Laddering Fixed-Rate Annuities Offers Combination of Good Rates and Flexibility for Future

By Ken Nuss

With today’s low interest rates, it takes planning to create sufficient retirement income without taking more risk than you need to. The days when you could get good income from a collection of Treasury bonds are long gone.

You can get income from dividend-paying stocks, bank accounts, bonds and bond funds, and several different types of annuities.

Each has pros and cons. Stocks that pay high dividends can yield a good amount of income but are volatile. You can lose money, and if you’re retired, you may not be able to wait until the market recovers. 

Guaranteed deposits like bank CDs and fixed-rate annuities may pay less, but both the interest income and principal are assured.

Most retirees use a portfolio of products and strategies. By mixing and matching appropriately, you can produce income, counteract inflation and provide some liquidity that you might need for anything from medical expenses to a great vacation or giving money to kids or grandchildren. 

The right mix is highly individual. Retirees with pensions that cover the bulk of their monthly expenses may be able to take more risk with their money.  Others who don’t have that cushion and can’t afford to lose anything look 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. Underwritten 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 set interest rate for a set period. 

Unlike bank deposits, fixed annuities are not FDIC-insured. However, there is a form of insurance provided by state guaranty associations in case the insurer becomes insolvent. Coverage varies by state. 

Annuity interest is tax-deferred until withdrawn. If you receive income from an annuity before age 59½, you’ll normally be hit with a 10% IRS penalty in addition to ordinary state and federal income tax.  

Fixed annuity features vary.  If you’ll be relying on an annuity for income, make sure that the product you’re considering allows either monthly or annual interest withdrawals, depending on your needs and preferences.

While these products often allow withdrawals of up to 10% annually, they do levy penalties for taking excessive withdrawals before the guarantee period is over. 

Laddering Fixed-Rate Annuities

A big advantage of fixed-rate annuities is that they usually 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, going short gives you flexibility. If interest rates improve in the interim, you’ll 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 spread among different annuities, I suggest laddering guarantee terms. Because no one knows for sure which direction interest rates are headed in the future, laddering makes the most sense. It gives you both good current income and future flexibility.

What’s the best laddering strategy? It depends on what the interest rate curve looks like at the time you’re creating the annuity ladder.  If the curve is flattish, going mostly short would make sense.  If it’s steep, you might want to commit more to longer terms.

Today, I recommend laddering annuities from three to five years.

Here’s why. 

First, there is a significant interest-rate bump when comparing two- and three-year terms. For example, currently (January 2022), you can earn 2.00% on a two-year annuity from an insurer rated A- for financial strength by A.M. Best.   

With a three-year MYGA, you can earn 2.50% from that same A- rated company. That’s 25% more interest.  Unless you’ll need all that money two years from now, it’s probably worth going for an additional year. 

Three years from now, you’ll be able to roll the proceeds tax-free, via a 1035 exchange, into any other annuity that looks most attractive then.  Maybe rates will be higher.

While a four-year annuity is an option too, five years is a sweet spot.  Even if you’re willing to tie up your money longer, you won’t get much more interest with a seven- or ten-year contract right now.

For instance, if you’re willing to go with a B++ rated company, you can get 3.15% on a five-year contract with limited liquidity.  You’d get only a bit more, 3.20%, with the same insurer’s seven-year annuity.

If you prefer an A- rated company, you can earn 2.85% on a five-year annuity and 3.00% for seven years with that company.

Fixed Annuities for IRAs

Besides being useful for nonqualified savings, fixed annuities also work well for IRAs.  And the same laddering approach works.

Between the ages of 59 ½ and 72, you may take taxable interest withdrawals from a traditional IRA annuity or you can let the interest compound and defer taxes.  At 72, you must begin taking required minimum distributions (RMDs). 

If you’re already taking RMDs or soon will be, look for an annuity that lets you take out your RMDs without penalty. Many issuers have that feature. 

If you have all of your IRA in equities or even long-term bonds, you may be forced to make an untimely withdrawal when the stock or bond market is down. Whether you choose a three- or five-year or other term annuity, you’ll be assured that you’ll have the guaranteed withdrawals to pay your RMD.

Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. He writes on regularly on retirement income and annuities.  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.