Purchasing Power Principle

InsuranceNewsNet

By Jacob Stern
InsuranceNewsNetMagazine, February 2012

Most producers who offer indexed annuities understand the many benefits of the product: annual reset, protection of principal, ability to participate in a variety of markets and tax deferral. But one important aspect that is often overlooked is how these products can help protect our clients’ purchasing power of their dollars.

Many people in retirement, or nearing it, want to ensure they can continue their lifestyle. But many do not understand the effect that inflation can have on their dollars. Inflation is a silent killer of purchasing power and many simply ignore this factor. Using the U.S. Labor and Statistics website, anyone can view the official inflation numbers.

There have only been a few times when inflation was below zero and is often in the 2 to 3 percent range. For example, if inflation were at 3 percent for a year, people would have to earn 3 percent on their funds just to be able to purchase the same amount of goods as they did a year ago.

To make matters worse, if the person happens to be invested in vehicles that can lose value, it magnifies the situation. In this article, we will examine how inflation can destroy a person’s purchasing power and how market losses are magnified by inflation. When beginning a conversation with clients about how much income they need in retirement, many agents forget to factor in inflation. Inflation, like losses and gains in investments, has a compounding effect that’s almost always to the downside (since deflation rarely happens, even during a recession). So, purchasing an indexed annuity can provide clients an added layer to combat inflation and protect their purchasing power.

The Numbers

I analyzed many years of S&P 500 data to fully understand how inflation can erode purchasing power. I started with March 2000 and baselined the S&P 500 to 1000 (actual value was 1498, but because we are looking at the percent changes, using a baseline of 1000 makes it easier to understand). In the analysis, I also assumed purchasing an indexed annuity with a modest cap of 5 percent (annual point-to-point) at the same time in March 2000.

Fast forward five years to March 2005, and the baseline S&P 500 was at 851. However, factoring in inflation, the “purchasing power” S&P 500 was at 751. This means that if clients were 100 percent invested in an S&P 500 fund, they lost approximately 25 percent of their purchasing power. If the person looked at their annual statement from their broker, they would only observe a 15 percent loss (1000 down to 851). But because inflation has a compounding effect, the purchasing power was further depleted.

In March 2005, the S&P 500 value of the baseline indexed annuity stood at 1100. As most agents understand, the down years in the market simply turn into zeros instead of losses for the client. In addition, with annual reset, gains in the indexed annuity can still be achieved even though the S&P 500 value is below the original value of 1000. So, the clients had gains of 10 percent over five years in their indexed annuity. Inflation brought the indexed annuity’s purchasing power to 971. If the client had the indexed annuity, they would have only lost approximately 3 percent of their purchasing power compared to 25 percent in an S&P fund.

March 2009 was an especially tough purchasing power time for people who invested directly in the S&P 500. The baseline S&P 500 value was at 625. Factoring in inflation, the person’s purchasing power was down to 499. So, the person lost more than half of their purchasing power when compared to what they could have purchased in 2000. The indexed annuity, however, performed much better. The baseline value stood at 1213 in March 2009, a little more than a 20 percent gain on their money nine years later. Inflation kept the purchasing power of the indexed annuity at 970 so people lost just 3 percent of the overall purchasing power instead of 50 percent.

Fast forward once again to March 2011. The baseline S&P 500 was at 1082, but the purchasing power value was only at 823. This means that over the 11-year period, clients lost approximately 18 percent of their purchasing power. Another way to think about this situation is that the clients can now only purchase 82 percent of what they could have purchased in March 2000. For people in retirement and on fixed income, this situation would directly affect how the person lived. Take a look at the indexed annuity, however, which provided a much better situation for the client. The baseline value of the indexed annuity was 1337 and the purchasing power was 1016. The indexed annuity kept up with inflation over the 11-year period. Obviously there were no real gains with the indexed annuity, but the clients could still purchase the same amount of goods in 2011 as they could in 2000, unlike purchasing an S&P 500 fund.

Never Forget Inflation

Inflation can be a damaging enemy for a client’s retirement funds. It is very important that agents discuss inflation with their clients, explaining how detrimental it can be to their standard of living during retirement, using examples similar to those provided above.

By changing the conversation from gains or losses to purchasing power, clients can gain a better appreciation of the power and protection of the indexed annuity. It is one of the few instruments that can help clients hedge against inflation and reduce their volatility.

Jacob Stern is CEO of Imeriti, a national insurance marketing organization based in San Diego. Imeriti has been wholesaling investment-oriented life insurance to financial institutions, stockbrokers, financial planners and broker/dealers for more than 30 years. He may be contacted at [email protected].