Annuities are a bet on future inflation rates and should not be purchased by retirees

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CULater
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Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by CULater » Tue May 28, 2019 9:48 am

Zvi Bodie and Dirk Cotton advise that nominal annuities carry uncertain inflation risk for retirees and that only real annuities should be purchased or none:
Economic theory implies that, faced with a choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars, a rational individual should consider the real annuity to be risk-free and the nominal annuity to be risky.
Purchasing a nominal rather than a real annuity is a decision to intentionally expose the annuitant to inflation risk. This inflation bet is similar to the example above in which a Canadian retiree buys a U.S. dollar-denominated annuity and inadvertently speculates on the future foreign exchange rate. Neither is the kind of speculation a retiree should consider.
Nonetheless, all financial products have pros and cons and, given their full appreciation in the context of the remainder of the retirement plan, a retiree can make a rational decision to purchase nominal or real annuities, or neither. Annuitants should understand before choosing that nominal annuities include a speculative bet on future inflation rates and the potential for substantial losses of purchasing power should high rates of inflation return, while real annuities include neither.
https://www.advisorperspectives.com/art ... -annuities
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by prd1982 » Tue May 28, 2019 10:03 am

Your title doesn't match the summary you posted. The summary says to not buy nominal (not inflation adjusted) annuities. It doesn't say to not buy annuities.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by adamthesmythe » Tue May 28, 2019 10:16 am

(title)

We already knew that. Doesn't mean it's a bad bet, when made at the right age and with a portion of assets in other investments.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by BigJohn » Tue May 28, 2019 6:41 pm

While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Sandtrap » Tue May 28, 2019 7:06 pm

BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
At "immediteannuities.com" there is a variable you can put in for COLA at any percentage for an SPIA. While it does not follow what might happen to inflation, it's a start.
j

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by TravelforFun » Tue May 28, 2019 7:16 pm

BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
I bought an annuity that has a 2% COLA a couple of months ago. The COLA feature reduces my initial payout by almost 20% but I considered it to be worth it.

TravelforFun

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by vineviz » Tue May 28, 2019 7:17 pm

CULater wrote:
Tue May 28, 2019 9:48 am
Zvi Bodie and Dirk Cotton advise that nominal annuities carry uncertain inflation risk for retirees and that only real annuities should be purchased or none:
Economic theory implies that, faced with a choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars, a rational individual should consider the real annuity to be risk-free and the nominal annuity to be risky.
Economic theory also implies that if I'm faced with a choice between buying a brand new BMW 540i sedan and a used 1984 Honda Accord for the same price that I should prefer the BMW.

There is no world in which an investor actually HAS a "choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars". I think there is only one insurance company offering annuities that pay out in "real dollars", and they definitely don't cost the same as one paying in nominal dollars.

Furthermore, the quoted pieces skip over the fact that a retiree might not actually NEED to offload the inflation risk to an insurance company. A retiree who expects to derive a significant portion of their retirement spending from Social Security (or an inflation-indexed pension) and/or is annuitizing a minority of their retirement savings might not actually be facing any significant inflation risk.

For such a retiree, paying someone else to bear a risk you don't actually face would be the very definition of irrational.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by antiqueman » Tue May 28, 2019 7:36 pm

I disagree with the broad conclusion that one should only buy an inflation adjusted annuity.

If a retiree has a nominal debt that will be owed until their death ( home mortgage as one example) then a nominal annuity would be fine . So long as the nominal payment of an annuity is paying some or all of a fixed debt then the nominal annuity would be fine.

I also don't think one should totally exclude an nominal annuity even if one did not have a nominal debt for the nominal payment . Other ways to hedge that inflation risk.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Taylor Larimore » Tue May 28, 2019 8:07 pm

CUlater

The Topic Headline is misleading. Bodie and Cotton wrote: "Only real annuities should be purchased or none.

I own two real annuities (SPIAs) and they have proven to be wonderful investments returning far more than I invested and giving me the peace of mind that I will never run out of money.

Best wishes.
Taylor
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by stlutz » Tue May 28, 2019 8:24 pm

So I priced out a nominal and an inflation-adjusted annuity for a 65 year old couple. The nominal annuity has a payout rate of 5.57%; the real annuity has a payout rate of 3.71%.

Suppose that inflation was 4% per year. Also suppose that the couple spends at the 3.71% rate. For the nominal annuity, they invest the extra payments in TIPS (paying 0% real) and later withdraw from the TIPS portfolio when inflation takes expenses past the 5.57% they are getting from the annuity.

According to my spreadsheet, the real annuity starts paying more than the nominal one in year 12, at age 77. The nominal annuity start to "fail" at year 24 (age 89), which is when the TIPS portfolio is depeleted. That's with 4% inflation.

With 2% inflation, the nominal SPIA + TIPS portfolio doesn't fail until year 46 (age 111).

Perhaps someone can check my numbers? I guess I'm not seeing where the currently available inflation-adjusted annuity is a particularly good deal.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by longinvest » Tue May 28, 2019 8:38 pm

The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by BigJohn » Tue May 28, 2019 8:48 pm

Thanks for the responses. I was aware that you could get a fixed COLA adjustment to an annuity at a cost. However, that isn’t what I think the authors were advocating with a real dollar annuity. This would need to be indexed to actual inflation in a manner similar to TIPS. As far as I know, this kind of annuity is not currently available. While the fixed X% is a step in the right direction if inflation stays at/near the Fed target, it won’t help much if we get a repeat of the late 70’s and early 80’s.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by JoMoney » Tue May 28, 2019 8:49 pm

If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.

What if the retiree completely understands that inflation is a risk, and holds a diversified portfolio of which a SPIA (or bonds) are just one aspect of?
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by ThrustVectoring » Tue May 28, 2019 8:56 pm

TravelforFun wrote:
Tue May 28, 2019 7:16 pm
BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
I bought an annuity that has a 2% COLA a couple of months ago. The COLA feature reduces my initial payout by almost 20% but I considered it to be worth it.

