This article discusses income laddering (aka annuity laddering) in retirement planning and how to go about it.
There are two extreme options in retirement planning: one where the corpus is managed in a diversified portfolio, and an increasing income is withdrawn from it as required. This is known as the bucket strategy.
We had earlier illustrated how to plan for retirement with such a strategy: I am 30 and wish to retire by 50; How should I plan my investments? And, Retirement plan review: Am I on track to retire by 50?
The second extreme option is to use pensions or annuities or secure fixed-income products. As one can imagine, this will guarantee a fixed income for life, but increasing the income each year or as required at the inflation rate would be hard.
The main advantage of using a bucket strategy is a lower retirement corpus. Although it is not hard to implement, many retirees (particularly those with little or no capital market experience) feel it is difficult. Therefore, earlier, we discussed a hybrid strategy using retirement buckers and a pension plan called income flooring: How to beat inflation after retirement with a guaranteed pension.
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The freefincal robo-advisory tool allows the user to plan for retirement with (a) a 100% bucket strategy, (b) a hybrid strategy with one pension/annuity/income plus retirement buckets (income flooring) or (c) a hybrid strategy with multiple annuities (income laddering).
Annuity laddering generally means a series of cash flows that become available at different points in time in the future. Typically, bonds or fixed deposits are used for income laddering. A series of FDs started today and are maturing every few years from now, which is one example of an income ladder.
Income laddering from annuities (immediate pension plans sold by insurers*) exploits the idea that the return provided by an insurer increases with age. * Never buy deferred annuity plans! Build your corpus independently and buy a pension plan if necessary. Sometimes, a government bond is a better choice (especially in the early stages of retirement). See: I need a pension. Should I buy an annuity or a govt bond?
Income flooring: Suppose our monthly expenses in the first year of retirement are Rs. 50,000. We buy an annuity so that our monthly pension = Rs. 50,000 (after tax!). This will take care of all our monthly expenses (hopefully) in the first year of retirement.
From the second year, inflation has to be accounted for. Assuming it is about 6%, the expenses will increase, as shown below. Since the pension covers a part of the expenses for life, we only need to handle the rest via prudent bucket strategy management. The schematic below illustrates this.
Naturally, income flooring will require a higher corpus than a 100% bucket strategy. An income ladder, which is nothing but a multi-level income floor, will require an even higher corpus. Those far away from retirement should think of these as additional milestones after reaching the basic 100% bucket strategy target. An income flooring example is discussed here: How to beat inflation after retirement along with a guaranteed pension.
Income laddering example: Consider a 55-year-old with Rs. 6,00,000 as annual expenses and 6% inflation. This is how his expenses will increase until age 90.
There are three ways to manage these expenses.
- We can use the bucket strategy method, as explained before. Retirement plan review: Am I on track to retire by 50?
- We can combine a single annuity policy and bucket strategy (income flooring). See: How to beat inflation after retirement along with guaranteed pension.
- We can combine multiple annuities and a bucket strategy (income or annuity laddering).
In the income flooring method, we buy a single annuity at the start of retirement and manage the remaining expenses using the bucket strategy.
This (annual) pension amount can be equal to the annual expenses in the first year, the average of the first ten years’ expenses (shown above), or any amount you like.
In the income or annuity laddering approach, we progressively buy annuities at higher and higher interest rates (due to the retiree’s age) and manage the balance expenses with a bucket strategy.
In the above picture, a total of four annuities are purchased
- At age 55, with an annual pension equal to the average of the first ten years of annual expenses
- At age 65, with an annual pension equal to the average of the next ten years of annual expenses (after accounting for the 1st annuity)
- At age 75, with an annual pension equal to the average of the next ten years of annual expenses (after accounting for the 1st and 2nd annuities)
- At age 80, with an annual pension equal to the project annual expense at age 90 (after accounting for the 1st, 2nd and 3rd annuities)
The pension can be adjusted depending on the comfort level and corpus available to the retiree.
Retirement planning with income laddering has both advantages and disadvantages.
Pros
- Money management post-retirement (reliance on bucket strategy) is lower (but not eliminated).
- Most of the corpus can be in liquid, safe, fixed income at an older age.
Cons
- The overall corpus required would be higher (ballpark estimates indicate a 25-40% higher corpus, which could be higher or lower depending on inputs)
- Tax inefficient as the pensions would be taxed as per slab.
- Estimating future annuity yields would be hard even at the start of retirement and quite impossible well before retirement.
- The annuities require maintenance with life certificates to be furnished once a year. This is not necessary for RBI bonds.
We can appreciate the differences among these methods using the initial withdrawal rate: What should be my safe withdrawal rate for retirement?
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