When an investor wants to diversify their stock portfolio, the standard "go-to" is a bond or bond fund. Bonds can help to stabilize a portfolio while providing regular income. If you're talking about U.S. Treasury securities in particular, they provide a risk-free return.
At least they did…
Stubbornly high inflation and a flood of new bond supply have pushed bond yields to their highest levels in two decades. The way basic bond math works, rising yields mean falling prices.
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Case in point: The iShares 20+ Year Treasury Bond ETF (TLT), a common proxy for long-term bonds, is down about 11% in the past six months. Rather than reducing risk, bonds have been adding to it.
Bonds are a risky bet today, but the need to diversify hasn't changed. This has created an opening for competing products such as annuities. If structured well, an annuity ladder can reduce your stock market risk and provide a tax-efficient alternative to bonds.
What is an annuity?
An annuity is a contract with an insurance company. You give the insurer money, either as one lump sum or as a series of payments. In return, the insurer promises either to grow that money at a set rate or to pay you income, sometimes for the rest of your life.
Annuities come in several types. Two matter most for laddering.
A single premium immediate annuity (SPIA) is the simplest to understand. A SPIA turns a lump sum into a stream of income that starts right away. Once you buy it, you generally can't get the lump sum back. But you get a regular monthly payout for the rest of your life. Think of it as a personal pension.
A multiyear guaranteed annuity (MYGA) is a little different. You lock in a fixed interest rate for a set term, often three to 10 years. But you don't take immediate income. Your returns are reinvested. When the term ends, you can withdraw the money, roll it into a new contract, or convert it into an income stream such as with a SPIA.
Other types exist, including fixed indexed and variable annuities. But those tend to be more complex and don't serve our immediate goal of replacing bonds.
What is an annuity ladder?
An annuity ladder spreads your money across several annuities instead of putting it all into one. Each annuity is a "rung." The rungs are staggered, either by when they mature or by when you buy them.
Conceptually, an annuity ladder looks and feels a lot like a traditional bond ladder, in which an investor builds a portfolio of bonds staggered by maturity. But the annuity ladder has two major advantages over the bond ladder.
To start, you pay taxes on bond interest as it's earned, regardless of whether you reinvest it or take it as income. Annuity earnings generally grow tax-deferred and only become taxable once you take distributions.
Additionally, annuities generally offer slightly higher yields than bonds (particularly U.S. government bonds) of a similar maturity.
There are two common approaches to building an annuity ladder.
Let's start with the MYGA ladder. This looks and feels like a traditional bond ladder. Say you have $300,000 to invest. Instead of buying one seven-year MYGA, you might buy three $100,000 contracts with three-, five- and seven-year terms.
Every few years, a rung matures. You can then take the cash, reinvest at whatever rates are available, or start income.
The second approach is the income ladder. Here you buy SPIAs in stages over several years. You might buy one at age 65, another at 68, and a third at 71. Each purchase adds a new layer of guaranteed income. The older you are, the higher the payout tends to be because the insurance company will pay out over a shorter remaining life expectancy.
Why build an annuity ladder?
The biggest reason to build an annuity ladder is to avoid betting everything on one moment. Interest rates change, so the rate you lock in today might look great in three years … or it might look terrible. A ladder lets you buy at several different points. If rates rise, maturing rungs can be reinvested at higher levels. If rates fall, the longer rungs keep earning what you locked in earlier.
A ladder also improves access to your money. Many annuities charge steep surrender fees if you withdraw early. With staggered maturities, part of your money becomes available on a regular schedule, which reduces the chance you'll need to break a contract and pay those penalties.
Fixed annuities are not tied to stock prices. When markets fall, the guaranteed rate or income stays the same. That stability helps protect retirees from one of their biggest risks: being forced to sell stocks during a downturn to cover living expenses. A ladder can act as a steady base, allowing the rest of your portfolio to ride out the swings.
What's the downside to annuity ladders?
Annuity ladders — and annuities in general — aren't right for everyone. Fixed payments lose purchasing power to inflation over time unless you pay extra for inflation protection.
Money in an SPIA is usually gone for good, even if your needs change. Withdrawals from non-qualified annuities before age 59½ might trigger a 10% tax penalty on earnings, on top of ordinary income tax. Managing several contracts takes more attention than managing one.
But for investors looking for diversification, downside protection and income that is generally higher than that of bonds of comparable maturities, an annuity ladder can be a smart addition to a financial plan.
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