Laddering fixed rate annuities offer higher rates than bank CDs, plus flexibility
With today’s low interest rates, you need to plan to create enough retirement income without taking on more risk than necessary. Long gone are the days when you could earn good income from a collection of treasury bills.
You can earn income from dividend-paying stocks, bank accounts, bonds and bond funds, and several types of annuities.
Each has advantages and disadvantages. Stocks that pay high dividends can generate good income, but stocks can be volatile. You can lose money, and if you’re retired, you might not be able to wait for the market to recover.
Secured deposits, such as bank CDs and fixed rate annuities, may pay less, but interest income and principal are insured (although in different ways).
Most retirees use a portfolio of products and strategies. By mixing and matching the right way, you can generate income, stave off inflation, and provide cash you might need for everything from medical bills to a great vacation or giving money to children or grandparents. children.
The right mix is very individual. Retirees whose pensions cover most of their monthly expenses may be able to take more risks with their money. Others who don’t have that cushion and can’t afford to lose anything turn to guaranteed strategies.
How Fixed Rate Annuities Work
One type of guaranteed product is the fixed annuity. A very popular option today is the Multi-Year Guaranteed Annuity, or MYGA. Backed by a life insurance company, it acts much like a bank certificate of deposit (CD). You deposit a lump sum, called a single premium. You then receive a fixed interest rate for a fixed period.
Unlike bank deposits, fixed annuities are not FDIC insured. However, there is a form of insurance provided by state guarantee associations in the event of the insurer’s insolvency. Coverage varies by state.
Annuity interest is tax-deferred until withdrawn. If you receive income from an annuity before age 59.5, you will normally be hit with a 10% IRS penalty in addition to regular state and federal income tax. .
The features of fixed annuities vary. If you rely on an annuity for your income, make sure the product you are considering allows for monthly or annual interest withdrawals, depending on your needs and preferences.
Although these products often allow withdrawals of up to 10% per year, they impose penalties for excessive withdrawals before the end of the guarantee period.
Laddered Fixed Rate Annuities
A big advantage of fixed rate annuities is that they generally pay higher rates than other fixed rate instruments, such as CDs and investment grade bonds. As with CDs and bonds, you’ll get a higher interest rate if you’re willing to tie up your money for a longer period.
But is it worth it? On the one hand, “going long” will produce more current income. Some people are comfortable with that.
On the other hand, being short gives you flexibility. If interest rates improve in the meantime, you may be able to get a better rate once the guarantee period is over.
So what makes the most sense? For people with enough money to split between different annuities, I suggest staggering the guarantee terms. Since no one knows for sure which direction interest rates will head in the future, laddering makes the most sense. It offers you both a good current income and future flexibility.
What is the best scaling strategy? It depends on what the interest rate curve looks like when you create the annuity ladder. If the curve is flat, it would make sense to go mostly short. If it’s steep, you might want to commit more to longer terms.
Today, I recommend staggering pensions from three to five years. Here’s why:
First, there is a significant rise in interest rates when comparing two- and three-year terms. For example, currently (January 2022), you can earn 2.00% on a two-year annuity with an insurer rated A- for financial strength by AM Best.
With a three-year MYGA, you can earn 2.50% from that same A-rated company. That’s 25% more interest. Unless you need all that cash in two years, it’s probably worth going for another year.
In three years, you will be able to transfer the proceeds tax-free, via a 1035 exchange, to any other annuity that you then consider most attractive. Maybe the prices will be higher.
While a four-year annuity is also an option, five years is a good compromise. Even if you’re willing to tie up your money longer, you won’t get much more interest on a seven- or ten-year contract right now.
For example, from February 2022, if you are willing to go for a B++ rated company, you can get 3.15% on a five-year contract with limited liquidity. You would only get a little more, 3.20%, with the seven-year annuity from the same insurer.
If you prefer a company rated A or better, you can earn 3.00% on a five-year annuity and 3.15% over seven years.
Fixed annuities for IRAs
In addition to being useful for unqualified savings, fixed annuities also work well for IRAs. And the same scale approach works.
Between age 59.5 and age 72, you can take taxable interest out of a traditional IRA annuity, or you can leave compound interest and defer taxes. At age 72, you must begin taking the Required Minimum Distributions (RMD).
If you are already taking RMDs or will soon be taking them, look for an annuity that allows you to withdraw your RMDs without penalty. Many transmitters have this feature.
If you have your entire IRA in stocks or even long-term bonds, you may find yourself forced to make an untimely withdrawal when the stock or bond market is down. Whether you choose a three or five year annuity or another term annuity, you will be assured of guaranteed withdrawals to pay your RMD.
Annuity expert Ken Nuss started the AnnuityAdvantage website in 1999 to help people looking for their best protected annuity options. A free quote comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.
CEO / Founder, AnnuityAdvantage
Retirement income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed rate, indexed and immediate income annuities. Interest rates from dozens of insurers are constantly updated on its website. He started the AnnuityAdvantage website in 1999 to help people looking for their best protected annuity options. More information is available from the Medford, Oregon-based company at https://www.annuityadvantage.com or (800) 239-0356.