Are we about to enter a rising interest rate environment after years of flat-line returns? Assuming we are headed to higher rates, how can we help conservative clients fearful of locking up principal long term if credited rates continue to rise?
Federal Reserve Chair Janet Yellen’s recent announcement to expect three quarter-point interest rate hikes in 2017 could be good news for savers considering a fixed annuity purchase. We will have to wait and see how the economy responds to the new administration and if the Fed will really follow through on all three forecasted increases, but most financial pundits see rates rising in 2017. The 10-Year Treasury rate has moved from 1.88 percent on November 8, 2016, to 2.45 percent on January 3, 2017.
According to Bankrate.com, the average five-year CD rate is at 1.79 percent as of early January, 2017. Five–year MYGAs (Multi-Year Guaranteed Annuities) are currently available at credited rates ranging from 2.15 percent to 3.00 percent.
Laddering concepts have been around for quite some time, frequently used with certificates of deposit or bonds. For our purposes here, a ladder is defined as a portfolio of bonds, CDs, or annuities with different maturity dates. Rather than purchase one large financial instrument with a single maturity date, the same principal is divided among several smaller purchases to minimize interest–rate risk and increase liquidity.
Fixed annuities enjoy a distinct rate advantage over certificates of deposit today. While we can build annuity ladders in a number of ways, incorporating SPIAs, MYGAs and even FIAs, I will use a simple multi-year guaranteed annuity (MYGA) ladder to illustrate the concept.
How Ladders Work
Yield ladders are a safe money yield enhancement technique based on the premise that yields tend to be higher as length of maturity increases. Laddering is designed to maximize yields without trying to guess where interest rates might go.
Yield ladders are built by placing equal parts of the principal into the different maturities, or maturity buckets, so that you have a part of your money available to earn new rates or meet liquidity needs. In this example our goal following the third year is to have approximately one-third of the total asset value available to re-invest each year.
Let’s say we are working with a total of $150,000 of non-qualified premium. Although a yield ladder may be built using any number of contract guarantee periods, we will start with a three-year period and split the money into three equal parts using a three year, four year, and five year MYGA policy–placing $50,000 in each segment. Our primary concerns are safety of principal and having periodic access to a portion our $150,000 asset.
As each of our MYGAs reach the end of their contract guarantee, we can push our tax-deferred earnings forward using a 1035 exchange to purchase a new policy. At the end of year three we have the option of replacing our initial three-year contract using that account balance to purchase a five-year MYGA. Using a 1035 exchange we can move our tax-deferred growth forward until we decide to access that annuity. This process is repeated at the end of year four using a 1035 to move the proceeds from the four-year contract into a new five-year MYGA.
What Has Happened
By using laddering we are earning rates greater than the three-year rates on all of our money even though we have access to one-third of the growing asset each year. The power of laddering is it permits you to get the higher yields associated with longer terms while maintaining your liquidity.
It is important to remember that by using fixed annuities we also enjoyed the advantages of tax-deferral and enjoyed protection from probate. You should also consider multiple carriers based on the crediting rate offered and specific carrier ratings and financials.
Many people sacrifice yield by keeping money in short maturity instruments because they don’t want to miss out if rates rise. A yield ladder means you always have money coming due that will earn the new rate, and you will be able to take advantage of any yield curve benefits of the longer rate term. Even though I used a three year timetable with three annual buckets, a yield ladder may be any length and have any number of maturity buckets. The key to success is having the discipline to keep the ladder going.
This is a very basic example of using annuity ladders to help your clients. You can also illustrate incredible guaranteed lifetime income solutions for clients combining FIAs, their social security and other financial assets using a laddering approach as well.
