For the last few decades, two of the most puzzling of these so-called puzzles in the general field of economics are related to retirement planning. The two are (i) the very low interest on the part of consumers in purchasing immediate annuities, and (ii.) the general public apathy towards inflation-linked savings bonds. Traditional (i.e. rational) models of consumer choice predict that the size or these two markets should be much larger. Thus, why retirees shun inflation-linked SPIA products is a puzzle to the power of two.
Indeed, up until a few years ago it was virtually impossible to purchase this combination in the open retail market. Recently though, The Vanguard Group has been selling a SPIA product whose periodic payments are linked to inflation via the urban Consumer Price Index (CPI-U). For example, if you purchase a joint-life annuity at retirement with $100,000 you would be promised payments of roughly $6,000 per year adjusted for inflation, as long as one member of the couple is still alive. The SPIA guarantee is backed by the well-known insurance company AIG (ok, maybe that solves the low demand puzzle).
Bottom line is that retirees don’t like these things no matter how much academic economists babble on about their welfare enhancing properties. Perhaps it has something to do with their illiquidity, credit risk, irreversibility, relatively low payouts, irrational discounting, myopic behavior, framing problems or the lack of compensation for the distribution channel. I have spilled much ink on this elsewhere.
Anyway, I’m not really in the puzzle-solving business, but I am interested in best practices and retirement decision-making. What prompted all of this is that I recently was interviewed by Money Magazine (October 2008) in which I was quoted as saying that “pensions and annuities…are a great solution to longevity risk, but they are not much help against inflation”. Of course, some pensions, like government pensions and Social Security are adjusted for inflation (although based on CPI-W, not CPI-U, mind you). In contrast, most corporate defined benefit (DB) pensions and most retail single-premium immediate annuity (SPIA) products are not adjusted.
So why not advocate or promote the importance and role of CPI-linked immediate annuities in the optimal retirement portfolio? (I was actually asked this by a number of people.)
This brings me to my main point for today’s post which is the topic of some research I recently conducted with a colleague of mine, Professor Huaxiong Huang at York University. I have attached a link to the draft whitepaper below. I have also tried to stress this in Chapter #5 of my recent book: “Are You a Stock or a Bond?”
http://www.ifid.ca/pdf_workingpapers/WP ... ec2007.pdf
Basically, as most people know, the consumer price index (CPI) is a weighted average. It weighs thousands of goods and services based an mythical “average” American with “average” income, and “average” preferences. It ain’t necessarily your inflation rate.
In fact, the Bureau of Labor Statistics (BLS) has been calculating a unique consumer price index for retirees, called the CPI-E. The index is composed of the same sub-categories of goods and services as the regular CPI, but the weightings are skewed away from the average and more towards items that retirees spend more. The gap between the CPI-E number and the regular inflation rate is not large, but is not trivial. Over long periods of time that gap is noticeable. A sum of $100 in 1982 would have decayed to $50 under the CPI-W but $44 under the CPI-E. The bottom line is as follows. Depending on how old you are, where you live, and what you like spending your money on, your inflation rate will differ. Don’t fool yourself into thinking that macro-economic inflation will be similar to your own inflation experience. They are correlated, but not perfectly.
Bottom line, for those retirees who are willing to go the SPIA route with a portion of their nest egg, I would recommend paying for a 3% to 4% COLA adjustment, as opposed to a product whose payments are linked to CPI (U, W or any other letter) increased. I suspect that the price you pay (especially with what TIPS are yielding today) to link to an index that is not a very good hedge for your own personal liabilities might not be worth the cost. Get a lifetime payout immediate annuity (LPIA) with some cost-of-living adjustment (COLA), but not necessarily inflation protection. The two are different.
[ add comment ] ( 195 views )
