Hedging Against Inflation Risk with Real Annuities

7 Pages Posted: 12 Jun 2019 Last revised: 21 Jun 2019

See all articles by Zvi Bodie

Zvi Bodie

Boston University - Department of Finance & Economics

Dirk Cotton

Independent

Date Written: May 31, 2019

Abstract


The only retirement contract that both insures against longevity risk and hedges against inflation is a life annuity that is linked to the consumer price index (CPI). It is denominated in the same units of account as Social Security benefits. We call it a “real annuity,” although it is also referred to as an inflation-indexed single-premium immediate annuity (SPIA). In computing a person’s replacement ratio of preretirement income, we can add Social Security benefits and the income produced by a real annuity to arrive at a meaningful number.

An annuity that is not linked to the CPI we call a “nominal annuity.” It is measured in units that are different from Social Security, so it would be a mistake to add the two in computing a replacement ratio. Despite those obvious facts, real annuities are largely ignored in practice and they comprise a tiny portion of the annuities market. The vast majority of income annuities sold are fixed in nominal dollars. From the perspective of rational economic decision-making, this is a puzzle. Let’s call it the “nominal annuity puzzle.” The purpose of this article is to explore the reasons behind this puzzle and to suggest ways to solve it. The lack of interest in real annuities can be explained by a lack of recognition that the purchase of a nominal annuity constitutes a speculative bet on future inflation rates and that the real annuity is the risk-free asset.

Keywords: SPIA, real annuity, nominal annuity, graduated payment annuity

JEL Classification: G11, G22

Suggested Citation

Bodie, Zvi and Cotton, Dirk, Hedging Against Inflation Risk with Real Annuities (May 31, 2019). Available at SSRN: https://ssrn.com/abstract=3395298 or http://dx.doi.org/10.2139/ssrn.3395298

Zvi Bodie (Contact Author)

Boston University - Department of Finance & Economics ( email )

United States

HOME PAGE: http://www.zvibodie.com

Dirk Cotton

Independent ( email )

No Address Available

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