Financial Advice for Retirement, Social Security, IRAs and Estate Planning

How to Use the Annuity Ladder for Higher Security

Last update on: Dec 27 2018
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Immediate annuities can enhance retirement financial security. They are not perfect, but some of their disadvantages can be reduced by purchasing annuities using an annuity ladder.

When hearing “annuity,” most people think of variable annuities or deferred annuities. The immediate annuity (IA) is a very different vehicle.

Regular payments begin soon after the IA is purchased. The payments are guaranteed to last for a minimum period. The period might be the owner’s life, the joint life of the owner and a beneficiary (usually the owner’s spouse), or for a period of years. The payments also can be for the longer of two periods, such as the longer of the owner’s life and a period of years.

Advantages of IAs are that they are much simpler than other annuities and as a general rule do not have high costs, investment risk, and complicated riders or options that increase their cost.

In addition, several studies have concluded that including IAs as part of a retirement portfolio increases the probability the portfolio will last through all of retirement. An IA provides secure, guaranteed income that replaces the pensions few retirees receive these days. The IA also is not subject to the market fluctuations of other investments. Having an IA in the portfolio allows you to take more risk with the rest of the portfolio and possibly earn higher returns.

There are two main disadvantages of IAs.

One disadvantage is the insurer might come out ahead. If you live to life expectancy, you and the insurer break even. If you live longer than life expectancy, you come out ahead. If you do not survive to at least life expectancy, the insurer profits. This disadvantage can be reduced by choosing a payment other than the single life annuity. But choosing other payment options, such as an annuity payable over the joint life of you and your spouse, reduces the amount of the annual payments.

Another disadvantage is the lost opportunity cost. Annuities have fixed payouts. Payouts generally are based on intermediate-term bond yields, and the yields prevailing when you purchased the annuity are locked in. If yields rise over the years, you do not benefit by receiving a higher payout. You also lose the opportunity to invest in higher-returning assets. Many people believe they can earn higher returns and have more retirement cash by investing the money themselves instead of accepting the annuity yield.

Annuities have been unattractive to many people in recent years because of the low yields. People do not want to lock in today’s yields, because they believe yields will rise in coming years. They also fear that inflation will rise, eating away the purchasing power of the income.

Many of these drawbacks can be overcome or reduced with the annuity ladder. The ladder involves purchasing annuities over time. You do not have to fund your retirement portfolio’s full annuity allocation at one time.

Suppose you decided 30% of your retirement portfolio should be in IAs. You do not have to put 30% of your portfolio in an IA the day you retire. Instead, you can buy an IA with 5% of the portfolio each year for six years. Other incremental purchasing schedules are possible, of course. You also can watch interest rates and payouts, and time when they bump up.

Laddered purchasing has several advantages. The payout from a new annuity increases as you get older, if interest rates are the same. You receive a higher payout from an IA purchased at age 70 than from one purchased at age 65. Purchasing IAs over time increases retirement income compared to a onetime purchase. You can see this by visiting an annuity shopping web site, such as www.Immediate-Annuities.com, and viewing payouts available at different ages from the same annuity.

If you expect interest rates to rise over time, an annuity ladder allows you to capture the rate increases, again increasing retirement income.

Laddering also overcomes some of the resistance caused by the potential for the insurance company to come out ahead. By purchasing IAs over time, the amount of money lost to the insurer by a premature demise is reduced.

Laddering also allows you to take more investment risk in the early years of retirement and earn higher returns than are not available from an IA. After earning those returns, they can be banked in an IA to generate higher income. An annuity ladder also increases flexibility. You can alter the investment portfolio allocation after the first few years of retirement if your plans or needs change. You won’t be locked into a full annuity allocation yet.

Most people should not put their entire portfolios in IAs, because the payouts will not keep pace with inflation. But IAs are good risk management and reduction tools. Having them in the portfolio reduces the risk of outliving your retirement cash. The disadvantages of IAs can be reduced by laddering purchases and investing the rest of your retirement money in a diversified portfolio.

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