TravelforFun
A cost of living adjustment isn't the same thing as a CPI or other inflation adjustment. You're still a net inflation payer, since you get a 2% COLA regardless of what inflation actually does, while your actual expenses can vary over time.
antiqueman wrote:
Tue May 28, 2019 7:36 pm
I disagree with the broad conclusion that one should only buy an inflation adjusted annuity.

If a retiree has a nominal debt that will be owed until their death ( home mortgage as one example) then a nominal annuity would be fine . So long as the nominal payment of an annuity is paying some or all of a fixed debt then the nominal annuity would be fine.

I also don't think one should totally exclude an nominal annuity even if one did not have a nominal debt for the nominal payment . Other ways to hedge that inflation risk.
In principle, a cash-out refinance + nominal SPIA + TIPS (in equal proportions) should be equivalent to a real SPIA. The cash flow to the refinanced mortgage corresponds to the lower initial payments on the SPIA, and the CPI adjustments in the TIPS are equivalent to the value you'd get from a real SPIA. The only difference is that the real annuity automatically annuitized the CPI adjustments, so you'd need to buy "booster" SPIAs later in order to keep things in line.

Biggest problem is the spread between treasury yields and mortgage rates, in part due to the embedded refinancing option on the mortgage that protects you from falling rates. You could technically replace the mortgage with floating-rate debt (at margin rates, which are decent but not fantastic) and shorting the relevant treasury futures contract, but that isn't self-financing like the mortgage plan is and has all the issues of investing on margin.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by 3-20Characters » Tue May 28, 2019 9:06 pm

Sandtrap wrote:
Tue May 28, 2019 7:06 pm
BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
At "immediteannuities.com" there is a variable you can put in for COLA at any percentage for an SPIA. While it does not follow what might happen to inflation, it's a start.
j
You can also choose CPI. Once you request any COLA however, you’re contacting an agent so I can’t compare to nominal payout.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by thx1138 » Tue May 28, 2019 9:15 pm

vineviz wrote:
Tue May 28, 2019 7:17 pm
CULater wrote:
Tue May 28, 2019 9:48 am
Zvi Bodie and Dirk Cotton advise that nominal annuities carry uncertain inflation risk for retirees and that only real annuities should be purchased or none:
Economic theory implies that, faced with a choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars, a rational individual should consider the real annuity to be risk-free and the nominal annuity to be risky.
Economic theory also implies that if I'm faced with a choice between buying a brand new BMW 540i sedan and a used 1984 Honda Accord for the same price that I should prefer the BMW.

There is no world in which an investor actually HAS a "choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars". I think there is only one insurance company offering annuities that pay out in "real dollars", and they definitely don't cost the same as one paying in nominal dollars.
If you take the time to read the article you’ll discover “cost” means net present value - hence a real annuity with the same net present value as a nominal annuity will of course have a much lower initial payout. It has to of course.

I think an interesting question is whether a nominal or real annuity better harvests so called “mortality credits” since that is what is unique about an annuity while there is more than one way to hedge inflation.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by HomerJ » Tue May 28, 2019 9:22 pm

vineviz wrote:
Tue May 28, 2019 7:17 pm
CULater wrote:
Tue May 28, 2019 9:48 am
Zvi Bodie and Dirk Cotton advise that nominal annuities carry uncertain inflation risk for retirees and that only real annuities should be purchased or none:
Economic theory implies that, faced with a choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars, a rational individual should consider the real annuity to be risk-free and the nominal annuity to be risky.
Economic theory also implies that if I'm faced with a choice between buying a brand new BMW 540i sedan and a used 1984 Honda Accord for the same price that I should prefer the BMW.

There is no world in which an investor actually HAS a "choice between two annuities (SPIAs) costing the same amount, one of which is fixed in nominal dollars and the other in real dollars". I think there is only one insurance company offering annuities that pay out in "real dollars", and they definitely don't cost the same as one paying in nominal dollars.

Furthermore, the quoted pieces skip over the fact that a retiree might not actually NEED to offload the inflation risk to an insurance company. A retiree who expects to derive a significant portion of their retirement spending from Social Security (or an inflation-indexed pension) and/or is annuitizing a minority of their retirement savings might not actually be facing any significant inflation risk.

For such a retiree, paying someone else to bear a risk you don't actually face would be the very definition of irrational.
This. That's a pretty silly comparison to make.

And who decides what the inflation rate is? That article states that a "real" annuity is risk-free. Nothing is risk-free... CPI may not track a retiree's spending increases very well, since health care is the biggest line item for a retiree which may not be reflected accurately in CPI

https://fredblog.stlouisfed.org/2017/07 ... inflation/

All that said, one should definitely look at both nominal, real, and even fixed COLA-adjusted annuities.

Each one might meet different needs.
Last edited by HomerJ on Tue May 28, 2019 9:28 pm, edited 1 time in total.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by AlohaJoe » Tue May 28, 2019 9:25 pm

3-20Characters wrote:
Tue May 28, 2019 9:06 pm
Sandtrap wrote:
Tue May 28, 2019 7:06 pm
BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
At "immediteannuities.com" there is a variable you can put in for COLA at any percentage for an SPIA. While it does not follow what might happen to inflation, it's a start.
j
You can also choose CPI. Once you request any COLA however, you’re contacting an agent so I can’t compare to nominal payout.
No, you're not contacting an agent. It displays it on the website just fine:

$100,000 for a male/female couple that are 65/65 and live in Colorado pays $470/month for life (nominal).

With 2% adjustments it pays $350.

With CPI adjustments it pays $305.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by vineviz » Tue May 28, 2019 9:26 pm

thx1138 wrote:
Tue May 28, 2019 9:15 pm
If you take the time to read the article you’ll discover “cost” means net present value - hence a real annuity with the same net present value as a nominal annuity will of course have a much lower initial payout. It has to of course.
If two cash flow streams have the same net present value, a rational investor will be indifferent between the two by the very definition of "net present value".

