIPS (acronym for Separate Trading of Registered Interest and Principal of Securities) would be useful is to provide for the gap years when no TIPS mature. The largest such gap is 2033-2039. Since TIPS mature in 2040-2044, there are interest coupons that will be paid during these 7 gap years. If the the interest from these TIPS were marketed as STRIPS, an investor could purchase them to cover the gap years. But as you say, thx, even though the Treasury provides the mechanism, the market hasn't developed. See the TreasuryDirect STRIPS web page for more info.
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Re: Market not interested in inflation protection?

Post by thx1138 »

Thanks for the thoughtful replies so far! Some additional thoughts/responses.

First of all, as more than one person pointed out I should really say "unexpected inflation" protection. Lots of ways to structure things at reasonable prices assuming a fixed or market estimate of inflation.

@Beliavsky - Good point on declining expenses with age, I've seen that with relatives. Of course that only works for "expected" inflation.

@Dale_G - Yes I suppose cost and volume are related, that's a good observation. If the costs are higher than what the market thinks it is worth then naturally volumes will be low. And "cost" for annuities is tricky. Right now it appears that an inflation adjust annuity costs you about the same to slightly more than a 3% indexed annuity. In other words the inflation indexed annuity is being priced as if inflation expectation is around 3% when the market forecast (based on TIPS spread) is more like 2 to 2.25% and presumably that TIPS spread includes some sort of inflation risk premium already. So does that make the inflation adjusted annuities "expensive" in the eyes of a buyer (I honestly don't know the answer to that). Also, another very important difference of inflation "insurance" is that it is pretty much perfectly correlated across all contracts unlike hazard or longevity insurance.

@dodecahedron - Interesting point on adverse selectivity (a.k.a. what killed the LTC insurance market). I have to think about that more with regards to nominal annuities, deferred annuities and fixed indexed vs. inflation indexed annuities. I can see how it potentially may extend the inflation risk exposure in an asymmetric way that is non-intuitive. Great post, thank you.

@rrppve - I think we are thinking alike about the value of protection. Looking at my numbers above, if I say inflation protection is going to "cost you" about an additional 1% in fixed indexing over the expected rate of inflation is that "worth it"? That is to say if inflation does go as expected you will lose 1% "rate of return" no your inflation indexed annuity do you go for the inflation protection?

@Chan_va - Yes, good clarifying point - riskless protection. For point 1 I think the proper comparison is to fixed indexed annuities, but yeah as said above inflation protected do cost a bit compared to those. Point 3 is interesting, it seems they are at this point a small enough fraction of the market to not be a solvency risk but I suppose there are all sorts of unexpected secondary effects. Point 4 jives with my thought that institutional investors don't have as large a need as an individual retirement account might.

@everyone else - Sorry, out of time to respond at the moment but thanks for the additional thoughts many of which emphasize the prior posts. I appreciate all the angles on this!
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Re: Market not interested in inflation protection?

Post by Beliavsky »

I just saw the Bogleheads wiki page Vanguard Variable SPIA: using Vanguard Inflation Indexed Securities Fund for inflation protection. Does an annuity invested in this way protect against inflation?
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Re: Market not interested in inflation protection?

Post by john94549 »

One might consider the degree to which ordinary folk understand inflation-protected products. To the extent folks do, aren't there products already available? Now, if all of a sudden more folks started to clamor for more, better, or different, and a buck was to be made thereby, I suspect the market would respond.

For example, as we boomers age, a huge issue becomes planning for long-term-care, private-pay, whether at-home or in assisted living, skilled nursing, or whatever. I'd love to buy a product, essentially inflation-protected, which would guarantee that, for however long I need the care, it will be provided. I suspect that such a product will one day be offered, probably by Kaiser.
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Re: Market not interested in inflation protection?

Post by thx1138 »

Thanks again to all who have posted, catching up with responses now that I have the evening free...

@Oicuryy - Put another way, there are solutions that get you part of the way there and getting all the way there is considered too expensive. So we should consider the cost difference between "ideal protection" and an "80% solution.'' Good point.

