Annuity Ladders: CD and Bond Alternatives

Here’s a direct request from a new client about annuity ladders.  Curtis mentioned that a lot of other people had this topic available and it might be a good idea to have it for my listeners as well.  He’s right and that’s the power of customer requests.  As with anything else I’ll take a different angle and try to give you a deeper perspective.

Laddering fixed investments is an old concept.  It’s been done with bonds and CDs for decades and the idea really comes down to diversification and management of interest rate risk.  If you know that rates are going to drop then it’s best to go long.  If rates are going to rise then you stick to a shorter term.  The problem is that we don’t know so blending maturities of bonds or CDs helps mitigate the uncertainty.  No matter what, a good ladder will have some positioned well and others not but it will all average out.  CDs are typically best for short-term holdings of less than five years whereas many bond ladders I’ve seen stretch the longest maturities to 15 years or more.

Annuities are typically better somewhere in between with surrender terms in the five to ten year range.  There are lots of other benefits of using annuities over CDs and Bonds so I’ll go into detail on each of those.  It’s going to come down to yield, taxes, safety, and liquidity.

Everyone wants to know how much money they can make.  CDs, Bonds, and Annuities are all fairly similar in terms of yield, depending on the credit quality of the backing institution.  The only time you see a major difference is with Bonds with lower ratings, or high-yield bonds or with callable bonds.  Really high bond rates come with more risk or you can have a five year bond that gets called in two years.  You get more interest if the company can change the terms and refinance the debt, leaving you to reposition that money when rates are less favorable.

Tax qualification of funds used to purchase any of these will reveal certain advantages.  If it’s pre-tax money like an IRA then you pick which one to use based on personal preference because taxes will be the same no matter what.  If it’s after tax money then CD growth and Bond interest will be taxed as ordinary income each year.  Annuities get an edge here with tax deferral but you have to be careful.  When withdrawals are taken interest has to come first so if you let it accumulate for several years you might be stuck.

Asset preservation or safety is the primary purpose with any of these.  Annuities come out on top by a wide margin because they are essentially a diversified bond portfolio with insurance company reserves to act as insurance.  Bond ladders need to be extremely well diversified because although safe, bonds do fail from time to time.  On average just under 1.5% of bonds fail annually with investment grade bonds being much less likely to fail than sub-investment grade bonds.  A small percentage is not going to crush a portfolio but very few people would pursue annuities if failure was as regular as this.  CDs have FDIC insurance because banks are highly leveraged and the insurance makes them very safe.  But you have to stay within the limits or it’s possible to lose money.  

Liquidity may not matter to some but most people are concerned with it and in many cases is necessary for retirement income planning or even required minimum distributions.   CDs don’t have any liquidity so a ladder is necessary for either of those two objectives.  Bonds pay regular interest but if more liquidity is needed then you have to sell the bond.  Changes in interest rates could increase or decrease the market value of a bond so you carry some risk in doing so.  The middle ground for all of this is an annuity.  It’s quite likely that all distributions can be met with no risk using the 10% free withdrawal of a fixed annuity contract (MYGA).

If yield is about the same in all three plus annuities are safer, have more liquidity and come with potential tax advantages, it seems like a pretty easy choice.

All types of safe asset ladders can be used to either accumulate money or distribute income.  I’ve built annuity ladders for both reasons but most common is to use an annuity ladder to bridge an early retirement income gap for someone who wants to delay social security.  In several cases I have recommended a combination of CDs. bonds, and annuities given that each has an optimal time frame.  It’s a lot of work to fill out an annuity application for less than three years so just use a CD.  Diversification of longer term maturities can blend annuities with bonds to bring a good balance of safety and yield.

Another way annuities have been used is to ladder income streams.  If you have three or four income annuities one can be turned on now and others activated at staggered intervals to create increasing income over time.  Several people I’ve known who do this consider it a good way to plan for inflation.  It’s not true inflation protection because there was a cost to do it and internal calculations hardly ever show an advantage.  But a healthy retirement means you have the luxury of buying products that make you happy if that’s what you want to do.

Asset ladders again are meant to protect money and hedge interest rate risk.  If rates rise, short-term assets can be repositioned with higher interest rates.  If rates drop, your long term holdings will have more value.  In just about every case I’ve seen this is exactly the goal of those who pursue it.  Have money becoming liquid so you can take advantage of potential improvements in yield.  It can do with fixed (MYGA) or fixed indexed annuities and there are a lot of people who do it.  And it’s just another little thing in the world of annuities where I specialize so get on my calendar if you’d like to address this in terms of your plan.

Have a great weekend!


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Last Updated on July 5, 2024 by Bryan Anderson