Annuity Ladder

So, with the recent downturn in the markets, many retirees are finding themselves discussing an oldie but goodie - annuity ladders.  There are two forces at work in the markets right now which are making annuity ladders extremely attractive:  (1) historically low interest rates and (2) decline of the global markets during the great recession.  

What is an Annuity Ladder

An annuity ladder is when an investor purchases annuities incrementally over a specified period of time in order to avoid the risk of being locked into a low rate of return on their investment.  Since interest rates fluctuate over time, an investor can spread their investment dollars in annuities over a 5 or 15 year period, with the hope that collectively these investments over time will yield a higher amount of interest versus if they were to buy the entire annuity at the prevailing interest rate.  An annuity ladder is an attractive option for people preparing for or entering into retirement, because it allows them to receive a monthly sum of money to cover their living expenses.

Annuity Ladder Strategy

The payouts for annuities originate from the return on investment the insurance companies make off your lump sum payment for purchasing the annuity.  So, if rates are low, your monthly payout for the respective annuity will also be low (assuming you purchased a fixed annuity).  As an investor your primary goal is to make the most amount of money over a period of time.  So, if an investor were to buy a $500,000 fixed annuity at once, they would know exactly how much money to expect for the remainder of their life span.  Another approach is to buy $500,000 worth of annuities spread out equally over a 5-year period.  Using this strategy, the initial monthly payouts would be smaller, because the investor would be receiving less monthly income, because the payout would be based on $100,000 versus the lump sum of $500,000.  However, over time the annuity ladder approach has the potential to yield more gains for the following reasons:
  1. As an investor ages, the monthly payout increases as the insurance company pays more as a person approaches their "expiration" date.
  2. The investor may be able to capture a better monthly return if interest rates go up over this 5-year period.
  3. The investor could place the cash they plan on investing in annuities in stocks over the 5 year period, with the expectation that additional returns on their investment can be used towards purchasing more annuities.  For example, after year one, the investor in theory could make 10% on the 400,000 worth of cash.  This would result in a $40,000 profit, which could be used later to invest in annuities, resulting in $540,000 invested versus $500,000.
The above scenarios of course come with a host of risks and endless variables which could affect the results.  But it is clear to see that if an investor forgoes the quick money up front and is able to let interest rates and the higher monthly payments as they age work in their favor, they may come out ahead.  Remember, the elephant in the room in all of this is that the investor of course will need to live beyond their expected life span in the actuarial tables.

Annuity Ladder Table

Annuity Ladder

For more information on annuity ladders visit the following external resources:

A Ladder of Annuities Can Hedge Your Bets - Kiplinger
Annuity Ladders - Financial Planning 

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Tim Ord
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