@LongerPrimer - I'm not familiar with who is getting in or out of the market actually. I certainly understand adjusting benefits in light of a feared persistently low interest rate environment not to mention looking over ones shoulder at Japan like deflation if you are writing nominal contracts! Does anyone know of a article or source regarding whether the number of annuity companies is growing or contracting?

@Epsilon Delta and Dale_G's response to that - Yeah, the pricing issue again. At first blush it seems like TIPS spread should provide some sort of reference or anchor to this, but I suspect that for nominal contracts the annuities aren't actually backed by something as risk free and low yield as a nominal treasury. So if you were to back an annuity with TIPS you'd take a hit on return compared to say annuities backed by a mixture of asset classes.

@Dale_G's comment regarding government changing the rules - Indeed that is very possible. One interesting thing about nominal obligations I saw pointed out somewhere is that nominal pensions create an opportunity for intergenerational wealth transfer, or for a younger generation to claw back wealth from an older generation. As a hypothetical if the Millennials decided the Baby Boomer's had somehow screwed them with low wages and debt while supporting the BB's retirement a way to turn the tables is through increased inflation. Of course that doesn't work on SS which is indexed, but most everything else isn't...

@#Cruncher - Thanks for the clarification. Yes, I'm aware for a normal retirement income regular TIPS or TIPS ladders are the appropriate tool for an inflation adjusted income source. What I was referring to is a fixed liability in the future. That's one of the uses for a nominal ZCB - I've got a nominal liability of $250K 8 years from now, the optimal minimum risk investment is a nominal ZCB as it has no reinvestment risk. I was just using the lack of a TIPS STRIP product as an illustration of how thin the market of products seems to be for inflation protected vs. nominal securities. But again, thanks for taking the time to clarify.

@Beliavsky (again) - So yes that kind of annuity is a way to protect (to a degree) against inflation. Of course it isn't risk free, but it falls into the category of alternative ways to get some degree of inflation protection. As mentioned above perhaps these surrogates are a less expensive solution to the ideal.

@john94549 - So unfortunately aside from inflation problems the product you desire has very severe adverse selection problems (see dodecahedron's earlier post). This is the issue with pretty much all LTC insurance. There are really two types of reasonable LTC outcomes and one extremely expensive outcome. One is a typical cascade of problems as bad leads to worse (broken hip leads to stuck in bed leads to respiratory problems and so forth until death). In this case the amount of LTC liability is pretty bounded, hard to live more than three years or so past when claims start being made. The other is recovery from surgery or other acute events - the patient actually gets better and recovers to the point LTC is no longer needed. Again, bounded in time. The third outcome is dementia and related problems. Hugely expensive and care can go on for a decade or more. Because of the later case the premiums for LTC are very high and thus we get the adverse selection. People who suspect they aren't at risk for dementia self insure with an emergency fund and thus don't enter the risk pool and only those who expect dementia buy the LTC insurance which increases payouts, which requires higher premiums, which leads to even more adverse selection, and so on. That's where LTC insurance sits these days. Much bigger problems to deal with before tackling inflation!

Once again, thanks to everyone for the thought provoking replies.
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Re: Market not interested in inflation protection?

Post by stlutz »

It really comes down to the type of debt that the Treasury chooses to issue. They issue more nominal than inflation protected debt. Insurance type products depend upon the availability of long-term bonds to make them work. If the government stopped issuing nominal debt and started selling only TIPS, annuities and any other such insurance product would all be issued on an inflation-adjusted basis and you wouldn't be able to get fixed annuities or other such products.
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Re: Market not interested in inflation protection?

Post by cowboysFan »

dodecahedron wrote:
1) Adverse selection is a big problem for annuity markets in general because annuities are differentially more attractive to folks who have reason to believe they can expect to live longer than average. (This would not be a problem if insurance companies knew as much about your relative risk of living longer than you do and could bake that information into the price. However, they don't always know as much as you do about your expected longevity (e.g., because you are privy to more of your family and medical history than they are)
I don't see why adverse selection would necessarily be a large factor. When I got a private life insurance policy, they asked for a very detailed personal and family medical history, requested from any medical provider I had seen in the past 10 years my records, and collected a blood sample. By the time the process was over, the insurance company knew as much as I did and more about my medical history and their actuaries would certainly be better able to analyze it to come up with a life expectancy than I am.
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Re: Market not interested in inflation protection?

