Is your income bucket plan an inflation trap?Article added by Kevin Startt on July 2, 2014
Joined: August 08, 2013
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In the financial services industry, we have been polarized between annuity advocates and the brokerage industry that has been trying for a decade or so to make indexed annuities a securities product. With the advent of more and more enhanced index annuity options that are designed to put the carrier in the best performance position possible — thanks to the new ninth wonder of the world, back-casted compounding — I am slowly moving towards the camp of making this popular product a security. I simply have met too many agents who don’t know a farmers market from the stock market and the Daytona 500 from the Standard and Poor’s 500.
One of the historical facts that we might agree on, however, is that the least likely movie sequel is Titanic II. When I ask my wife if she would like to watch this movie, she replies that she does not because she knows what happens in the end. What may happen in the end to fixed income investors who rely too much on single premium indexed annuities (SPIA) is the same sinking sound of lost opportunity to keep up with an increasing cost of living at the fuel pump and grocery store.
So it is with inevitable inflation. Without getting into post-Milton Friedman dogma from the incredible bread machine, beware of the agent or advisor who is touting a SPIA near an all-time low in interest rates and inflation as the first income bucket or step on the ladder to peace of mind and endless prosperity. The SPIA and single premium annuity that were bought in the early 1970s along with bonds were simply crushed in purchasing power as inflation raced ahead at 8 percent, according to the Consumer Price Index. With the Financial Rule of 72 in mind, that means that one’s principle in purchasing power terms was worth nothing when Ronald Reagan took office as the 40th U.S. president in 1981. Tickets at the box office doubled and savers began cashing their monthly checks and quickly found that they did not go nearly as far as they did in 1971.
SPIAs are ideal for an income-oriented saver who has a shorter life expectancy, but they tend to be overused in a bucket type of plan. One of the greatest fears of older Americans is that they will run out of money because they see a check as tangible when compared to a loss of purchasing power, which is looked at as intangible. Over the longer term, a SPIA bought at a time when rates have been higher 95 percent of the time according to AXA may not make sense. That, of course, holds until a consumer looks at record-high beef, pork and seafood prices and begins to realize just how much income has been transferred from savers' paltry yields.
In planning for a 25-30 year time horizon, the need to accommodate inflation must be considered in a well-thought-out income plan. One better inflation hedge for a first bucket than a SPIA may be a strategic income mutual fund or a balanced fund where a systematic withdrawal is utilized at the inception of the investment. There are several solid funds with 8 percent average annual returns that produce superior inflation protection when combined with a SPIA in the first income bucket or when used as a standalone first bucket. One of these funds has produced an 8 percent average annual return since 1947 with a broad mandate as to where it can invest conservatively. Even with the tax benefit of the exclusion ratio, which measures the portion of the annuity that is tax-exempt and is based on the age of the owner and type of annuitization, the fund or money manager wins hands down.
Of course annuity advocates will argue that principal is not guaranteed, but I learned a long time before executive life and money market funds that there are no guarantees in life. Too many investors do not look at paying taxes as an annual bear market (if tax rates are above 20 percent), nor do they look at losing all their purchasing power over 10 years as a complete loss of their saved funds. If they did, however, maybe we would have less polarization of safe withdrawal rates, bucket strategies and asset allocation and more ability to help a consumer truly keep more of what they earn in real and net returns.
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