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Laddering Annuity Purchases

A reader writes in, asking:

“I saw on the Bogleheads somebody mentioned the idea of laddering annuity purchases. Given the irrevocable nature of buying an annuity, buying annuities in chunks rather than all at once seems appealing. What would be the pros and cons of doing so?”

What Are You Doing With the Money in the Meantime?

The primary determinant in how this strategy plays out is how your money performs in the meantime (that is, while you wait before deploying it into an annuity at a later date). For example, is the money invested in I Bonds where it will precisely keep up with inflation? Or is the money invested in a typical retirement portfolio, of which unpredictable investments like stocks make up a significant portion?

Naturally, if your money earns very good returns while you wait to annuitize it, you’ll be better off waiting. And if your money earns very poor returns (e.g., due to a stock bear market), you probably would have been better off annuitizing right away rather than doing it over time.

For the time being, let’s assume that you keep the money in something that keeps up with, but does not outpace, inflation.

When Laddering Annuity Purchases is Helpful

When talking about inflation-adjusted lifetime annuities, the advantages to laddering the annuity purchases — rather than annuitizing a larger lump sum immediately — are twofold:

  1. You benefit if interest rates increase over the period during which you’re building your ladder, and
  2. Your heirs get more money if you die before the annuity ladder is completed.

For example, if you have $300,000 that you plan to annuitize over a 5-year period ($60,000 per year) starting at age 70, you will benefit from any interest rate increases that occur between ages 70 and 74, because you’ll be buying annuities at those higher rates.

Or, if you die at age 72, only $180,000 of the $300,000 amount will have been annuitized by that point, thereby leaving a significantly larger sum of money to your heirs.

What’s the Downside?

If you do not die prior to the point at which your annuity ladder is completed, you need rates to increase in order to win your bet.

If rates go down, laddering annuity purchases clearly works out poorly (relative to annuitizing all at once at the beginning of the period) because the payout on each of your successive annuity purchases will be based on a lower interest rate than the original annuity purchase.

In fact, even if rates stay the same you lose out by holding off on annuitizing. That’s because, the sooner you purchase the annuity, the more mortality credits you get to collect. (Mortality credits are the portion of the annuity payout that comes from the unused portion of annuity premiums from annuitants who died early, thereby relieving the insurance company of the obligation to make annuity payments to them.)

Granted, at young ages, these mortality credits are small, because few people are dying. (For example, out of a thousand people who have survived to age 60, the vast majority –more than 99% according to the Social Security Administration — will survive to age 61 as well.) But they’re still greater than zero.

In Short…

The decision to ladder the purchases of inflation-adjusted lifetime annuities will tend to be preferable to purchasing them all at once in scenarios in which:

  • interest rates go up while you wait,
  • you die prior to the ladder being completed, or
  • your money outpaces inflation while you wait to annuitize it.

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  1. This is a timely article since I just finished reading “Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life”. The book is written from a Canadian perspective, but most of the content is still relevant for U.S. readers.

    Regarding your point about interest rates, I would assume that interest rates are more likely to go up than down based on the current position of 10 year treasury rates:

    Do you agree?

  2. rjack, I enjoyed that book as well.

    Regarding interest rates, I agree that they will eventually come back up. But I am not sure I agree that up is the direction they’re headed next. I am not sure I see any reason why nominal Treasury rates couldn’t a) go all the way to zero or b) hang out where they are for an extended period of time.

    In other words, I have no interest rate predictions.

  3. Hi Mike,
    This annuity discussion interests me. I am just starting to educate myself on this product. The laddering of annuities with regard to where you write:
    ■interest rates go up while you wait,
    ■you die prior to the ladder being completed, or
    ■your money outpaces inflation while you wait to annuitize it.

    Just seems like a total crap shoot to me on all accounts since none of those criteria are predictable or controllable. Just flip a coin is my best guess. 😉
    Happy trails, Mike

  4. Mike, I agree.

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