Rates on bonds, CDs and annuities have all risen in recent months, increasing the relative attractiveness of these financial products.
One strategy of investing in these products is to buy multiple products with different maturity dates and create a ladder.
Laddering spreads out maturities of different fixed income instruments so that you are consistently able to access some funds for liquidity, while simultaneously taking advantage of higher rates on longer-term instruments.
Laddering can be done with any fixed income product of a predetermined maturity, including bonds, CDs or fixed annuities. It’s also possible to create a ladder that includes all three of these products.
The main benefits of laddering are spreading interest rate and reinvestment risk over time, and getting short-term liquidity while taking advantage of longer term rates.
The main drawbacks are that it requires a lot of work to maintain, you may get a lower overall rate of return relative to just investing in long-term maturities, and it will be more difficult to access the funds than if they were simply in a checking, savings or money market fund account.
In this article, I’ll discuss two different approaches to building a ladder and five questions to ask yourself before starting a ladder.
In terms of the two options to building the ladder, do you want to put all the money to work in the ladder now or wait and put it in over time? Let’s call putting all the money in now Approach A and putting in the money over time Approach B.
In Approach A, you first simultaneously purchase 5 CDs — one maturing at the end of Year 1, one maturing at the end of Year 2, one maturing at the end of Year 3, one maturing at the end of Year 4, and one maturing at the end of Year 5.
Then, every time a CD matures you invest the entire amount in a 5 year maturity CD. You keep doing this every year as long as you want to keep the ladder going.
The advantage to Approach A is if you have the money in cash or something paying less interest, this likely will be more lucrative than letting it sit there.
In Approach B, you purchase a 5 Year CD with ⅕ of the total money you want to invest. Then, every year you invest another ⅕. By the beginning of Year 5, you’ve invested the full amount. You keep doing this every year as long as you want to keep the ladder going.
Obviously, you don’t have to stagger maturities by 1 year and you don’t need to limit yourself to a 5 year maximum investment horizon. You can just as easily stagger the maturities at 3 month or 3 year intervals or have an investment horizon of 3 years or 10 years.
Ladder with Bonds, Annuities or CDs?
You can combine a bond ladder with an annuity ladder or an annuity ladder with a CD ladder. CDs and fixed rate annuities can be especially effective when combined together , with CDs the better vehicle for shorter-term maturities and annuities the better vehicle for longer-term maturities (assuming you plan to hold them until retirement or are in retirement already). With an annuity you’ll pay a 10% penalty on earned interest if you withdraw before age 59 ½.
Here’s more info on the differences between each of these three options:
- Bonds: You’ll get the easiest access to the funds with a bond ladder, but the price of the bond changes constantly, so if you withdraw early, you’ll receive an uncertain amount of money back. Bonds, however, are not FDIC or insurance company backed.
- CDs: CDs are simple and FDIC insured, but there are fewer options and generally lower rates for longer term (5 years and longer) maturities relative to annuities.
- Annuities: Annuities build interest on a tax deferred basis, but withdrawals prior to age 59 ½ are penalized by the IRS. Annuities generally have the most competitive rates for longer maturities.
Ask Yourself These 5 Questions Before Starting A Ladder
- What do you plan to use the cash for? Retirement? College? Not sure? Trying to figure out how you’re mostly likely to use the funds can have a large bearing on whether to build a ladder and what kind of ladder to build. If the money is for retirement, consider annuities, otherwise bonds and CDs will be a better fit.
- How much money can you contribute? Some fixed income products, like annuities, are banded. High bands have a higher minimum (i.e. $50,000) but pay higher interest rates. So depending on how much you’re looking to contribute to the ladder, you might be better off waiting to accumulate more funds. And leaving aside banding, minimums to open accounts with many institutions are relatively high, whether you use bonds (usually at least $1,000), annuities (usually at least $5,000) or CDs (it depends, but the best rates usually come with $5,000 or higher minimums).
- Do you have an emergency fund? Laddering of any kind means that you won’t have the same access to funds as you would in a checking or savings account, so make sure you have sufficient funds in an emergency account.
- How are you going to manage the ladder on an ongoing basis? You have to stay patient — if you move money out of the ladder because of market movements, the entire value of creating the ladder in the first place may be wiped out. You also need to stay diligent in making sure when the products mature that you look to get the most competitive rates when you reinvest them. There is not currently an easy, automated tool to manage your laddering strategy.
- Do you want to make sure you have FDIC insurance? If you’re looking for FDIC insurance, buy a CD and make sure no single account is over the FDIC limit ($250,000 in most cases). Bonds are not FDIC insured. Annuities are guaranteed by the claims paying ability of the insurer that issues the product. Annuities, in the case of financial difficulties, are also backed by state guaranty funds in the state where the policy was issued. These funds are smaller and less tested, however, than the FDIC. Different per policy or per owner limits apply depending on the state you’re in. You can learn more on the National Organization of Life & Health Insurance Guaranty Associations website or in this article.
Tools And Where To Learn More
There is not currently a good way to manage an annuity ladder. Fidelity has this Bond Ladder Tool. And here’s a simple CD ladder calculator from Barclays. Bankrate is currently the most well-known aggregator of different CD rates.
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