Inflation and Retirement 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. 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.