Thursday, February 24, 2011
Understanding the Difference Between Annuity, Bond and CD Ladders
One great way of creating a gradually disbursing retirement benefit while still keeping the long-term savings portion of your money conservatively invested is to create a bond, annuity or CD ladder. These ladders are separate investment instruments with varying maturity dates that allow you to take advantage of long-term savings rates while still making sure that some of your money is readily liquid when you need it. This strategy is called "laddering" because each maturity date is its own rung on the ladder of your retirement years.
While each ladder is a great strategy in its own right, it's important to understand the differences between each of them before you decide which is (or are) right for your retirement plan.
An annuity ladder is created when you spread out your annuity purchases over several years. Instead of investing all your retirement savings at once into a single annuity contract, you only invest some of the proceeds. The rest remains invested in equities, bonds, CDs and other appropriate investments. Then, over time, say every 5 years, you buy another annuity. Doing so helps insulate your savings from being locked in to low-interest annuities. This gives you the benefit of guaranteed income without interest rate risk.
Bonds are debt instruments that act as loans to companies and municipalities. While the issuer is using your principal for their projects they pay out interest to you. Once the bond matures, you are paid back the principal that you invested. When you create a bond ladder, you purchase several bonds with varying maturity dates. The later maturity dates afford the investor greater interest payments, but the earlier maturing bonds give the investor liquidity when they need it. Many bonds also have put options so that if you should pass away before the bonds in your ladder mature, your family can execute the put and be paid the principal by the bond issuer.
CD rates vary depending on how long you are willing to have your principal tied up in the CD. A 20-year CD will have a significantly higher rate than a 6-month CD, but tying all your retirement money up for 20 years in order to get that rate is not a smart strategy since you are likely to need something to live on during the 20-year period. With a CD ladder, you can invest a portion of your savings into CDs with varying maturities. They will mature and pay you your principal and interest throughout the years as you enjoy your retirement.
Liquidated earnings are subject to ordinary income tax, may be subject to surrender charges and, if taken prior to age 59-1вЃ„2, may be subject to a 10% federal income tax penalty.
Guarantees and payment of lifetime income are contingent on the claims paying ability of the issuing insurance company.