Hedging Against Inflation Risk with Real Annuities

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 and, unlike nominal annuities, its payments can be directly added to those benefits. The comparison of CPI-adjusted and nominal annuities often is incorrectly framed, using the nominal annuity as the baseline and interpreting the difference in initial payments as the “cost of insuring against inflation.” We show that the correct framing of the analysis is to consider the CPI-adjusted annuity as the baseline and then to consider the additional income that might be generated by exposing the annuitant to inflation risk. We explain the flaws in comparing initial payments of the two types of annuities, note that CPI-adjusted annuities can hedge inflation rather than insure against it, and show that purchasing a nominal annuity is a speculative bet on future inflation rates.

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

JEL Classification: G11, G22