Annuity laddering is the process of buying annuities in multiple installments over a time period. A laddered and deferred annuity are different. They require a single purchase but have payments deferred for a specific period. The deferred and laddered annuities that are being discussed here have fixed payments. Variable annuities are completely different.
The logic of laddering states that annuity payment amounts increase with age, and they also increase with interest rates. The widespread belief that interest rates would rise this year has led to a flurry in interest in laddering.
However, laddering logic is not conclusive.
- Rarely is laddering an option to the most feasible alternative, which is to transfer part of the assets into a deferred nuity.
- Laddering advocates ignore the question about what happens to earnings on assets that are kept for future annuity purchases. The earnings could either be accumulated to increase future annuity amounts. They could also be used for spendable funds or a combination of both.
- It is also important to consider the consequences of interest rates falling as predicted.
These issues are addressed in this article. It uses models created by Allan Redstone, my colleague. These models show how laddering with an annuity purchased right now, another purchased after 3 years and a third purchased after 6 years can impact the financial assets of a 65 year-old man with $600,000. The ladder is compared against a single, deferred annuity with a 10-year deferment period.
Chart 1 shows the ladder and the deferred market annuity. The rate of return on the financial assets used for purchasing both annuities is assumed at 6.1%. This is the historical median on a 25% stock/5% fixed income portfolio over 925 previous 10-year periods. Based on an annuity pricing formula developed by Allan Redstone and checked against current annuity prices, the current rate of return for the annuity has been assumed to be 1.5% percent. All annuities come with a COLA of 2% per annum, but no cash refund rider.
The ladder has a significantly lower spendable fund than the single deferred option for the first 6 years or until the last rung. This assumes that the remaining assets are accumulated and used to purchase larger annuities. If the ladder assets are instead withdrawn to spendable funds, the shortfall in the first three years is eliminated, but the single deferred payment option generates more during the rest of the retirees’ life.
In a stable rate environment, the 3-year/6 year ladder is inferior to a single annuity paying deferred 10 year payments. This leaves us with the question of how rising interest rate shifts the balance. To compare the ladder to the reference, I ran several rate increase scenarios. I chose a rate rise of 3% spread over 18 months.
Both the ladder as well as the reference case will be affected by rising interest rates. Assuming the reference case, the excess asset earnings that are needed to finance spendable fund during the first 10 year are used to buy an annuity immediately. This will result in a jump of spendable funds at deferment. The ladder, however, is crucial in that any asset earnings made during the first 10 years of the ladder are retained for future annuity purchase or drawn out as spending funds.
The future payments if the asset earnings are retained would be substantially higher that the reference after the last purchase of annuity, but significantly lower than before. If the asset earnings are distributed, the payments for the first 10 years will be greater than the reference but slightly lower afterwards. Chart 2 illustrates these points.
Annuity laddering with stable interest rates is a loser relative a immediate annuity with a payment deferred for 10 years. Rates rise after annuities have been purchased. However, this is not a better option than laddering overall.
This article is my first step towards integrating ladders in retirement plans. Keep watching.