Post by thx1138 »

@stlutz - Interesting point, I'll have to look into how the supply of TIPS from Treasury works. Or actually the supply for any given maturity really.

@cowboysFan - The big difference is that for life insurance you are required to disclose your medical history and often have a medical exam. For annuities you give them your age and your gender and that is it. I'm not sure of the regulatory environment but for whatever reason annuity rates are based on very little information leading to the adverse selection problem described. Note that in the UK at least there are products called "enhanced annuities" in which you do disclose health history and you get higher payout rates if you have poor health. That doesn't seem to exist in the US. Bottom line, the actuary problem between life insurance and annuities is wildly different.
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Re: Market not interested in inflation protection?

Post by LongerPrimer »

^^
A quandary I cam answer.
Life insurance, the underwriter don't want you to die and will do everything it can do in the screening process to determine if you won't die before the LI company gets your muney. The opposite happens in annuities where the insurance (same life insurance co) actually wants you to die early so that it can get your money earlier. :oops:
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Re: Market not interested in inflation protection?

Post by Johno »

thx1138 wrote: - The true "liability matched" security is a TIPS zero coupon bond, for which no market exists despite the treasury provided the mechanism for it.
I think the existing TIPS market is fairly complete for practical purposes of inflation hedging, but it's a relatively small market because in fact there's a limited interest. It seems to me the idea of regular 'fixed rate' strips is mainly suited to institutions, because it can match a known long term nominal $ liability (which individuals rarely have) and can match it within months of a certain far future date (individuals tend to be less constrained in this respect). A similar inflation protected security would have some usefulness, but as far as just literally the inflation protection component, there's not that much downside is just rolling over and reinvesting in TIPS. All TIPS' principal adjust by the same inflation factor. They only differ in the real margin over/under inflation. That's also important of course, but it's still different in that respect from rolling over/reinvest in coupon treasuries where the entire coupon of the future issue is unknown. However uncertain future fixed treasury coupons are, TIPS coupons for corresponding periods are less uncertain by the inflation adjustment.

This is somewhat a matter of personal taste, how much various people like to have everything laid out exactly, to give the feeling (the illusion?) of control of the future in general. But if I have a TIPS issue maturing in or a little before the general period where I might need the money, that's good enough for me. I don't think lack of a TIPS STRIP is much of either a cause or symptom or the relative lack of interest in explicit inflation protection.

As far as the general question, a point which may have been mentioned but if so I missed it, is how to measure 'inflation'. To the extent it's the CPI and the methodology is sound and carried out without political taint, it doesn't really relate much to the needs of institutions. For example CPI is not necessarily directly relevant to the cost escalation for a corporation or project with takes out a long term financing. So it's not surprising that it isn't popular for such financing to be priced at CPI+spread. And that's a lot of the fixed income market. And even for retail investors, general CPI might not be an accurate measure of the escalation of their living individual costs, though undoubtedly more relevant than for institutional financing in general. Then finally there's the risk that calculation of CPI is wrong and/or might in the future be tainted by politics. Some people believe this is true now in the US (though I don't believe so), and it's demonstrably true in some countries (Argentina for example). It's a valid risk to consider though IMO even in the US, for a long enough time horizon.

But as several other responses have noted, the basic reasons for the relative lack of interest in explicit inflation protection are:
-the general phenomenon of money illusion: the human brain just wired to naturally think of an inflation adjusted stream as a 'rip off' (even if priced at breakeven by the provider) compared to a non-inflation adjusted stream because the latter is bigger to begin with.
-the particular current situation that 'inflation expectations are well anchored' as the Fed likes to say. Again some people don't feel this way, and it seems it tends to be a political thing nowadays, with expectation of high inflation tending to correlate with strong disapproval of the current administration. But not everyone highly critical of administration expects high inflation. And the other side of the political spectrum and the mass of non-political people generally assume that inflation will be around 2-3% indefinitely. If so, explicit inflation protection isn't that critical. Included in that view IMO is to call stocks an inflation hedge. That's only true if inflation is moderate and predictable. High and unpredictable inflation (which tend to go together) are bad for stocks' real return; they were in the last such period in the US at least. Real estate is a bona fide implicit inflation hedge, but stocks are only if you assume inflation will be low and predictable. And in that case fixed rate bonds (or annuities, etc) aren't a bad investment either wrt inflation: they compensate you for inflation according to the same relatively benign expectation.
Last edited by Johno on Wed Jul 30, 2014 3:02 pm, edited 1 time in total.
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Re: Market not interested in inflation protection?