And if the authors actually conflate "cost" with NPV, that does not convince me that reading the article would be a productive use of time.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by thx1138 » Tue May 28, 2019 9:31 pm

vineviz wrote:
Tue May 28, 2019 9:26 pm
If two cash flow streams have the same net present value, a rational investor will be indifferent between the two by the very definition of "net present value".
LOL. Think that one through and try again.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by venkman » Tue May 28, 2019 9:59 pm

Even if you buy an inflation-indexed annuity, aren't you still placing a bet on future inflation rates? An annuity with an x% COLA is subject to the risk that inflation will be greater than x. Even an annuity that adjusted like TIPS, based on actual inflation, would be a bet on future interest rates made by the insurance company; and the costs of uncertainty would likely be passed on to the annuity buyer.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by vineviz » Tue May 28, 2019 10:07 pm

thx1138 wrote:
Tue May 28, 2019 9:31 pm
vineviz wrote:
Tue May 28, 2019 9:26 pm
If two cash flow streams have the same net present value, a rational investor will be indifferent between the two by the very definition of "net present value".
LOL. Think that one through and try again.
You first?

Hint: you'll probably find the explanation in your corporate finance text under "cross-over rate" or possibly "cross-over point".
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by randomguy » Tue May 28, 2019 11:24 pm

longinvest wrote:
Tue May 28, 2019 8:38 pm
The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
I wouldn't worry about 4% inflation either. 8%+ is what keeps me up at night:). What was the target inflation rate in the 70s/80s? Some how I doubt the target rate was what we got. Maybe the last 30 years of low inflation will continue for the next 30. But the thing about unexpected inflation is that it is unexpected. Nobody in 1965 when inflation was at 2% would have guessed it would be 12% 15 years later.

Maybe our tools are better now than back then but I think you are being very optimistic if you think the governments can control inflation to a narrow range.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Dottie57 » Tue May 28, 2019 11:40 pm

JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.

What if the retiree completely understands that inflation is a risk, and holds a diversified portfolio of which a SPIA (or bonds) are just one aspect of?
This is of course a good option.

Or several smaller SPIAs over a given period of years.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by AlohaJoe » Tue May 28, 2019 11:42 pm

randomguy wrote:
Tue May 28, 2019 11:24 pm
What was the target inflation rate in the 70s/80s? Some how I doubt the target rate was what we got.
There was no inflation targeting anywhere in the world before New Zealand "invented" it in 1990.

The explanations for why targeting is an improvement over the policies of the 1970s and 1980s aren't about any technical improvements but solely that by making a public commitment the central bank establishes credibility which then anchors inflation expectations among consumers and businesses.

The central bank of Japan has shown that central banks are not always able to establish credibility or alter inflation expectations, even with inflation targeting, so it is understandable that some find it naive to believe that central banks have solved the problem of inflation forever.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by AlohaJoe » Tue May 28, 2019 11:45 pm

JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.
I don't think Zvi Bodie would disagree? After all he wrote a book saying nearly everyone should be 100% invested in TIPS and ibonds for retirement and you shouldn't hold anything else until you have enough to TIPS to pay for your entire retirement.

At least he is consistent.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by longinvest » Tue May 28, 2019 11:58 pm

randomguy wrote:
Tue May 28, 2019 11:24 pm
longinvest wrote:
Tue May 28, 2019 8:38 pm
The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
I wouldn't worry about 4% inflation either. 8%+ is what keeps me up at night:). What was the target inflation rate in the 70s/80s? Some how I doubt the target rate was what we got. Maybe the last 30 years of low inflation will continue for the next 30. But the thing about unexpected inflation is that it is unexpected. Nobody in 1965 when inflation was at 2% would have guessed it would be 12% 15 years later.

Maybe our tools are better now than back then but I think you are being very optimistic if you think the governments can control inflation to a narrow range.
The US Federal Reserve has only adopted inflation targeting recently, in 2012. Pre-2012 US inflation behavior is irrelevant to evaluate the Federal Reserve's ability to keep inflation on target.

Let's pick a country with a much longer history of inflation targeting. Canada has changed its monetary policy in 1991 to adopt inflation targeting along with a flexible exchange rate. Here's how the Bank of Canada describes its monetary policy:
The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. This allows Canadians to make spending and investment decisions with more confidence, encourages longer-term investment in Canada's economy, and contributes to sustained job creation and greater productivity. This in turn leads to improvements in our standard of living.

Canada’s monetary policy framework consists of two key components that work together: the inflation-control target and the flexible exchange rate. This framework helps make monetary policy actions readily understandable, and enables the Bank to demonstrate its accountability to Canadians.

At the heart of Canada’s monetary policy framework is the inflation-control target, which is two per cent, the midpoint of a 1 to 3 per cent target range.
In the 28 years since then, inflation in Canada has been effectively low, stable, and predictable. It's not luck. Central banks have learned to tame inflation by influencing interest rates (e.g. by setting the target for the overnight rate and, sometimes, through other means) and letting currency fluctuate. Canada has been exposed to various crises, during that period.

Letting the exchange rate fluctuate and influencing interest rates to keep inflation on target has impacts on the economy. It hurts some sectors (sometimes concentrated in a few provinces) while helping other sectors (sometimes concentrated in other provinces). During the last 28 years, the Bank of Canada kept its independence from political pressures and simply implemented its policy. As a result, Canadian inflation has averaged 1.8% over 28 years and remained within the target 1% to 3% range (on an annual basis).

It's quite amazing, actually. I don't understand how it works, but it does. The Canadian dollar was trading at par with the US dollar in 2012 and it lost 30% of its value relative to the US dollar during the subsequent 4 years (one needed only $0.70 USD to buy $1 CAD in 2016). Remember that oil prices dropped in 2014 and oil production is a big part of the Canadian economy. In reaction, the Bank of Canada significantly lowered the target overnight rate in January 2015 (sending my total Canadian bond market ETF up 4.79% in a single month). As a result, the Canadian dollar dropped, but Canadian inflation remained low (averaging 1.2% over the 4 year period).
Last edited by longinvest on Wed May 29, 2019 12:56 am, edited 2 times in total.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by randomguy » Wed May 29, 2019 12:35 am

longinvest wrote:
Tue May 28, 2019 11:58 pm
randomguy wrote:
Tue May 28, 2019 11:24 pm
longinvest wrote:
Tue May 28, 2019 8:38 pm
The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
I wouldn't worry about 4% inflation either. 8%+ is what keeps me up at night:). What was the target inflation rate in the 70s/80s? Some how I doubt the target rate was what we got. Maybe the last 30 years of low inflation will continue for the next 30. But the thing about unexpected inflation is that it is unexpected. Nobody in 1965 when inflation was at 2% would have guessed it would be 12% 15 years later.

