The challenge of inflation and interest rate uncertainty in retirement

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Imagine you’re setting up a retirement goal that provides an annual income of $100,000 per year as long as you live. You’re enjoying the good life and feeling pretty secure about your financial situation – at least for a while. But then as you age, the buying power of that $100,000 can buy goods and services worth only $17,000. By then is too late for you to do anything to remedy the situation because you’re far past your working years. And even worse, suppose your health remains sufficiently good and you’re expected to live another 10-13 years. Could you afford it?

There are perils associated with creating a financial plan based solely on life expectancy. Whilst lifetime income annuities can address that major challenge better and less expensively than some other product alternatives, if not used appropriately, the plan would introduce significant exposure to the erosive effects of inflation on lifetime income.

Lifetime income annuities provide retirees with a constant monthly income throughout the remainder of their life. While there is great comfort in not outliving your income, the purchasing power of that income may diminish over time. 

The real impact of inflation

Consider the various inflation patterns of Australia. Figure 1 shows an annuity which delivers a sum of $10,000 per year throughout one’s life, provides diminishing purchasing power as time passes. [1]

the-impact-of-inflation

The chart depicts all of the past levels of purchasing power erosion since 1966, for periods lasting 5, 10, 15, 20, 25, and 30 years.[2] For example, the five-year loss in purchasing power from 1966 to 1971 was 16.9%.  From 1967 to 1972 it was 18.9%. From 1972 to 1977 it was 23.8%. 

The first vertical bar at five years’ duration displays the range of purchasing power, from the worst loss to the least loss, over every five-year period considered. (There are 46 such overlapping five-year periods.) That five-year range goes from a low of $5,120 (which happened during the 1972-77 time interval) to a high of $9,100 (2011-2016) in purchasing power. 

It’s reassuring the lowest loss in purchasing power was during the most recent five-year period, and that inflation has been modest in Australia over the past fifteen years, but it’s wise to prepare for the possibility that such low inflation rates will not persist over the 20-35 years of your retirement. Therefore, you simply can’t afford to make a mistake in this matter unless you are willing to gamble with your future.[3]

The inherent risks of escalation

Some types of lifetime income annuities have been developed that provide increasing payments each year which rise by a pre-specified amount, or the Consumer Price Index. 

For example, you could purchase an annuity that would start with a reduced initial payment, say $8000 per month, and climb by one per cent to six per cent each year, depending upon the percentage selection at the outset. If a five per cent annual escalation factor was used, after 10 years, you’d receive $13,031 per year (= $8,000 x 1.0510). But even professionally trained economists are not very adept at projecting future inflation beyond a year or two. How then are you supposed to know which escalation rate to select over the next 20-35 years? 

By selecting too high of an escalation factor, you’d be foregoing a lot of consumption during the early years and have more to spend than you might need in later years.

Alternatively, if you select too low of an escalation rate, you may quickly have a strained budget.

What matters is your changing needs

There is a useful study that illustrates the changing consumption basket for Australians as they age, and I recommend it for background reading.[4] Nonetheless, your changing needs may not mirror those even of the average ageing population cohort.

‘Staggered annuitisation’ can help manage your changing needs

A major element of this approach is what we refer to as ‘staggered annuitisation’. A ‘staggered annuitisation’ strategy is one where separate annuities are purchased at varying intervals dependent upon your personal cost of living. One reason to prefer to stagger the purchase of annuities is that predicting our personal cost of living is difficult and can change based on your personal circumstances.    

Remember that hedging against general inflation is not really the goal here. What we need to hedge against is our personal cost of living which can be achieved with staggered annuitisation. Because the repayment of the principal component of a lifetime annuity grows at an increasing rate as we age, there is a healthy, built-in incentive to forestall supplemental annuitisation until we simply cannot maintain the lifestyle we desire without activating another annuity. There is a simple trigger to remember: If you can’t afford your current lifestyle, you either need to adjust your spending or activate a supplemental annuity.  

Extract from David Babbel and CommInsure whitepaper, Retire Smarter – new strategies towards a comfortable retirement. You can access the paper via our website.

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[1] I fully recognise that $10,000 per year won’t get you very far in retirement, but the numbers shown can be multiplied to whatever level you need.  For example, if you require $60,000 per year during retirement, merely multiply all of the dollar numbers shown by six.

[2] The chart begins with 1966 because that’s when decimal current was introduced in Australia, which simplifies the calculation. 

[3] Before retirement, your continuing income and the luxury of time can help cushion some bad choices, but after retirement, you don’t have that cushion.  It becomes increasingly difficult after a few years of retirement to re-enter the workforce for three to five years to make up for a risky investment that winds up a losing gamble. 

[4]  “Spending patterns of retirees as they age – the needs of older retirees.” Association of Superannuation Funds of Australia, July 2011. 

https://www.superannuation.asn.au/ArticleDocuments/359/rc1107_SpendingPatternsOlderRetirees_July2011.pdf.aspx

General advice only. This material has been prepared without taking into consideration your personal objectives, financial situation or needs. Before acting on this advice, you should consider whether it is appropriate for you. You should read the relevant Product Disclosure Statement before making a decision to buy or continue to hold a product. The Colonial Mutual Life Assurance Society AFSL 235035.

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