How to make your own COLA

[Chuckanut]

Here is one person’s idea of how to make your own COLA pension or add a COLA to a non COLA pension. Yes, you need assets to do it.

The Pension Series (Part 7) - How to Create Your Own COLA - grumpusmaximus.com

“The difference in George’s question though is that he has a potential DBP coming his way in the not so distant future, so he is not looking for a way to replace the entire income of a pension. He just doesn’t have an associated COLA to accompany the pension. This means inflation will eat away at the value of his pension on an annual basis making his hypothetical $50K less valuable each year. For instance, if George simply started taking his hypothetical $50K pension this year, without an inflation-linked COLA, in 40 years at a 2% annual inflation rate, the purchasing power of his pension would equal $22,644.52 in today’s dollars. Ouch! That’s over a 50% reduction in value. Thus, George is astute to inquire as to how to amass his own pot of money that he can use to create his own inflation-linked COLA.”

 

[pb4uski]

Another way to do it is to buy a series of deferred payout annuities to simulate the COLA.

For example, let's say your fixed pension is $50k a year and we assume inflation is 2% a year. So after 5 years, you need $55,204 and after 10 years you need $60,950. When you retire, you buy a 5 year deferred life annuity for $5,000 a year and a 10 year deferred annuity that pays $6,000 a year... so every 5 years you get a COLA increase.

In years 1-5 you get $50k a year, in years 6-10 you get $55k a year, in years 11-15, you get $61k a year. Add additional layers to your heart's content.

If you wanted to be anal about it you could buy a series of deferred annuities that start each year and design cash flows that would be identical to a fixed COLA annuity.

 

[Independent]

My quick read says that this is not a CPI-linked increase, it is simply a 2% fixed annual increase.

IMO, there is a big difference.

 

[Independent]

I tried running Firecalc. I told it that I wanted a $50,000 annual (cpi adjusted) income, that I had a $50,000 non-cpi-adjusted pension, and I had assets of $600,000.

It said I had a 94.9% chance of 30 year success. It also said that I had an average ending balance of $2.2 million.

 

[Independent]

20 years ago, when I was w***ing for a financial services company, I pitched four ideas for retirement products. This was one of them.

You have a fixed dollar pension providing $X annually. You want a cpi-indexed pension. Use some of your 401k money to buy an annuity that provides just enough to fill the gap between your pension and what a cpi-indexed pension would pay. So it would pay zero in the first year, just one year's inflation in the next, then two year's, etc.

It was actually doable with TIPS yields at the time. IIRC, the first 30 year TIPS was sold in 1998 with a 3.6% coupon.

Marketing folks looked at a quick estimate of the premium and said they didn't think they had enough buyers who were sufficiently afraid of inflation to pay that amount.

 

[pb4uski]

Interesting.... I did the exact same thing. While we chatted about it some, it was easy to set up contractual annuity benefits that increased annually with the CPI, the difficult part was finding suitable investments on the asset side of sufficient scale to make it feasible.... and since management was a bit lukewarm on the whole idea to begin with we just gave up. Same on the last part... the marketing people were unenthusiastic.

 

[ERD50]

I tried running Firecalc. I told it that I wanted a $50,000 annual (cpi adjusted) income, that I had a $50,000 non-cpi-adjusted pension, and I had assets of $600,000.

It said I had a 94.9% chance of 30 year success. It also said that I had an average ending balance of $2.2 million.

I did a similar thing, but for 100% and 40 years, and selected the INVESTIGATE tab for min portfolio value to meet those inputs.

I got $760,700 - a higher number than he comes up with, not sure what success % he was going for, but I sure would not plan on 2% average inflation over the next 40 years. It might be a reasonable average, but I want my plans to take into account the "bad case" scenario.

-ERD50

 

[ERD50]

...
Marketing folks looked at a quick estimate of the premium and said they didn't think they had enough buyers who were sufficiently afraid of inflation to pay that amount.

... Same on the last part... the marketing people were unenthusiastic.