Maybe our tools are better now than back then but I think you are being very optimistic if you think the governments can control inflation to a narrow range.
The US Federal Reserve has only adopted inflation targeting recently, in 2012. Pre-2012 US inflation behavior is irrelevant to evaluate the Federal Reserve's ability to keep inflation on target.

Let's pick a country with a much longer history of inflation targeting. Canada has changed its monetary policy in 1991 to adopt inflation targeting along with a flexible exchange rate. Here's how the Bank of Canada describes its monetary policy:
The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. This allows Canadians to make spending and investment decisions with more confidence, encourages longer-term investment in Canada's economy, and contributes to sustained job creation and greater productivity. This in turn leads to improvements in our standard of living.

Canada’s monetary policy framework consists of two key components that work together: the inflation-control target and the flexible exchange rate. This framework helps make monetary policy actions readily understandable, and enables the Bank to demonstrate its accountability to Canadians.

At the heart of Canada’s monetary policy framework is the inflation-control target, which is two per cent, the midpoint of a 1 to 3 per cent target range.
In the 28 years since then, inflation in Canada has been effectively low, stable, and predictable. It's not luck. Central banks have learned to tame inflation by influencing interest rates (e.g. by setting the target for the overnight rate and, sometimes, though other means) and letting currency fluctuate. Canada has been exposed to various crises, during that period.

Letting the exchange rate fluctuate and influencing interest rates to keep inflation on target has impacts on the economy. It hurts some sectors (sometimes concentrated in a few provinces) while helping other sectors (sometimes concentrated in other provinces). During the last 28 years, the Bank of Canada kept its independence from political pressures and simply implemented its policy. As a result, Canadian inflation has averaged 1.8% over 28 years and remained within the target 1% to 3% range (on an annual basis).
Can I also ignore historical stock data before Dodd–Frank's? After all since it has been implemented the max stock draw down is only 20% or so. Clearly market volatility is a thing of the past:) 28 years is a blink of an eye. Notice how between 1990-2012, the US also didn't have any problems with inflation despite not explicitly doing inflation targeting. Did inflation targeting matter or did it just happen to coincide with a low inflation period?

Yes theres is some evidence that it helps. Does it help enough to prevent inflation from every getting back to 8%+:)? That is a much tougher thing to believe. I am sure we will not repeat the mistakes of the 70s (though it looks like we might get to repeat Smoot-Hawley). But I have a lot of confidence that we can do all new ones. We are probably 20 years away from the next inflation crisis. We need to let a few more of the people that remember it die off:)

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by thx1138 » Wed May 29, 2019 4:55 am

vineviz wrote:
Tue May 28, 2019 10:07 pm
thx1138 wrote:
Tue May 28, 2019 9:31 pm
vineviz wrote:
Tue May 28, 2019 9:26 pm
If two cash flow streams have the same net present value, a rational investor will be indifferent between the two by the very definition of "net present value".
LOL. Think that one through and try again.
You first?

Hint: you'll probably find the explanation in your corporate finance text under "cross-over rate" or possibly "cross-over point".
Sure if it is really that hard to figure out.

You are 75. There are two income streams you may purchase, both are contracts with an insurance company which are not transferable with no secondary market. Both have a net present value of 100k.

Contract A pays a lump sum in three years of 100k plus interest at the risk free rate.

Contract B pays a lump sum in fifty years of 100k plus interest at the risk free rate.

Still think our “rational” 75 year old is indifferent to choosing between these two contracts with identical net present values?

Hint: Keep reading that corporate finance book - most of the good ones have a lot of information on the limits of NPV in decision making and the other factors that go into to making “rational” decisions.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by jose » Wed May 29, 2019 5:50 am

There is a lot of financial, NPV analysis going on in this thread. Each time I see financial analysis on annuities, I think they are being evaluated as investments, which they are not. Annuities are insurance products, and therefore they cost money and are expensive so they do not make sense from a purely financial perspective. Annuities are not good investments, they are expenses.

Annuities are a zero-sum game, any gain for the buyer is a loss for the seller, and vice versa. The insurance company has to pay expenses and make money, at the expense of the buyer. Annuities are bets on longevity and inflation, which are two unknowns. The insurance company can hedge longevity by pooling (collective longevity is known). Risk pooling is the advantage of all insurance. Inflation is a collective unknown which the insurance company can hedge by investing in real assets, stocks, short-term bonds and TIPS. If the insurance company collectively loses, it will go bankrupt and lose its ability to pay.

From the perspective of the buyer, the analysis should be cost vs. risk coverage. Risk is not quantifiable and therefore NPV cannot be calculated because time and discount rate are necessary in NPV calculations, and are unknown. In order to compare with investments, you also to throw in the unknown investment return. No go.

Another factor to consider is when we will lose our cognitive ability to manage our own finances. From my perspective I plan to live my actuarial life expectancy and insure the social security gap for the risk of longevity and inflation.

jose

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Dandy » Wed May 29, 2019 7:08 am

Almost all questions regarding should I take a non COLA pension or a lump sum is answered take the pension. A non COLA pension or annuity is not a perfect option. It provides some protection for outliving your assets but exposes the holder to diminishing purchasing power due to inflation.

Usually the advice to retirees regarding annuities are to try to buy them later in retirement if possible e.g. 80 vs 70 and not to put their whole nest egg into annuities. The rest of the retiree's portfolio can help offset inflation risk either through a traditional equity/fixed income allocation or putting a portion of the remaining nest egg into Inflation protected securities.

Inflation and outliving your assets/income are both retiree concerns. Pensions, Social Security and annuities can help address lifetime income. A portfolio with a decent allocation to equities and/or Inflation Protected Securities can help address inflation. For some retirees without a pension and/or Social Security total reliance on their portfolio might not be the best solution. Obviously, the size of the portfolio matters.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Ben Mathew » Wed May 29, 2019 7:21 am

AlohaJoe wrote:
Tue May 28, 2019 11:45 pm
JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.
I don't think Zvi Bodie would disagree? After all he wrote a book saying nearly everyone should be 100% invested in TIPS and ibonds for retirement and you shouldn't hold anything else until you have enough to TIPS to pay for your entire retirement.

