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

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.

The table below provides a look at income adjustments assuming one adopts a Variable Immediate Annuity from Vanguard, funding the annuitization with the Vanguard Inflation Indexed Securities Subaccount. 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 preceding the existence of the Vanguard SPIA (2001 through 2003) we reduce the fund’s returns by the 0.52% insurance charge. From 2003  on we use the subaccount’s historical returns to illustrate how the SPIA provides income flows.

We are assuming the selection of a 3.5% AIR. 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: [1]


 * (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; [2] and column five shows the net after inflation change in the income stream. The final two columns compare the income distributions of the two annuitizations. 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 and then lagged inflation during 2005 and 2006 before turning around in 2007 and again falling markedly in 2008. Income in the SPIA would have actually fallen in 2005, 2006, and 2008. Over the full period, incomes from the subaccount annuitization provided an income that (due to early period returns) would have managed to moderately outpace the cpi until 2008.

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

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 returns.

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. 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:
 * The Vanguard Inflation Adjusted option
 * The Vanguard Variable Option with a 3.5% AIR
 * The Vanguard Variable Option with a 5.0% AIR

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


 * The Vanguard Inflation Adjusted option: $544.49
 * The Vanguard Variable Option with a 3.5% AIR: $597.28
 * The Vanguard Variable Option with a 5.0% AIR: $682.18