There are times when we have a large sum of money to be spent, not in one-shot, but over the course of a few years. Retirement of course is the most obvious and most complicated example wherein the corpus has to last from a few years to decades. There can other situations: a person who works in a salaried job wanting to start a business may desire to use a corpus to guarantee certain expenses (eg. school or college expenses) for a certain number of years until his business picks up. An expecting mother who may/will not be working for the next few years, a person who is working in a shaky job may all have such requirements.
An Income Ladder can be used for such requirements. The idea is to take a lump sum, divide it into many parts and lock them into fixed-income instruments (most popular being bank FDs) of differing durations to provide guaranteed sums each year to meet expenses. An inflation factor by which expenses can increase each year should also be taken into account. The main advantage of this method is it give one peace of mind that expenses for a fixed number of years is guaranteed. This is not just a calculation but also set of specific investments steps to be followed.
A simple example can illustrate this better: Suppose I need:
1 lakh for one year starting now
1.1 lakhs for one year, 12 months later, (10% inflation) and
1.21 Lakhs for one year 24 months later.
To create an income ladder, one lakh is kept away for meeting expenses for the first 12 months. Then one lakh is invested in a fixed deposit for one year offering a return of, say, 10% per anum (dream on!) and one lakh in a second fixed deposit for two years (@10% pa). The first FD matures after one year and provides for expenses in the second year. The second FD matures after two years and provides for expenses in the third year. This way using a corpus of 3 lakhs a total expense of 3.31 lakhs over 3 years can be covered. Let us call this method 1.
Another way to do it is to open FDs which pay out interest annually. This way the expenses for the second year will be met by the first FD and the interest from the second FD (call this method 2). A more detailed example can be found here.
Which method is better? This depends on the how the interest rates change with duration. Sometimes higher rates are given for shorter durations. In this case typically method 1 will result in a lower corpus requirement. If higher rates are given for longer durations then method 2 will result in a lower corpus. Howeverthe difference between the corpus’s is not that significant.
Inspired by and based on the ideas outlined at incomeladders I have made an Income ladder calculator. The ladder can be created for up to 14 years (I got bored at 14 and stopped. If you want it for longer, you can either extend it yourself or contact me). The calculator is fairly self-explanatory to use.
One of the most important usages of an income ladder is during retirement. One creates an income ladder and ensures expenses for the first 8-10 years of retirement are taken care of. This provides the retiree ‘peace of mind’ to invest the rest of the corpus in growth instruments of varying risk as outlined in the ‘retirement bucket strategy’.
Can you think of any other situation where such an income ladder will be useful?
Download the Income ladder calculator (.xlsx file) (updated Nov 2013. Now supports up to 16 years)
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