Post by Beliavsky »

thx1138 wrote: For annuities you give them your age and your gender and that is it. I'm not sure of the regulatory environment but for whatever reason annuity rates are based on very little information leading to the adverse selection problem described.
The adverse selection problem is much greater for life insurance than for annuities, which is why the former has underwriting. It's perfectly possible to know you have only a few months to live, so that the ratio of actuarial life expectancy to your life expectancy can be more than 100. No one *knows* that they will live longer than the actuarial tables say, any more than they know whether there will be an equity risk premium or a small cap value premium over the next 5 years. I think the market for inflation-indexed annuities is small because of lack of consumer interest and because the size of the nominal bond market is much bigger than that of the inflation-linked one, not because inflation-indexed annuities have especially serious adverse selection problems. It's my impression that insurance companies are big investor in corporate bonds. Maybe their accounting is such that the higher yields on corporate bonds improve their financial position, even if corporate bonds do not have higher Sharpe ratios than Treasuries historically. The inflation-indexed corporate bond market is almost nonexistent. So insurance companies may offer worse pricing on an annuity they can hedge with corporates than an inflation-indexed annuity that must be hedged with Treasury bonds (of the inflation-indexed variety).
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Re: Market not interested in inflation protection?

Post by denovo »

Chan_va wrote:I don't think the market is not interested in inflation protection. Most people already have 3 forms of inflation indexed assets - Social Security, real estate and equities.

I would be loathe to call real estate or equities inflation indexed assets. Social Security is , but keep in mind, that's not a guranteed, although we can't delve further into it on this forum. However, it is suffice to note that SS didn't use to have an inflation adjustment and they are thinking of adjusting the formula.

Moreover, real estate and equities are expected to have positive real returns, but there is no guarantee. I think the market isn't interested in the sense people are interested in growing their money by more than inflation.
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Re: Market not interested in inflation protection?

Post by dodecahedron »

thx1138 wrote:@stlutz - Interesting point, I'll have to look into how the supply of TIPS from Treasury works. Or actually the supply for any given maturity really.

@cowboysFan - The big difference is that for life insurance you are required to disclose your medical history and often have a medical exam. For annuities you give them your age and your gender and that is it. I'm not sure of the regulatory environment but for whatever reason annuity rates are based on very little information leading to the adverse selection problem described. Note that in the UK at least there are products called "enhanced annuities" in which you do disclose health history and you get higher payout rates if you have poor health. That doesn't seem to exist in the US. Bottom line, the actuary problem between life insurance and annuities is wildly different.
Actually, policies with options such as you mentioned in the UK, designed for folks in poor health, also exist in the US as well. See here. Essentially, you have the option of asking for a medical evaluation and getting yourself "rated" as older than your true chronological age. However, they don't seem to be very widely used here, for whatever reason.

One policy feature that does appeal to folks in poor health and thus mitigates the adverse selection problem somewhat are annuities with a guaranteed minimum payout period (but the degree of mitigation is less in a backloaded policy of any kind, including an inflation-indexed policy.)
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Re: Market not interested in inflation protection?

Post by Chan_va »

denovo wrote:
Chan_va wrote:I don't think the market is not interested in inflation protection. Most people already have 3 forms of inflation indexed assets - Social Security, real estate and equities.

I would be loathe to call real estate or equities inflation indexed assets. Social Security is , but keep in mind, that's not a guranteed, although we can't delve further into it on this forum. However, it is suffice to note that SS didn't use to have an inflation adjustment and they are thinking of adjusting the formula.

