The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program

Abstract

The current U.S. social security system provides retirees with a real annuity during their retirement years. Retirees are insulated from inflation risk, at least as long as their consumption bundle is not too different from the bundle used to compute the consumer price index. This chapter asks whether real annuities can be provided within a privatized system. It explores issues concerning real annuities, nominal annuities, and the inflation risks faced by prospective retirees, all of which are relevant to the prospects for individual accounts under social security reform. It first describes the annuity market in the United Kingdom before investigating the availability of real annuities in the United States. It then considers whether a retiree could use a portfolio of stocks or bonds, in lieu of a portfolio of indexed bonds, to hedge long-term inflation risk. Specifically, it evaluates how much inflation risk annuitants would bear if, instead of purchasing nominal annuities, they purchased variable-payout annuities with payouts linked to various asset portfolios.

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