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September 21, 2010 at 08:00 PM
It’s certainly not news that we are living in a low-interest-rate environment. In September 2010, Bankrate.com showed national average interest rates of 2.56 percent and 1.27 percent for five-year and one-year certificates of deposit. Interest rates stood at 1.47 percent and 0.26 percent for the five-year and one-year constant maturity treasury, respectively.
Even worse are the interest rates on many of the major money market mutual funds. Fidelity’s Cash Reserves fund has nearly $125 billion in assets, earning only 0.08 percent. Vanguard’s Prime Money Market fund has more than $100 billion in assets earning just 0.04 percent.
Can our clients, who rely upon attractive interest rates to generate a portion of their income, expect higher rates anytime soon? Perhaps not, if you listen to Ben Bernanke; the Federal Reserve chairman recently testified before Congress that he anticipates historically low interest rates to continue well into the future.
This leaves our clients in a conundrum. On the one hand, they may be afraid to put their money into long-term products because they fear they may be locking in today’s low rates for years to come. On the other hand, if they leave all their money in cash and cash equivalents, their savings will generate nearly no interest at all.
The solution may be a time-tested strategy that we tend to forget when interest rates are higher: annuity laddering, which balances the need to generate income while not locking in too much money for the long term.
Annuity laddering
Annuity laddering is similar to a strategy that financial professionals have employed extensively for many years – a strategy which, in the past, has used bank certificates of deposit or other stable-value financial products with defined maturities. Annuity laddering simply divides your client’s money fairly evenly over annuities with a variety of durations and from a variety of insurance carriers.
Let’s assume that your client has $500,000 to put into annuities. In one approach to laddering, we simply split the premium equally across 10 annuities. As the annuity durations increase, we find higher interest rates available on the annuity and an extra year of interest crediting over the prior duration. Under this approach, the yearly cash flow to your client increases each year.
| Duration |
Premium |
Interest rate* |
Payout at end |
| 1 |
$50,000 |
1.50% |
$50,750 |
| 2 |
$50,000 |
1.65% |
$51,664 |
| 3 |
$50,000 |
1.75% |
$52,671 |
| 4 |
$50,000 |
2.25% |
$54,654 |
| 5 |
$50,000 |
3.00% |
$57,964 |
| 6 |
$50,000 |
3.10% |
$60,051 |
| 7 |
$50,000 |
3.20% |
$62,334 |
| 8 |
$50,000 |
3.20% |
$64,329 |
| 9 |
$50,000 |
3.20% |
$66,388 |
| 10 |
$50,000 |
3.40% |
$69,851 |
* Interest rates are hypothetical, but are reasonably close to the annuity rates available in the marketplace in September 2010.
Alternatively, if your client wants a level annual cash flow, we can allocate more premium to the shorter-duration annuities and less premium to the longer-duration annuities.
| Duration |
Premium |
Interest rate* |
Payout at end |
| 1 |
$57,543 |
1.50% |
$58,406 |
| 2 |
$56,526 |
1.65% |
$58,406 |
| 3 |
$55,444 |
1.75% |
$58,406 |
| 4 |
$53,433 |
2.25% |
$58,406 |
| 5 |
$50,382 |
3.00% |
$58,406 |
| 6 |
$48,630 |
3.10% |
$58,406 |
| 7 |
$46,849 |
3.20% |
$58,406 |
| 8 |
$45,396 |
3.20% |
$58,406 |
| 9 |
$43,989 |
3.20% |
$58,406 |
| 10 |
$41,808 |
3.40% |
$58,406 |
*Interest rates are hypothetical, but are reasonably close to the annuity rates available in the marketplace in September 2010.
We can blend these two approaches to create an annual payout stream that increases at some desired inflation rate; you can see that annuity laddering gives your client quite a bit of planning flexibility.
