It’s certainly not news that we are living in a low-interest-rate environment. In September 2010, Bankrate.com showed national average interest rates of 2.56 percent and 1.27 percent for five-year and one-year certificates of deposit. Interest rates stood at 1.47 percent and 0.26 percent for the five-year and one-year constant maturity treasury, respectively.

Even worse are the interest rates on many of the major money market mutual funds. Fidelity’s Cash Reserves fund has nearly $125 billion in assets, earning only 0.08 percent. Vanguard’s Prime Money Market fund has more than $100 billion in assets earning just 0.04 percent.

Can our clients, who rely upon attractive interest rates to generate a portion of their income, expect higher rates anytime soon? Perhaps not, if you listen to Ben Bernanke; the Federal Reserve chairman recently testified before Congress that he anticipates historically low interest rates to continue well into the future.

This leaves our clients in a conundrum. On the one hand, they may be afraid to put their money into long-term products because they fear they may be locking in today’s low rates for years to come. On the other hand, if they leave all their money in cash and cash equivalents, their savings will generate nearly no interest at all.

The solution may be a time-tested strategy that we tend to forget when interest rates are higher: annuity laddering, which balances the need to generate income while not locking in too much money for the long term.

Annuity laddering

Annuity laddering is similar to a strategy that financial professionals have employed extensively for many years – a strategy which, in the past, has used bank certificates of deposit or other stable-value financial products with defined maturities. Annuity laddering simply divides your client’s money fairly evenly over annuities with a variety of durations and from a variety of insurance carriers.

Let’s assume that your client has $500,000 to put into annuities. In one approach to laddering, we simply split the premium equally across 10 annuities. As the annuity durations increase, we find higher interest rates available on the annuity and an extra year of interest crediting over the prior duration. Under this approach, the yearly cash flow to your client increases each year.

Duration

Premium

Interest rate*

Payout at end

1

$50,000

1.50%

$50,750

2

$50,000

1.65%

$51,664

3

$50,000

1.75%

$52,671

4

$50,000

2.25%

$54,654

5

$50,000

3.00%

$57,964

6

$50,000

3.10%

$60,051

7

$50,000

3.20%

$62,334

8

$50,000

3.20%

$64,329

9

$50,000

3.20%

$66,388

10

$50,000

3.40%

$69,851

* Interest rates are hypothetical, but are reasonably close to the annuity rates available in the marketplace in September 2010.

Alternatively, if your client wants a level annual cash flow, we can allocate more premium to the shorter-duration annuities and less premium to the longer-duration annuities.

Duration

Premium

Interest rate*

Payout at end

1

$57,543

1.50%

$58,406

2

$56,526

1.65%

$58,406

3

$55,444

1.75%

$58,406

4

$53,433

2.25%

$58,406

5

$50,382

3.00%

$58,406

6

$48,630

3.10%

$58,406

7

$46,849

3.20%

$58,406

8

$45,396

3.20%

$58,406

9

$43,989

3.20%

$58,406

10

$41,808

3.40%

$58,406

*Interest rates are hypothetical, but are reasonably close to the annuity rates available in the marketplace in September 2010.

We can blend these two approaches to create an annual payout stream that increases at some desired inflation rate; you can see that annuity laddering gives your client quite a bit of planning flexibility.

Advantages to your client

Annuity laddering strikes the necessary balance. Take a look, for example, at the 3.40 percent interest rate available on the 10-year annuity. Over the next 10 years, if interest rates rise substantially, your client will be happy that they didn’t lock all of their money into that rate for 10 years. On the other hand, if interest rates continue to fall, your client will be happy that at least some money earned that rate for 10 years.

As a result of the annuity ladder, your client has a fully guaranteed stream of cash available every year for the next 10 years, with no risk to principal. Each year, they can spend the portion that they want to spend and put the rest into a new 10-year annuity, extending the ladder another year.

But also consider this: In most states, a $500,000 premium is well above the protections provided by the state guaranty fund. By splitting the money among a variety of insurance carriers, your client is better protected by the state guaranty fund.

Don’t forget about taxes: By purchasing annuities from 10 different insurance carriers, your client will be able to avoid the detrimental effects of IRC Section 72(e)11 A(ii), the tax law that addresses annuity aggregation. As a result, your client would be able to withdraw the entire value of any one of their annuities at the end of its surrender charge period and have a substantial portion of the withdrawal treated as non-taxable return-of-cost basis.

Advantages to you

Your client is happy with this collection of annuities because it provides a ladder of protection – that is, a bucket of surrender-charge-free, tax-advantaged, reinvestable money every year – with the ability to continue extending the ladder for the rest of the client’s life.

Of course, a happy client is good for you, but you benefit in some additional ways, as well. Because you were able to sell annuities consisting of a variety of durations, including some with a long duration that pay a high commission rate, you made a healthy commission at the initial sale. But notice that every year, a newly freed bucket of money can be rolled into a new annuity. This gives you a good reason to meet with your client every year, continuing to build your relationship and making an additional annuity sale with the freed-up money.

Thus, the annuity ladder is a win for both you and your client – a simple strategy that works to successfully address the challenges of a low interest rate environment.

Chris Conklin is a licensed agent and principal and actuary of Insurance Insight Group and MyAnnuityTraining.com. He can be reached at 801-290-3320 or chris.conklin@iigsolutions.com.