Interesting, and I'd bet that was the right decision from the marketing folks.

Unfortunately, it does illustrate that most people just aren't thinking about the effects of inflation over 30-40 years, and they should.

-ERD50

 

[Chuckanut]

My quick read says that this is not a CPI-linked increase, it is simply a 2% fixed annual increase.

IMO, there is a big difference.

That's my read on it also. Still, given the number of people with non-COLA pensions or partial COLA pensions it seems better than nothing assuming one has the assets.

It's just an option for some people in my point of view.

 

[mystang52]

You guys are better than I. Gotta confess, after a while I just lost patience reading the full article and gave up. I like pb4uski's suggestion of deferred annuities as a better alternative (i.e., I presume a better alternative since I gave up reading the article!).

 

[jazz4cash]

The SWR being used in the link is only 3.5%

Doesn't the 4% of starting balance SWR rule of thumb include annual increases for inflation?

 

[ERD50]

The SWR being used in the link is only 3.5%

Doesn't the 4% of starting balance SWR rule of thumb include annual increases for inflation?

Yes (at 95% historical success), but it appears (I stopped reading in great detail) this article is looking at a situation where someone has a $50,000 non-COLA pension, and tries to calculate how big a portfolio would be needed to 'fill-in' the COLA increases. So the portfolio would have a zero $ withdraw in year 1, and CPI* $50,000 year 2, etc.

As shown a few posts back, this can easily be modeled in FIRECalc with historical data, rather than any flat assumption on CPI.

-ERD50

 

[Independent]

Interesting.... I did the exact same thing. While we chatted about it some, it was easy to set up contractual annuity benefits that increased annually with the CPI, the difficult part was finding suitable investments on the asset side of sufficient scale to make it feasible.... and since management was a bit lukewarm on the whole idea to begin with we just gave up. Same on the last part... the marketing people were unenthusiastic.

Great minds, I guess.

 

[43210]

When I saw the title I thought, why not just buy an inflation-indexed SPIA, but then I remembered that they don't seem to exist (any more).

 

[Clone]

Unfortunately, it does illustrate that most people just aren't thinking about the effects of inflation over 30-40 years, and they should.

To me- an extended period of long term inflation is one of the boogey-men lurking in the shadows. This extended period of high returns in the market (even with the few short term blips that we have seen) and very low inflation could allow people to retire early based on over-confidence in the market.

We have seen very few early retirees have challenges the last 9 years, because the market has grown investments in a magnificent manner. What happens if we have a significant market drop that hangs in there for awhile, and a significant run of inflation at the same time? Those folks with an 80% prediction in FireCalc may find themselves on the 20% side of the results.

Many of us are in a better position. I look at it from this perspective- If everything collapses, I will still be in a better position than 95% (just a guess) of the folks out there. When it comes to torches and pitchforks time, they will be coming for me and my stash.

 

[pb4uski]

When I saw the title I thought, why not just buy an inflation-indexed SPIA, but then I remembered that they don't seem to exist (any more).

I think there are still a few available, but they are a rare breed.

 

[Clone]

I thought this was going to be a discussion about how frugal it is to make your own soft drinks. So then I thought, hmmmm, I wonder how the stock price of SodaStream has behaved, being that it was a bit of a fad that you don't hear much about.

I looked up SODA (Nasdaq). Over the life of the company, it has gone for a bit of a ride. Pretty much matched the S&P performance when you look at the 7 year run. But I wish I had owned it the past 12 months! (Of course, the same goes for CAT, which I trust a bit more than a product hawked on television.)

 

[ncbill]

We have seen very few early retirees have challenges the last 9 years, because the market has grown investments in a magnificent manner. What happens if we have a significant market drop that hangs in there for awhile, and a significant run of inflation at the same time?

IIRC, online you can still find insurance company ads from the 1920s showing happy couples who retired...on a $200/month annuity.

One set of grandparents (both born before WWI) retired in the late 1970s, granddad living another 25 years, grandmother another decade after he passed.

Think of what the market experienced during their retirement.