At least he is consistent.
I agree with Bodie. Given that the expected yield of TIPS isn't significantly less than that of nominal bonds (and some are claiming it's more), it's not clear to me why most people choose to hold nominal bonds instead of real. TIPS offer free, or almost free, insurance against unexpected inflation. Why take a risk we don't have to?

Same with real vs nominal annuities. If there isn't a significant cost, real is better than nominal.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by rich126 » Wed May 29, 2019 7:37 am

Ben Mathew wrote:
Wed May 29, 2019 7:21 am
AlohaJoe wrote:
Tue May 28, 2019 11:45 pm
JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.
I don't think Zvi Bodie would disagree? After all he wrote a book saying nearly everyone should be 100% invested in TIPS and ibonds for retirement and you shouldn't hold anything else until you have enough to TIPS to pay for your entire retirement.

At least he is consistent.
I agree with Bodie. Given that the expected yield of TIPS isn't significantly less than that of nominal bonds (and some are claiming it's more), it's not clear to me why most people choose to hold nominal bonds instead of real. TIPS offer free, or almost free, insurance against unexpected inflation. Why take a risk we don't have to?

Same with real vs nominal annuities. If there isn't a significant cost, real is better than nominal.
Maybe because unexpected inflation may not occur, and instead the interest rates will stay low or even possibly go negative? In the latter case the TIPs rate can also go negative. I just don't see any real chance of high inflation for many years. It seems obvious that rates can't go much lower and conventional wisdom says they have to go up, but they don't really have to. At least not any time soon (I'm not referring to a percentage here or there but something more substantial).

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by dodecahedron » Wed May 29, 2019 7:55 am

JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.

What if the retiree completely understands that inflation is a risk, and holds a diversified portfolio of which a SPIA (or bonds) are just one aspect of?
It is true that bonds are also a bet on future inflation rates, but a standard recommendation to mitigate inflation risk is to hold your bond duration down. Folks like Bill Bernstein have suggested that short term bonds are one strategy for managing inflation risk. Many Bogleheads would be willing to go out somewhat farther and hold intermediate term bond funds in order to get some additional return, potentially including some roll yield, but very few go for long term bonds or long term bond funds.

Of course the actual duration of a life annuity can only be known ex post, since the holder does not know how long s/he will live.

But as a thought experiment, lets consider a 50 year old who purchases a nominal annuity and lives to exactly their life expectancy of age 80. If we mathematically compute the ex post duration of their annuity financial instrument, it is a lot lower than the duration of a 30 year nominal bond held over the same period, because the annuity payment stream is far more front-loaded than the payment stream of a 30-year bond, which has a balloon payment at the end.

Perhaps someone on this board who enjoys crunching numbers would like to compute the duration of a typical nominal annuity. Maybe a nominal annuity has a duration not too different from a nominal intermediate bond? In that case, it seems as though it might be a reasonable alternative to a nominal intermediate bond fund in one´s portfolio, which most Bogleheads think is fine, as long as there are other assets (e.g., equities, TIPS, real estate holdings) in the portfolio which give some protection against unexpected inflation.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by JoMoney » Wed May 29, 2019 8:07 am

dodecahedron wrote:
Wed May 29, 2019 7:55 am
JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.

What if the retiree completely understands that inflation is a risk, and holds a diversified portfolio of which a SPIA (or bonds) are just one aspect of?
It is true that bonds are also a bet on future inflation rates, but a standard recommendation to mitigate inflation risk is to hold your bond duration down. Folks like Bill Bernstein have suggested that short term bonds are one strategy for managing inflation risk. Many Bogleheads would be willing to go out somewhat farther and hold intermediate term bond funds in order to get some additional return, potentially including some roll yield, but very few go for long term bonds or long term bond funds.

Of course the actual duration of a life annuity can only be known ex post, since the holder does not know how long s/he will live.

But as a thought experiment, lets consider a 50 year old who purchases a nominal annuity and lives to exactly their life expectancy of age 80. If we mathematically compute the ex post duration of their annuity financial instrument, it is a lot lower than the duration of a 30 year nominal bond held over the same period, because the annuity payment stream is far more front-loaded than the payment stream of a 30-year bond, which has a balloon payment at the end.

Perhaps someone on this board who enjoys crunching numbers would like to compute the duration of a typical nominal annuity. Maybe a nominal annuity has a duration not too different from a nominal intermediate bond? In that case, it seems as though it might be a reasonable alternative to a nominal intermediate bond fund in one´s portfolio, which most Bogleheads think is fine, as long as there are other assets (e.g., equities, TIPS, real estate holdings) in the portfolio which give some protection against unexpected inflation.
I would suggest that a SPIA is essentially a ladder of bonds maturing each year out for what the individuals actuarial life expectancy is.
When I've played with with numbers, I like to use the Vanguard Total Bond Market mutual fund's yield to maturity because that fund is essentially built with bonds with maturities from short all the way out to very long bonds, and I figure close enough for back of the envelope calculations for what such a ladder of bonds would look like.


Vanguard's "Total Bond Market" fund currently has a Yield to Maturity of 3.0%
If I assumed that rate of interest for the life expectancy of a 60 year old ( 25.2 years )
Using an amortization calculation, divide $100,000 starting portfolio at that interest rate out to annual payments/withdrawals of $5,712 a year for the remainder of life (based on expectancy table)
(one way to do this amortization is use a 72t SEPP calculator that does an amortization method)


If I go to https://www.immediateannuities.com I can get a rough quote that a 60 year old AZ female can buy a SPIA for $100,000 that guarantees $5,724 a year for the rest of her life regardless of how long she lives.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by thx1138 » Wed May 29, 2019 8:16 am

vineviz wrote:
Wed May 29, 2019 7:45 am
thx1138 wrote:
Wed May 29, 2019 7:02 am
vineviz wrote:
Wed May 29, 2019 6:43 am

If you are convinced that your examples A and B have the same NPV, I don't have the time to bring you up to speed in this thread.

