A Taller Ladder

David Cooper

I RETIRED ALMOST TWO years ago, at age 56. My wife, who is nine years younger, decided to semi-retire so we could relocate from Rhode Island to Florida. We were able to afford early retirement in part because we’d lived below our means for many years, diligently saving while also paying off our mortgage and other debts.

Relocating to a state with a lower cost of living and lower taxes also helped. In addition, I’m fortunate to get a modest pension and relatively affordable retiree health insurance coverage for both of us.

So, yes, we’re lucky—and grateful. The trouble is the date I retired: Dec. 31, 2021. It was days before the onset of a bear market that tanked our stock index funds, and only months before steep interest rate hikes sent our bond index fund tumbling, too. All in the face of rising inflation. Talk about bad timing.

Despite it all, I’m calm and confident about our retirement. Why? First, we’ve been living easily within our projected monthly budget. We draw down about 3.5% of our total nest egg each year, adjusted annually for inflation.

Second, we have a relatively aggressive mix of 70% stocks and 30% in bonds and cash. This high stock exposure gives me confidence that we’ll stay ahead of inflation over time.

I’m not worried that this mix is too aggressive for a retiree like me because it contains enough cash reserves to live on for four or five years. If necessary, selling bonds could then see us through an additional three or four years.

Unfortunately, we pay a price for this peace of mind. Our cash is likely to lose ground to inflation in the coming decades. We have an online savings account that pays a higher interest rate, but in recent years the returns haven’t come close to keeping up with inflation.

One popular strategy to squeeze out even higher yields from cash is to ladder CDs, or certificates of deposit. This might mean depositing a year of expenses in an online savings account, while also buying CDs in the same amount for terms of two, three, four and five years. By replacing each of these at maturity with a new five-year CD, you soon end up with a maturing five-year CD every year.

Laddering CDs strikes me as a safe strategy to lessen the bite of inflation. But they aren’t the only option for a laddering strategy. I’ve decided to stash most of our cash reserves in a multi-year guaranteed annuity ladder.

Multi-year guaranteed annuities are the life insurance industry’s answer to CDs. As the name implies, they’re fixed-term annuity contracts that pay a guaranteed annual rate of return on a lump-sum premium for a specified term. Despite mimicking CDs, however, they have important differences.

Typically, multi-year annuities pay about one percentage point above CD rates. As of this writing, the highest annual yield that I could find for a five-year CD was 4.9%. I can find a multi-year annuity paying 6% with a $20,000 premium.

Almost as important as the higher yields are annuities’ tax-deferred compounding. While interest earned on CDs is taxable annually, annuity yields are taxable only when you cash out.

Better still, when these annuities mature, they can be rolled over tax-free in a 1035 exchange. The exchange doesn’t need to be with the same company, so you can roll them over to the best rate available. In theory, these yields could compound indefinitely until you opt to cash out.

There are drawbacks to annuities, too. One is that they come with less solid government protection against default. Most CDs, as the product of a bank or credit union, are protected by federal deposit insurance up to $250,000. In the case of most annuities, the protection is provided by the state-sponsored insurance guaranty association.

Although the amount of protection promised in most states is the same as the federal protection for bank products, state-level protection doesn’t rise to the same level of surety as federal guarantees. This additional risk is real, but to me it seems manageable. By design, each of the five annuities in my ladder is from a different company, thus spreading the risk. None of the companies has ratings below B+, and most have A or A- ratings for financial strength.

A second drawback is that annuities require more time and effort to purchase than CDs. It’s essential to work with a good insurance agent with annuity expertise. Even the best agent can’t eliminate what’s inherently a painful process, however.

Each annuity requires reviewing a complex annuity contract, and then completing a lengthy and intrusive application process. Each contract can vary significantly on key features such as early withdrawal allowances. Although most companies have user-friendly online applications, others still do everything by paper and mail. All in all, expect it to take weeks or longer to get final approval.  

Both CDs and annuities have early withdrawal penalties, but there are differences here, too. Unlike CDs, which by law must impose early withdrawal penalties, some annuity contracts allow for interest earned, or a percentage of the initial premium, to be withdrawn yearly without penalty. Others don’t, however, and can impose steep penalties, especially in the early years.

What about the commission paid to the agent I use, as well as an annuity’s other expenses? I don’t need to worry about those costs because—as with a CD—the yields that are quoted already reflect all expenses. 

Like all annuities, mine are subject to a 10% federal tax penalty on any interest earned if I cash out before age 59½. If I died prematurely, my spouse would incur this penalty unless she kept rolling over the annuities until she reached 59½. These annuities may not be a good option for anyone who’s a lot younger than 59½.

So, is annuity laddering a good alternative to CD laddering? For me, the answer is yes. That extra one percentage point in interest may not sound like much. But thanks to tax-deferred compounding, it could make a big difference over many years. That said, I imagine there will come a time when my wish for financial simplicity will outweigh my desire to squeeze out a little extra interest.

David Cooper worked for many years as a career policy official in the Office of the Secretary of Defense. He subsequently became a professor of national security affairs. David had no particular interest in personal finance until it dawned on him in his late 40s that he had no idea how or when he could retire. He’s grateful for the many insights he’s gleaned as an avid HumbleDollar reader.

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