In this article, we discuss the idea of annuity laddering (also known as income laddering) and how it is helpful in retirement planning.
Annuity/Income laddering generally means a series of cash flows that become available at different points in the future. Typically, bonds or fixed deposits are used for income laddering. A series of FDs started today and maturing every few years from now 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.
* There are deferred annuity plans also sold. These provide a pension after X years. Never buy those!
Before we begin, there are important caveats to consider.
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- The annuity rates shown below for different ages are current rates. They will likely be lower when we get to that age. This decrease must be factored into the calculation approximately. We have done this.
- Annuities are taxed as per slab rates, and these keep changing from year to year. We have not factored tax into our discussion, but it is crucial to do so.
- A simple “annuity of life” is sufficient when we buy the first annuity (see How can I use my corpus to get a pension at the best return?). However, other options may be more efficient when buying later in retirement. This must be considered. In this example, we only use the annuity rates for “annuity for life”.
Let us first look at the annuity rates for the “for life” option from LIC Jeevan Akshay. For more details, see: Higher annuity rates of LIC Jeevan Akshay applicable from Feb 2023
| Age when the annuity is purchased | LIC Jeevan Akshay VII from Feb 2022 From Feb 28th 2023 |
| 30 | 6.90% |
| 40 | 7.28% |
| 50 | 7.95% |
| 60 | 9.27% |
| 70 | 12.05% |
| 80 | 18.49% |
Notice that the older the annuitant, the higher the interest rate. We can exploit this in the following way.
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.
- Entirely using the bucket strategy method explained before in the Retirement plan review: Am I on track to retire by 50?
- Using a combination of a single annuity policy and bucket strategy (aka income flooring). See: How to beat inflation after retirement along with guaranteed pension.
- Using a combination of multiple annuities and a bucket strategy (aka income laddering 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 10 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 remaining 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 10 years of annual expenses
- At age 65 with an annual pension equal to the average of the next 10 years of annual expenses (after accounting for the 1st annuity)
- At age 75, with an annual pension equal to the average of the next 10 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. This is another way to set up the ladder.
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.
A screenshot of the spreadsheet calculation is shown below. The average of the entries in the red rectangle is the pension from the first annuity.
From ages 65 to 74. the excess annual expenses are found (entries in the blue rectangle), and their average becomes the second annuity. The sum of the first and second annuities is shown in the green rectangle.
So, how do we compute the corpus? A detailed annuity laddering calculator is now part of our robo advisory tool as a standalone module. Here are some glimpses.
- Suppose we set the first annuity rate for a 55-year-old as 7.6% (users can change all settings). Assuming an effective tax rate of about 12% for those in the 20% slab, the corpus needed after tax is about Rs. 1.39 crores (including GST).
- The second annuity will only be purchased 10 years from now. So, we depreciate today’s rate by about 2% a year. Also, we have 10 years of investment time. So the amount required (after tax) is about Rs. 70 lakhs.
- Similarly, we need about Rs. 44 lakhs for the third annuity and Rs. 34 lakhs for the fourth.
Then, we consider the balance expenses each year not covered by annuities.
It should be enough to cover these extra expenses if we invest Rs.10 lakhs (twice the amount marked above) at the start of retirement.
- So that is a total of about Rs. 2.95 Crores or about 3 crores
- We shall have an emergency bucket = 5% of the above sum = Rs. 15 lakhs
- So that is a grand sum of Rs. 3.15 Crores.
- You can use our robo advisory tool, which has a stand-alone annuity laddering calculator module for this calculation.
- If we had used a bucket strategy without any annuity, the robo tool indicates that the corpus will be about 31% lower. That is the price of “assured income” with annuities!
Annuity or income laddering is an option that one should consider only after achieving comfortable financial independence or retirement. Only then the inputs (esp. annuity rates and tax slabs) would be reasonably accurate. For those far away from retirement, a diversified bucket strategy would suffice.
It must be understood that retirement planning is a journey, and as we reach higher rungs of experience and wealth, we consider additional possibilities. For example, I thought a pension was unnecessary, but age taught me a retirement planning lesson!
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