Good luck.
They do in fact.
Not in this world.

As I said, good luck.
LOL they are quite literally the exact definition of present value/future value! I mean there isn’t anything more basic than those two examples. In case you forgot the equation for FV and PV here it is:

Image

The examples given are exactly that equation in words. And since the future payment is guaranteed (i.e. there is no risk) then the correct rate to use is the risk free rate. I mean this is the most fundamental Finance 101 kind of stuff imaginable.

And to the original point even if the NPV of two contracts/investments are identical a reitiree may have a drastically different utility between them because of the schedule of their payments even if the sum of the present value of all those payments is the same.

This is really basic stuff. Kind of shocking you dispute it.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by vineviz » Wed May 29, 2019 8:40 am

thx1138 wrote:
Wed May 29, 2019 8:16 am
LOL they are quite literally the exact definition of present value/future value! I mean there isn’t anything more basic than those two examples. In case you forgot the equation for FV and PV here it is:
You are way off base, both in your understanding of how to calculate NPV and your assessment of my knowledge.

I'm going to let it go at that, and I hope you will too.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by dodecahedron » Wed May 29, 2019 8:49 am

vineviz wrote:
Wed May 29, 2019 8:40 am
thx1138 wrote:
Wed May 29, 2019 8:16 am
LOL they are quite literally the exact definition of present value/future value! I mean there isn’t anything more basic than those two examples. In case you forgot the equation for FV and PV here it is:
You are way off base, both in your understanding of how to calculate NPV and your assessment of my knowledge.

I'm going to let it go at that, and I hope you will too.
Thx1138, I have taught present value discounting for over 40 years and will just add:

1) the ¨risk free rate¨ is a theoretical term, helpful for expository textbook analysis and theoretical discussions, but very hard to pin down an operational definition of the risk-free rate for real life decisionmaking

2) a contractual promise to pay by an insurance company is not a risk free payment, especially if that payment will be made 50 years in the future, so even if you could ascertain the risk free rate, it would not be the appropriate one to use in discounting cash flows generated by an insurance company

3) the problem does not specify whether the $100K to be paid in three or fifty years is a real or nominal $100K.

Things that may be tautologically true in a textbook do not always work out that way in the messy real world.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by Ben Mathew » Wed May 29, 2019 8:52 am

rich126 wrote:
Wed May 29, 2019 7:37 am
Ben Mathew wrote:
Wed May 29, 2019 7:21 am
AlohaJoe wrote:
Tue May 28, 2019 11:45 pm
JoMoney wrote:
Tue May 28, 2019 8:49 pm
If annuities are "a bet on future inflation rates and should not be purchased", the same goes for bonds.
I don't think Zvi Bodie would disagree? After all he wrote a book saying nearly everyone should be 100% invested in TIPS and ibonds for retirement and you shouldn't hold anything else until you have enough to TIPS to pay for your entire retirement.

At least he is consistent.
I agree with Bodie. Given that the expected yield of TIPS isn't significantly less than that of nominal bonds (and some are claiming it's more), it's not clear to me why most people choose to hold nominal bonds instead of real. TIPS offer free, or almost free, insurance against unexpected inflation. Why take a risk we don't have to?

Same with real vs nominal annuities. If there isn't a significant cost, real is better than nominal.
Maybe because unexpected inflation may not occur, and instead the interest rates will stay low or even possibly go negative? In the latter case the TIPs rate can also go negative. I just don't see any real chance of high inflation for many years. It seems obvious that rates can't go much lower and conventional wisdom says they have to go up, but they don't really have to. At least not any time soon (I'm not referring to a percentage here or there but something more substantial).
Just like with any insurance, forgoing the insurance will be a win if you get lucky but a loss if you get unlucky. Purchasing the insurance locks in the expected payout (minus insurance costs.) In this case the cost of insurance seems to be low, so the case for insurance is particularly strong.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by dodecahedron » Wed May 29, 2019 9:04 am

Things that currently concern me about inflation protected annuities:

1) there is only one company (Principal) offering them. Principal is a company I had never heard of before, and while it seems to have reasonable ratings, the subprime meltdown has taught us to be wary of ratings. If I go with annuities, I would want to spread the risk around by purchasing from more than one insurance company.

2) state insurance regulators have a lot of experience regulating nominal annuity products, determining whether reserves are adequate, etc. They don´t have much experience regulating real annuity products. Selling real annuities exposes an insurance company to a new type of risk that is completely outside the range of the regulators (and bond raters) experience.

A better approach to real annuities than what Principal offers, in my opinion, would be the formation of mutual tontines that would contractually hold inflation protected securities in a way that pools longevity risk in a simple and transparent manner.

Edited to add: that said, I am only 65, and feel no urgent need to insure against longevity any time soon. My hope is that there will be product innovations within ten years or fifteen years, by which time I may feel ready to consider annuities.
Last edited by dodecahedron on Wed May 29, 2019 9:08 am, edited 1 time in total.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by HomerJ » Wed May 29, 2019 9:06 am

Dandy wrote:
Wed May 29, 2019 7:08 am
Almost all questions regarding should I take a non COLA pension or a lump sum is answered take the pension. A non COLA pension or annuity is not a perfect option. It provides some protection for outliving your assets but exposes the holder to diminishing purchasing power due to inflation.

Usually the advice to retirees regarding annuities are to try to buy them later in retirement if possible e.g. 80 vs 70 and not to put their whole nest egg into annuities. The rest of the retiree's portfolio can help offset inflation risk either through a traditional equity/fixed income allocation or putting a portion of the remaining nest egg into Inflation protected securities.