Moreover, real estate and equities are expected to have positive real returns, but there is no guarantee. I think the market isn't interested in the sense people are interested in growing their money by more than inflation.
I agree. My full quote was
I don't think the market is not interested in inflation protection. Most people already have 3 forms of inflation indexed assets - Social Security, real estate and equities.

So, what you are saying is that there doesn't seem to be much of a market for riskless inflation protection. I think there are a few reasons
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gasman
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Re: Market not interested in inflation protection?

Post by gasman »

I think that "the market" is incredibly interested in inflation protection. That is why the price of protection is so dear, e.g., low to negative real TIPs yields.

If the market "wasn't interested" real yields on TIPs would be much higher.
letsgobobby
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Re: Market not interested in inflation protection?

Post by letsgobobby »

dodecahedron wrote: folks in general may not value the benefits as much as the insurance companies project the likely costs to be.
I have always thought this was the primary driver of the funny market. Basically, the average consumer doesn't understand and underestimates the risks of inflation, and therefore underestimates the fair price.
Angst
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Re: Market not interested in inflation protection?

Post by Angst »

letsgobobby wrote:
dodecahedron wrote: folks in general may not value the benefits as much as the insurance companies project the likely costs to be.
I have always thought this was the primary driver of the funny market. Basically, the average consumer doesn't understand and underestimates the risks of inflation, and therefore underestimates the fair price.
So would it follow that b/c the avg consumer is not in the mrkt for inflation protection d/t their underestimation of value (fair price), that the lower demand means that pricing is more favorable than it might otherwise be? I.e. that the price of inflation protection, in whatever form you're looking at, is actually pretty good?
letsgobobby
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Re: Market not interested in inflation protection?

Post by letsgobobby »

I don't know - that sounds like a good story in a purely rational and efficient marketplace. But we're in the realm of psychology and behavioral finance where rationality cannot be assumed. For instance maybe insurance companies have written off 'the masses' and only sell this product to those 'in the know' who are willing to pay a fair price for it. Or worse for the consumer, maybe they have determined that the only market they want to sell to is those who *over*value inflation protection, and are thus prone to overpaying, and therefore prices are too high.
richard
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Re: Market not interested in inflation protection?

Post by richard »

The Fed and other major central banks want to keep inflation low and have the power to do so (Volcker is probably the most familiar example). Recent history shows they are willing to endure slow growth, high unemployment and possible debt crises in order to pursue this goal. This might influence the market's perception of the danger of inflation.

On a technical level, I'd guess what most people want to protect against is an increase in their cost of living. The Fed currently regards the labor market (employment and wage growth) as the main driver of inflation and intends to act to counter large increases in employment or wages. I doubt most people want protection against higher wages - most people seem to like getting raises.
Johno
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Re: Market not interested in inflation protection?

Post by Johno »

gasman wrote:I think that "the market" is incredibly interested in inflation protection. That is why the price of protection is so dear, e.g., low to negative real TIPs yields.

If the market "wasn't interested" real yields on TIPs would be much higher.
I think your point has some validity at the margin. And by the same token the difference between nominal (on-the-run) treasury yields and TIPS yields is not exactly 'the market's prediction of inflation' exactly. It's also influenced by the relative liquidity of the two types of security, and inflation risk preferences, IOW 'the market's interest in inflation protection'. But OTOH the yield relationship of nominal treasuries and TIPS's can't be completely out of line with actual inflation expectations. So for example now the nominal 10yr yields around 2.5% and 10yr TIPS around .25%. If the TIPS yield were to return to the 2% level often seen years ago, but the nominal was still 2.5, that would break even at inflation of .5%, and there are solid objective reasons to think that's not the expected inflation level (starting with the fact that the central banks' all but explicit target for inflation is >=2%).

So, I don't think we can tie market interest in inflation protection directly to the change in TIPS prices in recent years. I believe the (relatively) small size of the TIPS market is a better measure. The Treasury could make it larger if they wanted to, with some increased risk to the proposition 'they'll never default they can just print money', but ostensibly, and IMO in reality, Treasury officials are not planning to escape the debt problem with much higher inflation. The TIPS market is mainly small because demand is limited: interest in inflation hedging is limited.

