Vanguard Variable SPIA: using Vanguard Inflation Indexed Securities Fund for inflation protection

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TIAA-CREF has suggested that annuitants can fashion an inflation indexed income stream by taking an immediate annuity funded by the TIAA-CREF Inflation-Linked Subaccount.

Protecting income from inflation:

When faced with a potentially lengthy retirement period, some retirees will be justifiably concerned about protecting themselves against the erosive effects of inflation on purchasing power. By purchasing a life annuity linked to TIAA-CREF’s Index Linked Bond Account, the assets of which are invested predominantly in Treasury Inflation Protected Securities, retirees receive a high degree of inflation protection over the rest of their lives.

-- A Paycheck For Life: The Role Of Annuities in Your Retirement Portfolio Jeffry Brown, TIAA-CREF Institute, June 2008 available at TIAA-CREF Trends and Issues


The table below provides a look at income adjustments assuming one adopts a variable immediate annuity [1] from Vanguard, funding the annuitization with the Vanguard Inflation Indexed Securities Subaccount [2]. This option is only available when annuitizing a rollover qualified plan, since the Vanguard Inflation Indexed Subaccount is not currently available for non-qualified annuity accounts. For the years (2001 through 2003) preceding the existence of the Vanguard SPIA (Single Premium Immediate Annuity) we reduce the fund’s returns by the 0.52% insurance charge. From 2003 on we use the subaccount’s historical returns [3] to illustrate how the SPIA provides income flows.

We are assuming an initial income stream of $1,000 and the selection of a 3.5% AIR (Assumed Interest Rate). Income adjustments to the variable annuity income stream are determined by the total return of the underlying portfolio of assets and the AIR, and are derived from the following formula: [4]

(1 + Fund Return) divided by (1 + AIR), less 1

The second column of the table below provides the portfolio return; column three indicates the change in annual income; column four provides the annual inflation rate; [5] and column five shows the net after inflation change in the income stream. The final two columns compare the income distributions of the SPIA with an inflation indexed annuity based on the CPI (Consumer Price Index) inflation rate. As one can see, the fact that the income stream from the inflation indexed subaccount is derived from annual total return demonstrates that the income stream will not exactly track the CPI. Income streams surpassed inflation from 2001 through 2004. Income in the SPIA would have actually fallen in 2005, 2006, and 2008. The income streams outpaced inflation from 2009 to 2011 . Over the full period, incomes from the subaccount annuitization provided an income that moderately outpaced the CPI through 2011.

Inflation Indexed Subaccount SPIA (2001-2008), $1,000 initial income, 3.5% AIR
Year Return Income CPI Difference SPIA Income CPI Income
2001 7.09% 3.47% 2.85% 0.62% $1,034.69 $1,028.50
2002 16.06% 12.14% 1.58% 10.56% $1,160.25 $1,044.75
2003 7.48% 3.85% 2.28% 1.57% $1,204.86 $1,068.57
2004 7.71% 4.07% 2.66% 1.41% $1,253.87 $1,096.99
2005 2.06% -1.39% 3.39% -4.78% $1,236.43 $1,134.18
2006 -0.09% -3.47% 3.23% -6.70% $1,193.54 $1,170.82
2007 11.01% 7.26% 2.85% 4.41% $1,280.15 $1,204.19
2008 -3.35% -6.62% 3.85% -10.47% $1,195.40 $1,250.55
2009 10.03% 6.31% -0.34% 6.65% $1,270.82 $1,246.30
2010 5.62% 2.05% 1.64% 0.41% $1,296.85 $1,266.74
2011 12.65% 8.84% 3.16% 5.68% $1,411.50 $1,306.77


If we assume one has the misfortune to start the annuitization during a period of lagging returns we see the following income flows:


Inflation Indexed Subaccount SPIA (2005-2008) , $1,000 initial income, 3.5% AIR
Year Return Income CPI Difference SPIA Income CPI Income
2005 2.06% -1.39% 3.39% -4.78% $986.09 $1,033.90
2006 -0.09% -3.47% 3.23% -6.70% $951.88 $1,064.29
2007 11.01% 7.26% 2.85% 4.41% $1,021.95 $1,097.74
2008 -3.35% -6.62% 3.85% -10.47% $954.30 $1,140.00
2009 10.03% 6.31% -0.34% 6.65% $1,014.51 $1,136.12
2010 5.62% 2.05% 1.64% 0.41% $1,035.29 $1,154.70
2011 12.65% 8.84% 3.16% 5.68% $1,126.81 $1,191.25


One can generate a higher initial income by selecting a 5.0% AIR. But as you can see, this higher discount rate results in lagging subsequent income returns and lower income appreciation.

Inflation Indexed Subaccount SPIA (2001-2008) $1,000 initial income, 5.0% AIR
Year Return Income CPI Difference SPIA Income CPI Income
2001 7.09% 1.99% 2.85% -0.86% $1,019.90 $1,028.50
2002 16.06% 10.53% 1.58% 8.95% $1,127.33 $1,044.75
2003 7.48% 2.36% 2.28% 0.08% $1,153.96 $1,068.57
2004 7.71% 2.58% 2.66% -0.08% $1,183.74 $1,096.99
2005 2.06% -2.80% 3.39% -6.19% $1,150.60 $1,134.18
2006 -0.09% -4.85% 3.23% -8.08% $1,094.82 $1,170.82
2007 11.01% 5.72% 2.85% 2.87% $1,157.49 $1,204.19
2008 -3.35% -7.95% 3.85% -11.80% $1,021.95 $1,250.55
2009 -3.35% 4.79% -0.34% 5.13% $1,070.91 $1,246.10
2010 -3.35% 0.59% 1.64% -1.05% $1,077.23 $1,266.74
2011 -3.35% 7.29% 3.16% 4.13% $1,155.71 $1,306.77


Note

The initial income from an actual annuitization will depend on numerous factors, including the age of the annuitant, the choice of single or joint annuitizations, guarantee periods, choice of AIRS, and the level of current interest rates.

The following initial incomes were available on August 15, 2008 from the Vanguard SPIA [6]. We have selected a 65 year old single male using a 10 year guaranteed SPIA, selecting monthly payments, and investing an initial $100,000 of qualified dollars into:

  1. The Vanguard Inflation Adjusted option
  2. The Vanguard Variable Option with a 3.5% AIR
  3. The Vanguard Variable Option with a 5.0% AIR

On this date, the difference in initial monthly incomes are:

  1. The Vanguard Inflation Adjusted option: $544.49
  2. The Vanguard Variable Option with a 3.5% AIR: $597.28
  3. The Vanguard Variable Option with a 5.0% AIR: $682.18

The following table examines the subsequent income streams from these initial income levels, using annual income adjustments to the initial income level.


(view Google Spreadsheet in browser or download as xls, ods, or pdf)

See also

References

  1. Overview:Vanguard Variable Immediate Annuity
  2. Vanguard Inflation Indexed Securities Subaccount
  3. Vanguard Inflation Indexed Subaccount historical returns
  4. Goodman, Benjamin, and Heller, Michael, Annuities: Now, Later, Never?, TIAA-CREF Institute (October, 2006), p.5.
  5. inflationdata com.
  6. Vanguard SPIA quote