Inflation and outliving your assets/income are both retiree concerns. Pensions, Social Security and annuities can help address lifetime income. A portfolio with a decent allocation to equities and/or Inflation Protected Securities can help address inflation. For some retirees without a pension and/or Social Security total reliance on their portfolio might not be the best solution. Obviously, the size of the portfolio matters.
A nuanced well-thought out response.
The J stands for Jay

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by thx1138 » Wed May 29, 2019 9:34 am

dodecahedron wrote:
Wed May 29, 2019 8:49 am
vineviz wrote:
Wed May 29, 2019 8:40 am
thx1138 wrote:
Wed May 29, 2019 8:16 am
LOL they are quite literally the exact definition of present value/future value! I mean there isn’t anything more basic than those two examples. In case you forgot the equation for FV and PV here it is:
You are way off base, both in your understanding of how to calculate NPV and your assessment of my knowledge.

I'm going to let it go at that, and I hope you will too.
Thx1138, I have taught present value discounting for over 40 years and will just add:

1) the ¨risk free rate¨ is a theoretical term, helpful for expository textbook analysis and theoretical discussions, but very hard to pin down an operational definition of the risk-free rate for real life decisionmaking

2) a contractual promise to pay by an insurance company is not a risk free payment, especially if that payment will be made 50 years in the future, so even if you could ascertain the risk free rate, it would not be the appropriate one to use in discounting cash flows generated by an insurance company

3) the problem does not specify whether the $100K to be paid in three or fifty years is a real or nominal $100K.

Things that may be tautologically true in a textbook do not always work out that way in the messy real world.
I agree with all those statements - thanks for interjecting!

I feel the forest is being missed for the trees.

The assertion by vineviz is that if the NPV of two income streams is identical than the rational investor should be indifferent to the choice between them.

That's wrong. The rational investor would still have a choice between them dictated by the utility of those two streams to the investor which is completely separate from the NPV of those streams.

I gave a very simple example to demonstrate the difference between utility and value. Indeed one could endlessly nitpick the exact PV of that simplified example. But that would fundamentally miss the entire point. No matter how you fine tune them to have the same PV the utility of them is drastically different because even if the insurance company exists in 50 years with a state guarantee there is the virtual certainty that the retiree is *dead* in 50 years which drastically changes the utility between the 3 year payment and the 50 year payment.

Is there something in that difficult to accept?

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by CurlyDave » Wed May 29, 2019 9:37 am

longinvest wrote:
Tue May 28, 2019 8:38 pm
The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
Over the past 30 years the US CPI has increased from 121.1 to 251.71. https://www.usinflationcalculator.com/i ... 3-to-2008/ . Taking January - January data.

This is a CAGR of 2.47%. While one can look at this and say that is "close" to the target 2%, the reality is that it is 23% higher. IMHO, consistently missing their target by 23%, over 30 years does not make it at all plausible that they will ever succeed in achieving a long-term 2% inflation.

I know that my personal inflation rate has run a lot closer to 5% than the 2.5% CPI rate. Maybe this is just me, or maybe it is the result of letting the fox guard the hen house.

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by longinvest » Wed May 29, 2019 9:42 am

CurlyDave wrote:
Wed May 29, 2019 9:37 am
longinvest wrote:
Tue May 28, 2019 8:38 pm
The US Federal Reserve's monetary policy aims for a 2% inflation over time. It's quite plausible that it will succeed.

Canada's central bank has had a 2% inflation target (the midpoint of a 1% to 3% target range) as a cornerstone of its monetary policy since 1991; it has remarkably succeeded to maintain inflation within target for the last 28 years, despite the various crises that affected the Canadian economy during that long time period.

I wouldn't worry about 4% inflation.
Over the past 30 years the US CPI has increased from 121.1 to 251.71. https://www.usinflationcalculator.com/i ... 3-to-2008/ . Taking January - January data.

This is a CAGR of 2.47%. While one can look at this and say that is "close" to the target 2%, the reality is that it is 23% higher. IMHO, consistently missing their target by 23%, over 30 years does not make it at all plausible that they will ever succeed in achieving a long-term 2% inflation.

I know that my personal inflation rate has run a lot closer to 5% than the 2.5% CPI rate. Maybe this is just me, or maybe it is the result of letting the fox guard the hen house.
Dave, this is an inappropriate comparison. As I wrote in a follow up post, the 2% inflation target was adopted in 2012 in the US. Here's my detailed post about this:
longinvest wrote:
Tue May 28, 2019 11:58 pm
The US Federal Reserve has only adopted inflation targeting recently, in 2012. Pre-2012 US inflation behavior is irrelevant to evaluate the Federal Reserve's ability to keep inflation on target.

Let's pick a country with a much longer history of inflation targeting. Canada has changed its monetary policy in 1991 to adopt inflation targeting along with a flexible exchange rate. Here's how the Bank of Canada describes its monetary policy:
The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. This allows Canadians to make spending and investment decisions with more confidence, encourages longer-term investment in Canada's economy, and contributes to sustained job creation and greater productivity. This in turn leads to improvements in our standard of living.

Canada’s monetary policy framework consists of two key components that work together: the inflation-control target and the flexible exchange rate. This framework helps make monetary policy actions readily understandable, and enables the Bank to demonstrate its accountability to Canadians.

At the heart of Canada’s monetary policy framework is the inflation-control target, which is two per cent, the midpoint of a 1 to 3 per cent target range.
In the 28 years since then, inflation in Canada has been effectively low, stable, and predictable. It's not luck. Central banks have learned to tame inflation by influencing interest rates (e.g. by setting the target for the overnight rate and, sometimes, through other means) and letting currency fluctuate. Canada has been exposed to various crises, during that period.

Letting the exchange rate fluctuate and influencing interest rates to keep inflation on target has impacts on the economy. It hurts some sectors (sometimes concentrated in a few provinces) while helping other sectors (sometimes concentrated in other provinces). During the last 28 years, the Bank of Canada kept its independence from political pressures and simply implemented its policy. As a result, Canadian inflation has averaged 1.8% over 28 years and remained within the target 1% to 3% range (on an annual basis).

It's quite amazing, actually. I don't understand how it works, but it does. The Canadian dollar was trading at par with the US dollar in 2012 and it lost 30% of its value relative to the US dollar during the subsequent 4 years (one needed only $0.70 USD to buy $1 CAD in 2016). Remember that oil prices dropped in 2014 and oil production is a big part of the Canadian economy. In reaction, the Bank of Canada significantly lowered the target overnight rate in January 2015 (sending my total Canadian bond market ETF up 4.79% in a single month). As a result, the Canadian dollar dropped, but Canadian inflation remained low (averaging 1.2% over the 4 year period).
It seems quite obvious, from experience, that when a central bank wants to control inflation (like when it's a cornerstone of its monetary policy), it has the ability to do it. But, it has to be willing to do what has to be done to achieve its goal.

