What Is an Annuity Ladder?

An annuity ladder is an investment strategy that entails the purchase of immediate annuities over a period of years to provide guaranteed income while minimizing interest-rate risk. Annuity ladders allow retirees to maintain a portion of their investments in equities and bonds while periodically using a portion to purchase annuities. Purchasing annuities from a variety of insurance companies minimize the potential for losses if an insurer goes under.

Key Takeaways

  • An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees.
  • An annuity ladder is an investment strategy that entails the purchase of immediate annuities over a period of years to provide guaranteed income while minimizing interest-rate risk.
  • Annuity ladders allow retirees to maintain a portion of their investments in equities and bonds while periodically using a portion to purchase annuities.
  • When interest rates are low, it doesn't make sense to lock in that interest rate for a long time, therefore, purchasing annuities over a period of time will allow for variable interest rates; some higher than the first purchase.

How an Annuity Ladder Works

An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees. Annuities are created and sold by financial institutions that accept and invest funds from individuals and then, upon annuitization, issue a stream of payments at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.

When interest rates are low, it doesn't make sense to lock in that interest rate for a long time. Since no one can predict where interest rates will go, purchasing annuities over a period of years allows an investor to minimize the risk of low returns. An annuity ladder can also generate tax-free income by using a Roth IRA conversion strategy.

For example, for annuities that are guaranteed by the insurer that issues them, yields for one year could be between 2% to 3% annually for two to five years. A multi-year-guaranteed annuities ladder could be constructed by buying a 2-, 3-, and 5-year annuity. However, the payout can vary depending on the insurance company offering the annuity.

Downsides of an Annuity Ladder

Like all annuities, penalties may apply for withdrawals before the expiration of the guarantee, and income tax can be deferred until money is withdrawn. Withdrawals before age 59-1/2 may trigger a 10% penalty in addition to ordinary income tax. Keep in mind that these are not CDs and don't have FDIC protection. 

Access to your cash is limited, and if you die when the contract is in force, you'll lose your principal and the payments will stop unless the annuity includes a joint and survivor payout. This is important to establish as your spouse or heirs can benefit from the money you have already contributed.

Variable annuities can be used on a ladder as well. While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts (usually for some extra cost), which allow them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.

Annuity Ladder Strategies

There are a variety of ways an individual can construct an annuity ladder. One method is to spread out your principal over a few years. For example, if you have $500,000 available to purchase annuities, instead of spending the entire $500,000 in one year, you can spend $100,000 a year for five years. This staggers the maturities as well as possibly harnessing different interest rates in each year; some that might pay out more than another year.

Another strategy would involve purchasing different types of annuities. A portion of your investment capital can go towards a fixed annuity while another portion can go towards indexed or variable annuities. You can also ladder your payout dates; the age at which you start receiving your annuity payments.