Few people are left untouched by the distressing impact of inflation. But diminished purchasing power can be especially worrisome for those who depend on income sources that stay constant year after year, such as some annuities, to cover their monthly expenses.
With a cost-of-living rider, you can minimize the impact of inflation by adding a periodic or annual increase to your benefits over time. These benefit increases make it easier to manage your personal finances and enjoy a more secure retirement.
What Is a Cost-of-Living Rider and How Does it Work?
A cost-of-living adjustment rider (COLA), also known as an inflation rider, is an optional add-on to an annuity that periodically increases income payments to help offset inflation.
When you purchase an annuity, you pay a premium in exchange for future payments that will help you maintain a steady income in retirement.
During the income phase of your annuity, inflation can reduce the purchasing power of your payments over time. An inflation rider can help you minimize the impact of higher costs by automatically increasing your annuity income.
How To Choose Your Annuity
The size of the annuity you choose initially is typically based on your estimated future expenses and the amount of premium you can pay. For example, if you’ll need $3,000 per month to cover housing, food, clothing, medical care, and other miscellaneous costs in retirement, you should purchase an annuity with terms that provide some or all of that necessary income.
There are other considerations in play, too, including:
- Your age
- When you plan to retire
- When you want payments to begin (you can choose between immediate annuitization or deferring your payouts)
- Your other retirement income streams, like a pension or 401(k)
- The annuity’s rate of return terms
- Your risk tolerance
These considerations, in concert with market conditions, optional annuity riders, and other variables, help determine how and when your annuity pays out.
Core Benefits of a Cost-of-Living Rider
Opting into a living adjustment COLA rider pays off in two significant ways:
- Protection against inflation: Say your annuity pays $2,000 a month during retirement but never increases. If annual inflation averages 2.5%, your expenses will increase 28% over 10 years. That means you’ll have 28% less purchasing power with your $2,000 payment. With a COLA rider, your future annuity payouts can better retain their value.
- Peace of mind: Just like health insurance offers some peace of mind if you’re ever in a car accident or become ill, a COLA rider provides some reassurance that your income will continue to align with the rising cost of living.
In most cases, the best time to purchase an inflation rider is when you first purchase your annuity. However, some annuity contracts may allow you to add a COLA rider later on.
Understanding COLA Rider Costs
While there may be fees associated with some annuities, there are typically no upfront costs for a COLA rider. That said, you will pay for the inflation protection in other ways.
The primary drawback of adding a cost-of-living or inflation rider to your annuity is that your initial monthly benefits will be reduced. Annuity income is based on a payout percentage of your account value at the time you begin taking withdrawals. If you exercise a COLA rider, the initial payout percentage is lower than if you opted for equal payments. Your $2,000 monthly payment without the rider may begin, instead, at $1,700 a month. It will take several years before your payments equal or surpass what you would have received without the rider. The lower initial payout is essentially your cost of adding a rider and it helps the insurance company pay for the increasing payments over time.
An experienced annuity agent can help you calculate your annuity payouts both with and without a COLA rider. Then you can decide if it’s better to weather lower payouts early on for inflation benefits later or to keep payments steady and prep for inflation in other ways.
How Are COLA Adjustments Calculated?
The increase in your annuity’s payment can be calculated in one of two ways.
Some COLA riders use a set percentage, typically ranging from 1% to 6% annually. Regardless of the actual rate of inflation, your payments will increase by this set amount each year. Keep in mind the higher the annual increase, the lower your initial monthly payout will be.
Other COLA riders use the actual inflation rate, as expressed by the Consumer Price Index (CPI) to calculate your new payment. The U.S. Bureau of Labor Statistics uses the CPI to quantify price shifts in spending categories integral to life, including housing, energy, and food. COLA riders that use the CPI typically result in an initial lower payout amount than those using a level percentage increase.
Payout increases are also affected by whether the rider uses a simple calculation or a compound calculation:
- Simple increases: Annual percentage adjustments are only applied to the original benefit amount, ignoring any inflation-related payout increases made previously.
- Compounded increases: Annual adjustments are applied to the previous year’s monthly benefit amount. This approach generates interest based on your principal plus all previous interest increases, resulting in a higher total payout versus the simple increase method.
For COLA riders with CPI-based adjustments, the actual rate of inflation helps determine that year’s periodic benefit increases. These adjustments may be calculated on a sliding scale that acknowledges CPI increases without matching them exactly, such as a 2% payout bump for inflation rates between 2 and 2.9%.
Other Annuity Riders To Consider
In addition to inflation riders, there are other types of annuity riders you can add to your annuity contract if they match your needs:
- Long-term care riders increase your monthly benefit amount to help cover the costs of long-term care, such as assistance from an in-home caregiver or placement in an assisted living facility or nursing home.
- Disability income riders act as a supplement or alternative to traditional disability insurance by providing a temporary boost of income if you’re too ill or injured to work. These riders are only active for a finite period of time.
- Guaranteed lifetime withdrawal benefit riders set a minimum monthly benefit amount that must be met regardless of market conditions.
- Death benefit riders transfer your annuity payouts or a lump sum death benefit to a designated beneficiary in the event of your passing.
- Return of premium riders offer an alternative to death benefit riders. In this case, any remaining principal is paid out to your beneficiaries as a lump sum rather than continuing monthly payouts.
Is an Inflation Rider Right for Me?
While purchasing an annuity can help set you up for financial security when you retire, failing to account for inflation may leave you with guaranteed income that falls short of your monthly needs. If you’re comfortable taking a smaller payout now in exchange for less worry in the future, a COLA inflation rider might be the extra layer of economic defense you’ve been looking for.
Complex financial decisions are easier when you have professional input. Reach out to one of our trusted annuity agents to see how a strategic retirement plan could help set you up for a more secure financial future—even in the face of inflation.
Disclaimers:
All guarantees are subject to the claims-paying ability of the insurer.
Any reference to the taxation of annuities in this material is based on Annuitiy.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.
Riders may be subject to eligibility and underwriting requirements, additional premium requirements and/or minimum or maximum coverage amounts. Availability and rider provisions may vary by state.
