Deflated Pensions
INFLATION IS BAD news for bond investors, but it���s really terrible for annuitants and those receiving company pensions. Bond investors can at least reinvest maturing bonds in newer bonds paying higher yields. But most income annuities and pensions pay a fixed monthly benefit for life. In fact, you can no longer even buy inflation-adjusted single-premium immediate annuities. Meanwhile, just 7% of all private-sector pensioners received automatic cost-of-living increases, according to a 2000 survey by the Bureau of Labor Statistics.
Just how big a problem would sustained inflation be for annuitants and pensioners? In recent months, inflation has averaged 6%, as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). If it remained stuck there, it would cut a pension���s purchasing power in half in just 12 years.
One pension, however, has near complete protection from the ravages of inflation. The Federal Employees Retirement System contains a cost-of-living adjustment (COLA) that raises payments annually. Here's how it works: If inflation, as measured by CPI-W, is 2% or less, the COLA matches it. If inflation runs between 2% and 3%, the COLA remains at 2%. Most important, if inflation exceeds 3%, the COLA equals the CPI-W minus one percentage point. In other words, the worst-case scenario is that the COLA lags behind inflation by one percentage point in any given year.
If inflation spirals out of control at 10% a year, the COLA would add 9% to federal pension payments annually. If a federal worker���s pension were to lag inflation by one percentage point annually���remember, this is the worst-case scenario���its purchasing power would decline 26% after three decades. That���s not too bad, considering the alternative. An annuity or pension without inflation protection would have lost 94% of its value after the same 30 years.
Federal pensions are also backed by the full faith and credit of the federal government. That���s no small thing when you compare them to state pension plans. In aggregate, statewide pension plans were only 72.9% funded in 2019, near the lowest point in modern history. Given the current headwind of ultra-low interest rates, that shortfall is unlikely to narrow.
I���m certainly not predicting sustained 10% inflation. But even 5% inflation would drive down purchasing power by 77% in 30 years for those pensioners without a COLA. Worse yet, many economists feel that the official measure of inflation significantly underreports��the true price increases we encounter in our daily lives.
Just how big a problem would sustained inflation be for annuitants and pensioners? In recent months, inflation has averaged 6%, as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). If it remained stuck there, it would cut a pension���s purchasing power in half in just 12 years.
One pension, however, has near complete protection from the ravages of inflation. The Federal Employees Retirement System contains a cost-of-living adjustment (COLA) that raises payments annually. Here's how it works: If inflation, as measured by CPI-W, is 2% or less, the COLA matches it. If inflation runs between 2% and 3%, the COLA remains at 2%. Most important, if inflation exceeds 3%, the COLA equals the CPI-W minus one percentage point. In other words, the worst-case scenario is that the COLA lags behind inflation by one percentage point in any given year.
If inflation spirals out of control at 10% a year, the COLA would add 9% to federal pension payments annually. If a federal worker���s pension were to lag inflation by one percentage point annually���remember, this is the worst-case scenario���its purchasing power would decline 26% after three decades. That���s not too bad, considering the alternative. An annuity or pension without inflation protection would have lost 94% of its value after the same 30 years.
Federal pensions are also backed by the full faith and credit of the federal government. That���s no small thing when you compare them to state pension plans. In aggregate, statewide pension plans were only 72.9% funded in 2019, near the lowest point in modern history. Given the current headwind of ultra-low interest rates, that shortfall is unlikely to narrow.
I���m certainly not predicting sustained 10% inflation. But even 5% inflation would drive down purchasing power by 77% in 30 years for those pensioners without a COLA. Worse yet, many economists feel that the official measure of inflation significantly underreports��the true price increases we encounter in our daily lives.
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