The Takeaways:
- Investing in a time of inflation is essentially buying the best physical and financial products to preserve the value or the purchasing power of your money. The goal is to invest so that your rate of return on investment will beat the inflation rate.
- An annuity is mostly a retirement product offered by insurance companies to provide protected, reliable income for life after retirement. It can help bridge the income gap between the savings you’ve accumulated over time, traditional sources of retirement income, like Social Security and the goal of living a comfortable retirement life.
- The chain of reactions: Inflation entices fed to raise interest rates, which in turn push bond yield high, and potentially lead to higher annuity income. Bond yield is the rate of return earned by an investor who buys a bond and holds it until maturity (i.e., Annual Interest Payment / Face Value x 100.).
- The higher the interest rate, the more money you earn on your annuity. When you’re ready to retire, you’ll have more wealth in your account as a result of earning higher interest, also with regular payment that is inflation adjusted to keep the same purchasing power for your retirement money.
A Common Question People Ask
I’m not sure about you but in my experience one of the most common questions people have asked is what the best investment is today. We can be curious for different reasons — sometimes just for the sake of striking a conversation, other times deadly serious about investing and making money.
Of course, you do not need me to tell you that one of the biggest concerns for today is inflation. Thus, the above question becomes what investment tool we should choose that can beat inflation.
Let’s find out first what ChatGPT has to say. Below is the heavily edited answer, as the original version was too “plain vanilla” for lacking a better word. My hope is to make the explanation easier and livelier.
Inflation means price hikes for goods (e.g., gas, eggs, meat) and/or services (e.g., ridesharing price), which lowers down how much goods you can buy with the same amount of money (e.g., $10).
Sometimes people ignored the fact that inflation must be sustainable for a period of time rather than a short-term phenomenon. You may also hear people saying inflation is “general” price hike, although inflation can be “sectorized,” meaning different sectors of an economy can receive different impacts rather than all sectors move together.
In a farming economy, food price can be a major driver of inflation, but in an energy or natural resource centered economy like Russia, oil price change plays a big role.
A simple, hypothetic example is $1 buys 3 eggs now, compared with 4 eggs before inflation. The value of your $1 decreased and it took one egg away from you (or 25% of its original value was “eaten” by inflation.)
Formally, we say the value of your money decreases, even though a $10 bill will always be $10 on the face value, no matter how long it sits in your wallet. Another way to say the same thing is consumer’s “purchasing power” goes down when inflation goes up. Note value of money comes from its purchasing power, in addition to other factors like its intrinsic value (e.g., gold or silver), acceptance, scarcity, stability, government backing.
General Principle of Investment During Inflation
Regarding what investment is the best for inflation, the idea is this: During inflation most if not all goods are getting more expensive or priced higher. This is the time to ask yourself what specific goods you should buy so that not only your initial investment will not be washed away or severely reduced by inflation, but you make money beyond the invested money — despite inflation.
Let me use an example to illustrate the point. If you believe the price of pork will be significantly higher one year from today, it will be a good idea for you to buy piglets and raise them so that one year later you can not only get your investment money back but with a large profit margin.
The pig example involves physical property. Another example of physical property is real estate. For those not know yet, real estate is known for its value in fighting inflation because housing price and rental income both tend to go up during inflation.
They are like boats: When the water level is up, boats go up with that.
As you can see from the above example, the key to fight inflation is to compare two rates. The first is inflation rate, typically measured by Consumer Price Index (CPI). The CPI is a measure of the average change in the prices paid by urban consumers for a basket of goods and services over time.
The second is your rate of return on investment. Say one year later the inflation rate hits 5%, but selling pigs gets you 10% of return, you win because your return is twice the inflation rate. On the other hand, with the same 5% inflation rate but your pig sales only offered you 4% of return, you know your real return is actually 4% – 5% = -1% or negative 1%, because real return must be adjusted against inflation.
Note sometimes you hear people mixing up “rate of return on investment” and “profit margin.” They are related but not the same. Briefly, profit margin focuses on measuring the efficiency of a company’s operations, while the rate of return on investment is on evaluating the performance of a particular investment, although both are percentage figures.
