Often, people think of their savings as one lump sum to be divided up into a few large chunks, like a pie, with the individual slices deposited into multiple types of products. Through this model, you might put 20 percent of your “pie” into stocks, 50 percent into fixed products, and 30 percent into mutual funds.

On its own, this process diversifies a saver’s holdings—but is it enough? After all, if 50 percent of your savings is locked into a long-term CD, annuity or bond, you may have liquidity issues while also being trapped in a low interest rate even though, outside your investment, rates are rising. Instead of taking this limiting approach, it could be better to consider laddering.

What is Laddering?
Laddering is a method of breaking up the piece of investment pie devoted to fixed products and depositing that segment of cash into a variety of accounts or contracts with different maturity dates. This staggers your access to the deposited principal, which can reduce your likelihood of triggering early withdrawal charges and penalties.

To fully grasp the concept, visualize the future maturity dates of your fixed investments. Think of each one as a rung in a ladder. Using a traditional investment strategy, you might have one or two maturity dates fifteen or twenty years from now, and nothing toward the bottom of your imaginary ladder. If you need to access that cash sooner, or want to free it up to make a different investment decision, you face penalties and fees. Using the ladder strategy, however, you’ll have many different maturity dates every five years from now into the future. Those instruments maturing sooner have the lowest interest rate, while those maturing far later earn more interest.

The Benefits of Laddering
As mentioned above, one major benefit to laddering the purchase of fixed products is that it allows for regular access to maturing segments of deposited principal, which reduces the likelihood of surrender and withdrawal fees. There are other benefits, too, including:

  • Ladders help to reduce interest rate risk. When all of your savings is confined to one fixed investment with a set interest rate, you may miss out on opportunities to reinvest that principal as rates rise. When you ladder your holdings, however, you ensure that portions of your savings mature on a short- and mid-term basis, which gives you more opportunity to take advantage of rising rates.
  • Laddering improves overall portfolio diversification, which reduces risk.
  • Post-retirement income planning is easier when you have varying accounts and contracts maturing at set dates over many years. This can help you better manage cost of living increases and growing medical bills.

Other Considerations
Laddering is generally a good idea inside an IRA where taxes on interest growth are either deferred or, in the case of a Roth, tax-free. Outside an IRA, this is not always the most effective strategy unless annuities are the tool you’re laddering.

Also, it’s important to remember that laddering is generally done with lower-interest fixed products, which could mean that the interest earned is not enough to make a significant difference to savings.

Types of Ladders

  • CD ladders: Buying multiple CDs with varying maturity dates gives you a range of interest rates (higher interest on long-term CDs and lower interest on short-term CDs). There are downsides to this arrangement, however. First, while you can count on the interest for income over the term of the CDs, you might not be able to secure the same interest rate once the CD matures. Also, because CDs have such a low interest rates historically, it can be difficult to create a livable income with minimal principal.
  • Bond ladders: Like CD ladders, bond ladders are created when you buy multiple bonds with varying maturity dates. Bonds have many of the same benefits and drawbacks as CDs, but you can secure higher interest rates with bonds. The problem? The higher the interest rate you get, the more risky the bond is, which means you may not get back your principal upon maturity.
  • Annuity ladders: Laddered annuities offer tax-deferred growth even when purchased outside an IRA. Best of all, annuities, unlike CDs and bonds, allow for tax-free exchanges after maturity, which means you have the option of rolling the principal and interest over to another annuity each time one matures. Since annuities have an income-for-life feature, savers can also ladder the start date for the distributions, pushing them back and ultimately increasing their overall payout.

Laddering annuities, CDs and bonds may give you better control over your savings, less interest rate risk, and ensure continuing liquidity throughout your retirement. It’s definitely an option worth exploring for many seniors and pre-retirees, no matter what their anticipated income needs are. So be sure to talk to your financial advisor.

The Retirement Pros
September 2014