Annuity laddering can be a smart way to optimize your retirement income. It is a strategic approach to purchasing annuities. Laddering allows you to spread out your potential risk, diversify income streams, and better adapt to changing financial conditions.
You may have encountered the concept of laddering as it relates to bonds or certificates of deposit. Laddering is also applied to other financial vehicles as well. However, it has proven to be a potent tool in annuity planning, especially if you are someone who is concerned about interest rate fluctuations, longevity, and inflation.
What exactly is annuity laddering?
Laddering is a straightforward process that involves purchasing multiple annuities with different guarantees or surrender periods. Laddering’s goal is to create staggered income streams. Building an annuity ladder gives retirees increased flexibility and efficiency. With a ladder, you can specify when and how your income begins. Doing so could help you mitigate risks such as longevity risk or the risk of locking in too early at a low interest rate.
With a ladder, you won’t put all your savings into a single annuity. Instead, your principal is split across several different annuities. These annuity contracts may purchased over time or all at once. However each annuity will have different terms and payout dates. Such an approach ensures you will end up with different income streams starting at different times throughout your retirement. The diversification offered by a well-designed ladder can also extend to the types of annuities and providers used, adding another layer of security.
How do you build an annuity ladder?
The process of creating an annuity ladder starts by splitting the premium that would typically be used to purchase a single annuity into smaller portions. By splitting your premium, you can then buy several annuities instead. For instance, instead of investing $500,000 in one fixed annuity, you might invest $200,000 in a five-year guaranteed annuity this year, then $100,000 in a three-year annuity the following year, and another $200,000 in a seven-year annuity later on.
When the first annuity matures, you can either reinvest your payout or roll it into a new annuity at potentially higher rates, giving you much more flexibility. When you have a ladder, you’re no longer reliant on the rates that were available at the time of your initial purchase.
Are ladders best in the accumulation or the distribution phases of retirement?
Some safe money experts believe laddering is one of most effective ways to hedge against interest rate risk. Let’s say you’re saving for retirement and have $250,000. You could invest the full amount into a single annuity at a 3.5% interest rate, but if rates rise to 5% next year, you’d miss out. Laddering prevents this by allowing you to gradually buy annuities over time when you might be able to snag higher rates.
Laddering as you accumulate wealth:
Consider this example of how laddering might be used by a pre-retiree who wants guaranteed returns on his savings. Kevin just turned fifty-five and is nearing retirement. He is eager to ensure that he earns guaranteed returns on his savings. Instead of locking all his money into a single annuity, Kevin’s advisor suggests that he invests in three separate fixed, deferred annuities with three, five, and seven year terms. By the time the first annuity matures, Kevin can either withdraw the funds without penalty or reinvest them at higher rates.
Laddering in the distribution phase: As you plan your retirement, your primary objective should be to create reliable streams of income. Laddering in the distribution phase works by setting up different annuities to start payments at various stages on your financial timeline. For example, instead of creating a single income stream starting at age sixty-five, you might structure your ladder so that one annuity starts at sixty-five, another at age seventy, and a third at seventy-five.
Take Dawn, for instance. Dawn just turned sixty-five and she’s ready to stop working and enjoy life. On the advice of her safe money expert, Dawn purchases a series of immediate annuities that start payments in five-year intervals. The first annuity starts paying immediately, the second begins payouts when Dawn turns seventy, and the third kicks in when she reaches age seventy-five. Dawn’s ladder gives her more income as she ages, which could help her overcome longevity risk. Her ladder also addresses inflation risk because it’s designed to increase her income over time.
What are the main advantages of an annuity ladder?
As the examples above indicate, a laddering strategy may have several positive effects on your financial planning. Some of the more obvious ways in which a ladder can benefit a retiree include:
- Assisting in portfolio diversification: When you use a ladder, you spread your exposure across different annuity types (fixed, variable, or indexed) or companies. Spreading your money around in this manner gives you stability, increased protection against economic turbulence, and more growth opportunities. When you combine fixed annuities, which offer guaranteed rates, with other types of annuities, such as fixed indexed annuities, you increase the possibility of participating in market-based growth. With this type of ladder, you can strike a balance between stability and higher returns.
- A ladder gives you some inflation risk protection: Staggered payouts can combat inflation by creating more income later in retirement, when expenses are likely to rise. For example, instead of receiving a single income stream that stays the same over time, laddering ensures that new streams kick in, providing additional funds as you get older.
- You can use a ladder to reduce interest rate risk: When you spread out your annuity purchases, you reduce the risk of locking into a single interest rate. This is particularly critical if rates are low at the time of your initial purchase. Since you probably don’t want to be locked in to a low rate, you can use a laddering strategy to take advantage of rising rates later.
- You have more liquidity and flexibility with a ladder: By staggering annuity terms, you can avoid locking up all your funds at once. As each annuity matures, you have the option to either withdraw or reinvest, giving you more control over your financial future.
What are some typical laddering approaches?
- Time-Based Laddering: This strategy involves staggering your purchases over time to spread out interest rate risk. For instance, you might buy annuities over the course of several years, locking in different rates as the market changes.
- Payout-Based Laddering: You can also structure your annuities so that each one starts paying out at a different time, creating multiple income streams as you age. This strategy not only helps mitigate longevity risk but also ensures that your income increases over time to keep up with inflation.
- Diversification by Type: Another option is to ladder different types of annuities. For example, you could invest a portion of your funds in fixed annuities for guaranteed income and another portion in variable or indexed annuities for the potential of higher returns. This way, you get the best of both worlds—reliable income from fixed annuities and the growth potential of more market-sensitive products.
Is Laddering Right for You?
Laddering is particularly beneficial for conservative investors looking to balance income security with growth potential. If you’re nearing retirement or already retired, laddering can help you gradually transition your assets into income-generating products without locking everything into one strategy.
However, annuity laddering may not be ideal for those who need immediate liquidity or prefer short-term access to their funds. It’s important to understand the surrender charges and tax implications before committing to a laddering strategy. Consulting with a qualified retirement income advisor is highly recommended.
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