Investing in Financial Products
Investing in physical properties (pigs, real estate) sometimes is not the most convenient thing to do to earn a high return. To raise pigs you will need the piglets, the feed, the pig farm, the labor and the veterinary, to name just a few. To invest in rental income you must do a good job in maintaining the properties and also in dealing with dishonest renters.
Is there anything else that allows profit but is easy and fast to operate?
You bet. They have a special name “financial products” to differentiate from physical property. The former possess ideal features and should be among your first consideration for investing.
Speaking of investable financial products, in the old days gold came first but not anymore, as there are financial products that do better nowadays. I won’t get into the list of all the investment portfolio options for inflation purpose here. Let’s just consider one financial product that will benefit from inflation: annuity.
A Sideline Story of Eggs
Before proceeding, let me tell you a side story to lighten up the reading a little bit.
Assuming my previous hypothetic example of egg price in inflation is real, does it mean we should all stop buying eggs because their prices are so high and $1 now only gets you 3 eggs instead of 4?
I actually asked ChatGPT this egg question just for fun. Interestingly, although the database of ChatGPT does not cover the latest news, WebChatGPT, a free Google Chrome extension, does that. Every time you ask a question, the app will search three pieces of latest news related to the inquiry and then ask ChatGPT to present a conversational answer drawing from these reference.
Perhaps you already know the answer but formally, no, we don’t want to stop buying eggs if they are important to us. WebChatGPT also correctly points out that “the increase in egg prices is not directly caused by inflation, but rather as a result of various market factors.”
We need to separate consumption from investment, as well as separating segments of consumers. For some people eating eggs is a daily necessity and eggs are their staple food that nothing else can substitute. Others however will be happy to explore alternative sources of protein that are more affordable, such as beans, lentils, and canned fish.
Now let’s switch to the topic of “Annuity and Inflation.”
Nature of Annuity
Let’s begin from ChatGPT again. The following is an edited version of the answer.
An annuity is a financial product that provides regular payments to the owner over a certain period, often for the rest of their life. This means you won’t be too far off if you link annuities to retirement, as they are frequently retirement related investments products.
I say “not far off” because some annuity like immediate annuity provides regular income payments right away for a set period of time or for life, and you don’t have to wait until retirement. Instead, you can begin receiving payments immediately after purchasing the annuity with deposited fund.
Similarly with deferred annuity you may or may not have to wait until retirement — as long as you wait long enough to enter annuity’s “annuitization” phase (i.e., time to receive annuity payment).
You may hear some people calling annuity “annuity insurance” but that is not exactly right — even though annuity is a type of insurance contracts between insurance company and the person receiving annuity payment, or “annuitant” as they are called.
For one thing, insurance, especially life insurance, is designed to benefit one’s loved ones (i.e., spouse or children or any designated party), while annuities are mostly for oneself.
Secondly, annuities usually do not need a particular “trigger event” to start the payout, as long as enough money has been accumulated to pay. Life insurance however always requires that (most likely death but also terminal or chronical illness) to start the payout. In other words, you can’t start receiving insurance payment just because you feel like it. You must convince the insurance company that it’s time for them to pay you according to terms of the insurance policy. Annuity does not need you to do anything in particular, as everything is in the contract and is predetermined.
Finally, most annuity features regular payouts over a fixed interval, while life insurance can have a lump-sum payment to the beneficiaries.
Parties in the Annuity Contract
The typical parties listed on an annuity contract are:
- Annuity owner: The person who buy the annuity either in a lump sum payment or more typically through a series of regular contributions in order to receive regular payments either immediately or wait for a period of accumulation.
- Annuity issuer: The company or institution that issues the annuity and is responsible for making the payments to the annuity owner. This is generally an insurance carrier but can also include other financial service firms.
- Annuitant: The person whose life expectancy is used to calculate the annuity payments. The annuitant can be the same person as the annuity owner or a different person. This is why I say annuity is mostly designed to protect oneself.
- Beneficiary: The person or persons who will receive any remaining funds in the annuity upon the death of the annuity owner or annuitant. However, unlike a life insurance policy there is no guarantee for annuity beneficiary to receive money. It all depends on whether there is fund left in the annuity account when the annuitant died.
Let’s use a hypothetic example to show how annuity works on the high end. I made the human characters up, but the rest of story is reasonably realistic.
