These days, the notion of running out of retirement income before your time runs out is a real threat. According to financial planners, a 4% rate of withdrawal on retirement assets is most likely to ensure that your income will outlast you. It sounds simple, but this also means that in order to collect $40,000 per year, you'll need to have $1 million in the bank. Laddering annuities is an approach that alleviates the worries of relying on Social Security and pension plans and then running out of money during retirement because this investment strategy can create income that's guaranteed for life.
According to the Urban Institute, an economic and social research organization, retirement accounts lost 32% of their value between September 2007 and December 2008 – the heart of the economic crisis in the U.S. While the economy has recovered, not everyone who lost money during that period has been made whole. Economic downturns can impede retirement goals. But there are ways to hedge against it. Research has found that laddering annuities can be an effective strategy in many market conditions.
What Is an Annuity?
An annuity is a contract between you and an insurance company. An individual provides money to the business and the cash accumulates through capital gains. Taxes are deferred. The tax is paid when you start making withdrawals, but that's after the age of 59½. In certain situations, an IRS tax penalty is imposed to discourage people from taking money out of an annuity product, such as a deferred annuity, too soon.
In addition, the insurance company with which you set up your annuity is likely to apply surrender charges to recoup costs of the annuity they sold. This is particularly likely if the amount taken exceeds a stipulated free withdrawal amount of 10% of the annuity that the insurer may have allowed. There's also inflation to worry about, but luckily there are inflation-protected annuities (IPA), too. (See: Inflation-Protected Annuities: Part of a Sold Financial Plan.)
Currently, it doesn’t make sense to look for an IPA, says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.” “Investors need to remember that they must pay a premium in order to hedge inflation risk. On top of that, the insurance company needs to make money on the contract, so investors can expect a lower payout than what can be provided by interest rates as determined by the market.”
When it is time for you to receive payouts, you can either take the money out all at once or have the insurance company provide systematic payouts, such as each month, quarter or year. How the annuity payout is calculated is determined by interest rates and your age. Insurance companies tend to pay more with age because you are nearing your life expectancy. However, there are situations that can arise when an owner or annuitant dies. (For more, see: Deciphering Deferred Annuity Designations.)
How Laddering Is Done
An annuity ladder involves the purchase of annuities in phases and can involve multiple annuity products. Someone at age 65, for example, may want cash to help with bills. That individual may divide some of the money set aside for an investment in annuities to purchase an immediate fixed annuity product now. Meanwhile, his or her remaining assets in stocks and bonds continue to grow and build wealth. Five years later, the retiree can help supplement the income from the fixed immediate annuity with the purchase of another annuity from a different company using a portion of his or her savings. A couple of years after that, the retiree may purchase another annuity from a different company and so continue to buy annuities over time.
This strategy can create not only an income stream, but can also help maintain and build a substantial amount of money in other securities. Purchasing annuity products from different companies helps to reduce damage to an investment portfolio if a company happens to encounter financial difficulties or closes shop.
Another strategy is purchasing all the annuity products at once. In this case, the individual may buy a fixed immediate annuity that will start payments right away and also acquire deferred annuities that accumulate interest. As the income stream ends for the fixed immediate annuity, one of the deferred annuities would begin making payouts. The other annuities would begin payouts at future dates. Strategize an effective ladder with the help of a financial advisor. Fixed deferred annuities provide a way for investors to build their own pensions. (See: Personal Pensions: Repackaging the Annuity.)
The Benefits of Annuity Laddering
Laddering “produces more guaranteed lifetime income, develops more liquidity to address other retirement needs and builds more long-term wealth than other commonly adopted retirement income strategies,” notes a report by Mass Mutual. Four methods of managing a retirement income account over 181 time periods between 1965 and 2006 were tested, according to the report. The report discovered that all three strategies involving an income annuity outperformed the strategy of having stock and bonds only, regardless of market conditions.
“In fact, the investment-only approach – even during strong equity and bond markets – ran out of money in 25% of cases. In contrast, the strategy of laddering into a life annuity matched the income goal in 100% of the cases tested,” the report said. Another added benefit is that certain annuities will allow your beneficiary to collect the payments at a minimum amount if you die during the payout period, so an annuity also might be a good choice if you have a family. (See: Annuities: How to Find the Right One for You.)
Keep This in Mind
Laddering annuities has some perks, but it is important to consider other factors, such as how monthly payments on an annuity of the same size can vary with different companies. Also, don’t put all your eggs in one basket: It’s important to make sure that your investment portfolio is diverse. Consistently check and reevaluate your performance, and rebalance your portfolio, if necessary.
The Bottom Line
Laddering annuities has been a little-known investment strategy, but it has been shown to be a very effective tool that withstands fluctuating market conditions. The technique can provide a comfortable income stream throughout your retirement. However, keep in mind that “when it comes to guaranteed income in retirement, safety is of the utmost concern. Investors should be looking for insurance companies with the highest credit ratings, indicating high degrees of liquidity and solvency,” says Hebner.