And again we see evidence right on this thread of some of the reasons, eg. 'equities are an inflation hedge'. The modern period of serious US trouble with inflation in late 60's-early 80's contradicts such a statement, but the current typical investor hasn't lived in a period of high inflation. Again as the Fed says 'Inflation expectations are well anchored', for better or worse. And one of the natural results of that is relative lack of interest in investments which are true inflation hedges*.

*at risk of derailing the discussion with the emotional arguments that come out for and against gold (usually against, on this forum): there's a significant interest in gold, especially by number of investors rather than $'s, as seen in mass market advertising. It's ostensibly an inflation hedge. And in reality it can be though an imprecise one (though more of an inflation hedge than stocks). But it's also kind of a general hedge against mistrust of 'Wall Street', 'govt', the institutions of society in general, or risk of such mistrust being justified in the future even if it's not justified now. And for some it's just speculation. So interest in gold is partly an expression of interest in inflation protection, but it's other things also.
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thx1138
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Re: Market not interested in inflation protection?

Post by thx1138 »

@Johno - Wow, thanks for the excellent and insightful post. Great observations on the lower utility or need for TIPS STRIPS, that makes a good deal of sense. Interesting point on the potential lower utility of CPI indexing to an institutional investor - I hadn't thought of that. Other surrogates could likely be "just as good" for them since CPI may not be correlated to their liabilities anyway. And to various political opinions on inflation it is sort of amazing to often see very similar folks simultaneously worried about run away inflation as well as Japan style deflation. But yes, the market seems very convinced 2-3% forever is an OK bet (of course the same market thought if you put enough liars loans together they magically become AAA rated). And I agree with your behavioral assessment as well - we are wired to think nominal.

@Beliavsky - The thing I'm realizing with everyone's input is the potentially indistinguishable difference between lack of demand vs. lack of supply vs. fair price. They are all of course related and it becomes very chicken or egg. Certainly the availability of underlying assets to hedge risk plays some role and confuses things even more. I need to do some homework on just how the volume of TIPS issued is even determined.

@denevo & Chan_va - I suppose the distinction is truly inflation indexed, something you'd want in an annuity or something else truly liability matched, versus assets that help combat unexpected inflation. I was asking more about truly inflation indexed, but it is becoming clear it is hard to think about that market with out comparing it to other ways of "solving the problem".

@dodecahedron - Thanks for the pointer to that! I wasn't sure they were available in the US.

@gasman - So I'm not sure how dearly it is being paid for. When you compare the TIPS nominal spread to the consensus forecast of inflation (Swedroe discusses how to do this) it looks like investing in nominals is not getting much if any risk premium for exposure to inflation risks. Basically if you think there is any risk at all of unexpected inflation then TIPS should be returning even less than they are!

@letsgobobby and Angst - Interesting question. I had assumed that there would need to be a sufficient amount of demand for institutions to bother creating, selling and marketing any sort of inflation indexed instrument. It isn't like they have any need to sell them at all. If the market has low demand because it doesn't understand the actual price I see no reason why a company would create a market to sell securities at low margin. But obviously there is more than one way to look at it!

@richard - Monetary policy isn't my strength, so forgive me if I'm misunderstanding something fundamental, but I would have thought that recent history has shown Fed was pretty desperate to *raise* inflation and avoid deflation at any cost. They've been making access to money for lending ridiculously cheap which tends to drive growth and inflation. Now the ECB is definitely different, their only mandate being to keep inflation low and so they've trailed the Fed a lot as far as stimulative monetary policy (it isn't in their charter at all, all they are suppose to do is prevent too high inflation, which is different from the Feb which has a wider reaching charter). But anyway, regardless I guess the takeaway either way is that the Fed appears willing to go to great measures to get inflation where it wants it regardless of competing monetary factors. And so the market doesn't feel threatened my inflation necessarily (but perhaps feels more threatened by side effects of the Fed's efforts to control inflation instead). And yeah, on the wages thing there is even a name for it - nominal wage stickiness. Don't you dare cut my nominal pay, but if you reduce my real spending power I'm less likely to notice.

Thanks again everyone for the excellent and informative discussion.
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