Here's what the US Federal Reserve writes on its website:
Why does the Federal Reserve aim for 2 percent inflation over time?
The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public's ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling--a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.
The Federal Reserve wants the public to be able to make accurate long-term economic and financial decisions. This seems consistent with pursuing its objective of keeping inflation on a 2% target.

With such a monetary policy in place, and given the success of other central banks to keep inflation on target over a long time period, it seems safe enough for a retiree to buy* a 2%-indexed SPIA** in absence of a competitively-priced CPI-U indexed SPIA.

* Only if necessary, and only with part (not all!) of the portfolio.
** Single-Premium Immediate Annuity.
Last edited by longinvest on Wed May 29, 2019 10:14 am, edited 5 times in total.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by CULater » Wed May 29, 2019 9:57 am

Here's the thing. Real annuities are virtually unavailable. Just about nobody purchases them. When people buy annuities they buy nominal annuities; probably don't know any better and that's all that's available anyhow. The idea of buying a nominal annuity with annual step-up does not provide inflation protection. Zvi Bodie has long advocated the importance of inflation protection, recommending inflation- linked TIPS and I-Bonds for retirees, so it's entirely consistent that he would not recommend nominal annuities or stepped up annuities. Bottom line is that this article is effectively advising retirees to avoid buying annuities, IMO. Retirees are gigantically exposed to inflation risk, and it's one of the most important risks they should consider.
Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

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HomerJ
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by HomerJ » Wed May 29, 2019 10:10 am

CULater wrote:
Wed May 29, 2019 9:57 am
Bottom line is that this article is effectively advising retirees to avoid buying annuities, IMO. Retirees are gigantically exposed to inflation risk, and it's one of the most important risks they should consider.
Bottom line, nothing is that black and white.

A retiree that annuitized ALL their money is exposed to inflation risk, but none of us here recommend that.

A nominal SPIA can certainly be useful as part of a retirement plan. But you are correct that inflation risk should be taken into account.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by midareff » Wed May 29, 2019 10:13 am

TravelforFun wrote:
Tue May 28, 2019 7:16 pm
BigJohn wrote:
Tue May 28, 2019 6:41 pm
While I understand the theoretical argument, from a practical perspective is it possible to by an inflation indexed SPIA? From comments I’ve read on this forum I thought not but would be glad to be pointed in the right direction.
I bought an annuity that has a 2% COLA a couple of months ago. The COLA feature reduces my initial payout by almost 20% but I considered it to be worth it.

TravelforFun
Sort of implies a 17 or so year period to break even doesn't it?

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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by vineviz » Wed May 29, 2019 10:18 am

thx1138 wrote:
Wed May 29, 2019 9:34 am
The assertion by vineviz is that if the NPV of two income streams is identical than the rational investor should be indifferent to the choice between them.

That's wrong. The rational investor would still have a choice between them dictated by the utility of those two streams to the investor which is completely separate from the NPV of those streams.
Will you please step back and hear what we are trying to tell you?

If the NPVs of two projects is the same, the rational investor must be indifferent between them.

If the rational investor has a preference for one project over the other, the NPVs can not be the same.

It it appears to you that the NPVs are the same AND the rational investor has a preference for one over the other then either the NPVs are wrong (probably because the discount rate is inappropriate) or some non-economic meaning of the word "rational" is being used.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by longinvest » Wed May 29, 2019 10:19 am

midareff wrote:
Wed May 29, 2019 10:13 am
Sort of implies a 17 or so year period to break even doesn't it?
"Break even"? As if the retiree should hope to die young and select a nominal SPIA*?

A retiree buys a COLA** SPIA, which is an insurance product not an investment, to dampen the financial risk of long life. So, it's imperative for the income it provides to have kept it purchase power when that risk shows up. A nominal SPIA is obviously inappropriate if it is meant to be part of an income floor in old age.

* Single-Premium Immediate Annuity.
** Cost of living adjusted.
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Re: Annuities are a bet on future inflation rates and should not be purchased by retirees

Post by dodecahedron » Wed May 29, 2019 10:26 am

CULater wrote:
Wed May 29, 2019 9:57 am
Bottom line is that this article is effectively advising retirees to avoid buying annuities, IMO. Retirees are gigantically exposed to inflation risk, and it's one of the most important risks they should consider.
I think this is too strong a statement to capture the bottom line of the paper or the authors´ views. The authors´ own words (which you quoted in your OP) are more nuanced and do a better job than the subject line to this thread.
Zvi Bodie and Dirk Cotton wrote:Nonetheless, all financial products have pros and cons and, given their full appreciation in the context of the remainder of the retirement plan, a retiree can make a rational decision to purchase nominal or real annuities, or neither. Annuitants should understand before choosing that nominal annuities include a speculative bet on future inflation rates and the potential for substantial losses of purchasing power should high rates of inflation return, while real annuities include neither.

The safer choice for a retiree is the real annuity, which avoids speculating on inflation rates, while hedging inflation and its tail risk.
(Underlining added by me.)

The article is very thought-provoking and worthwhile to read. (Full disclosure disclaimer: Zvi Bodie was a longtime friend and former colleague of my late husband´s. I have never met Dirk Cotton in person but I am a fan of his blog and have corresponded with him extensively in the past.)

I think their analysis and nuanced words of warning in the article are very much worth bearing in mind. At this time, I am not contemplating buying any annuities of any type, but I do think there are circumstances where a nominal annuity could be PART of a reasonable plan for someone currently concerned about longevity risk, given the products currently available on the market, as long as their retirement plan also includes Social Security, a significant chunk of TIPS holdings, some equities, some REITs or real estate, a paid-off home, etc.

To the extent that a retiree (and/or their prospective heirs) have any nominal liabilities (e.g., fixed rate mortgage, student loans, etc.) both deflation and inflation are risks to be taken into account.

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