Many millions of Americans depend on fixed annuities to provide the twin advantages of keeping their principal secure and deferring taxes. The major disadvantage that is a component of fixed annuity products, once annuitized, is the failure of annuity income to keep pace with inflation in the long term.
As a hypothetical example, let us assume that you have deposited a premium of $100,000 in a single premium immediate fixed annuity product. A major annuity company currently offers a contract that provides an annuity income of $7,900 in a year. The issue is, if we assume a 3% inflation rate, the purchasing power of one's income from these payments will be lower every single succeeding year. That is, $7,900 will only buy you $4375 of goods and service in 20 years.
To defeat this challenge, owners of fixed annuities can decide to buy a cost-of-living rider on their annuity policy. This rider aims to ensure the annuity income rises to keep up with the rate of rising prices in the long term. However, there is a cost for this benefit. For instance, an immediate annuity policy with the inflation rider for $100,000 with a 3 percent rising prices protection rider will pay just $5988 per year to start (not $7,900 as we saw above). Nonetheless, the annuity payments will go up 3 percent each year as long as the actual payout is due, thereby supplying a measure of protection versus inflation. The catch is obvious; the price of the rider reduces the initial annuity income in comparison to the payment made on a contract with no COLA rider. The annuitant can benefit in the long term and this of course depends on how long the annuitant lives and the actual rate of inflation. For example, you are a big winner with inflation-adjusted anuity income if inflation averages only 2% annually and you outlive your life expectancy. The oppposite is also true.
Each company offering annuity income inflation adjustments structure their product differently. Thus, COLA riders too change in their forms. While some COLA riders have a specific extra cost, others (for example the one discussed above) modify the monthly annuity income to start. You can also choose from a range of inflation rates to protect against, based on the desired level of inflation protection. For instance, anything discussed above can also be structured for 6% inflation if that is your estimate. This will increase the risk for payout at the beginning of the annuity income stream being proportionately lower, with a higher payment towards the end of the annuity term.
Be aware that with immediate annuities, it is not possible to give up the annuity income for value. The income coming from deferred annuities is taxed in the same manner as ordinary income but annuity income from annuitization is taxed part as return of principal and art as ordinary income. Additionally, withdrawals before the age of 59 ½ years are subjected to a ten percent penalty. All guarantees should be looked as based on the ability of the company supplying the insurance to pay claims. One should be aware that the actual COLA rider does not assure that annuity payments will cover actual inflation.
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