For millions of Americans, fixed annuities provide safety of principal, tax deferral and higher rates than those offered by banks and other traditional savings institutions. However, one disadvantage inherent in most fixed annuity products is their inability to keep up with inflation over the long term.
For example, assume that you invest $100,000 into a single premium immediate fixed annuity. A current contract from a major carrier would then pay out $658.59 per month, for a total of $7,903.08 for the year. The problem is, if the rate of inflation is 3%, then the purchasing power of these payments will decline from one year to the next. Obviously, $7,903 will not buy in a future year what it can now.
One way that annuity investors can deal with this problem is to purchase a cost-of-living rider on the contract. This rider is designed to ensure that the income from the annuity stays abreast of the rate of inflation over time. For example, the same SPIA contract with a 3% inflation protection rider will only pay $499.06 per month initially. But this amount will increase by 3% each year for the duration of the payout, thus providing some protection from inflation. Of course, it is plain to see that there is a cost to this rider, as the initial monthly payment is $159.53 less than the contract without the COLA rider. However, if the annuitant should live long enough to receive payments for the next 20 years, then the payment by year 20 would be $901.36 per month, or $242.77 per month more than the straight-life contract payout.
COLA riders can come in different forms, with some riders having a specific cost, while others (such as the one shown above) merely affecting the dollar amount of the monthly payout. Different rates of increase are also generally available, depending upon how much inflation protection the contractholder desires. For example, the contract shown above also has a 6% inflation protection rider option, which would result in the contractholder receiving a proportionately lower payment each month to begin with, and a higher payment at the end of the term.