Owning a Luxurious Shipboard Condo
Beth is in her 50s and has never married with no child. As a company executive, her personal assets are in the millions. One day she received a phone call from her friend Gloria who is also in her 50s and a female executive in another firm. Gloria suggested Beth to check out the sales materials she received and invited Beth to own one of the “private residential yacht” apartment rooms next to her, in the world’s largest residential ship called MS The World with 12 decks, 165 luxurious shipboard condos built 13 years ago and equipped with every possible modern convenience in each apartment, costing from $825,000 to $7.3 million. Beth and Gloria each must prove a net worth of at least $5 million, then add another 10 to 15 percent for annual maintenance and other fees based on your apartment size.
Beth and Gloria have no problem with provable net worth, the concern is with the regular annual payment for maintenance and other fees. They both want to set up a way to take care of the money. Beth has a Farmers insurance agent friend named Tiffany who heard the issue and offered to help. Tiffany told Beth, and through her to Gloria, that since they both will own the shipboard condos after retirement, annuity would make sense for them.
How Annuity Works
The steps are listed below:
- You make either a lump sum payment or a series of payments into an annuity account. For Beth and Gloria, a one-time only, lump-sum investment makes sense.
- The annuity provider (or issuers, in this case, Farmers insurance) invests money from Beth and Gloria in a portfolio of assets such as stocks, bonds, and other securities.
- The investments generate interest, dividends, or capital gains, which accumulate in the annuity account and are tax-deferred until you withdraw them. Here “tax deferred” means taxpayers owe IRS taxes on investments, revenues, or profits but they don’t have to pay now and can be “delayed” or “postponed” to the future. (If you know the concept of “time value of money,” you know $1 today carries more value than $1 next year, so delayed tax payment is a good thing.)
- Depending on the type of annuity, you may receive payments immediately — if you made a lump sum investment into the annuity like Gloria and Beth will do, or at a future date, either for a fixed period or for the rest of your life. Most people will choose not to receive a lump sum payment. The whole reason they invest in annuity is to get a stream of regular payments month to month, quarter to quarter and year to year. In that case, the annuity issuer (i.e., Farmers in Beth and Gloria case) will write you a check on a regular basis and it’s worry free.
- The amount of the payments depends on several factors, such as the size of the initial payment, the duration of the annuity, and the interest rate or returns generated by the investments.
An important thing to know is that sometimes an annuity can pay you (the annuitant, like Beth and Gloria) more money than you initially invested because the earnings from stock and/or interest rate from bonds are higher than expected.
Beth and Gloria each will invest $500,000, but Beth picks a “Single Premium Immediate Annuity (SPIA)” that provides a guaranteed income stream for life (or a specified period). This annuity is ideal for those who want to convert a lump sum into a guaranteed income stream. It is possible that Beth’s $500,000 may turn out to be $550,000 in the end, due to good marketing performance of the investment by the annuity issuer.
Gloria on the other hand decides to invest in a variable annuity, which is for annuitant with a higher risk tolerance and wants to invest in a range of mutual funds or other investment options within the annuity. Variable annuities can offer potentially higher returns but come with more risk and fees.
Why Is Annuity More Attractive During Inflation?
When price increases during inflation, annuities become a more attractive investment option because it provides a fixed income stream that is immune to inflation. For others without owning annuity, inflation lowers their purchasing power of money. An annuity, however, can provide a guaranteed income stream that is typically linked to inflation, meaning that the income increases along with inflation. This can help protect annuity owners from the negative effects of inflation on their purchasing power.
For example, say an investor (not Beth nor Gloria) purchases an annuity that promises to pay her $1,000 per month and inflation is 3%, the annuity may increase the payout to $1,030 per month to keep up with inflation. This has a special name for it: cost-of-living adjustments (COLAs), which helps her payments keep pace with inflation and keep her purchasing power over time, even if the general cost of living goes up.
Of course, money does not fall from the sky. The reason annuities can afford to pay COLA is because the insurer (or annuity issuer) will invest the annuity premiums in assets that will provide a higher return to offset the impact of inflation. According to this report, “In general, insurance companies earn more in bond yields when the Federal Reserve raises interest rates. As a result, they can offer their customers higher rates.”
Remember the “boat” metaphor I used earlier for real estate? When price level goes up, rental income and housing price goes up as well. This applies to annuity which is guaranteed income to annuitant.