MONEY: CD Ladders for the novice.

What are “Ladders?

A ladder is a climbing device that is characterized by “rungs” that one steps on as you move “upward”. Oh, you knew that. In the financial world, ladders are a bundle of financial assets that have different maturities over time. Those assets could be bonds with different due dates; as opposed to stocks that are an equity interest.

Ladders are of interest in that one can construct a portfolio of bonds that has essentially a different characteristic from the underlying components. Bonds have some typical characteristics: amount, term, rate, and rating. Using a “ladder”, you can create a portfolio that has an higher effective annual interest rate than you’d anticipate. Using a different type of “ladder”, you can create your own version of a bond mutual fund. And, using again a different type of ladder, you can create your own “pension fund”.

“Certificate of Deposit” ladders, my particular favorite, are essentially a bundle of individual certificates of deposit that you consider as a unit or a “portfolio”. You can use all sorts of bonds and even preferred stock as you see fit. My preference is for FDIC insured Certificates of Deposit. (Please be sure to check with the FDIC website. This is pretty much as close to certainty as you can get.)

One drawback of say one year certificates of deposit is that of the low interest rate; use a ladder to get the five year rate. One drawback of a bond mutual fund is that variability in the value of the fund as interest rates fluctuate. One draw back of a pension from a pension fund is that the monthly pension goes away at death.

If you look into the technical descriptions, you will find that our “CD Ladder” overcomes many of the drawbacks. Low one year CD rates can be overcome by rolling five year CD terms. (More about that later) The fluctuation of a bond fund can be overcome by the date certain aspect of a CD; you always get your money back regardless of interest rates. And, the pension check disappearing at death can be overcome by the ladder goes into your estate when you die.

Laddering is a hedge against market volatility. If rates go up, you will be able to invest in a higher rate CD; bond funds lose value when rates go up. On the other hand, if the rates go down, at least you’ve got the other CDs invested at a good rate for longer and the not all of your eggs come due at the same time; bond funds go up in value but pay less interest at the new rate.

To create a CD ladder, you buy several CDs with varying lengths and interest rates. Let’s just use a simple ladder that I recommend to old retirees. The “12 by 5”! Think 60 Five Year 5% CDs spread out over the Twelve Months across Five Years that mature every month. Lets use a portfolio of 60k$ for ease of thinking. Every month, they have a 1k$ CD to roll over. They can take the interest 50$ and party. Trivial for a pension, right? But these are rich senior citizens. Make that a 50K$ CD and that’s 2.5k$ per month. Or, 30k$ per year. That’s a 3M$ portfolio. Better than Social Security. And, it safe, secure, and can be created by an individual with ease. Sleep easy!

OK, you don’t have 3M$ idle and let’s look at another example.

Emergency funds, or savings, are nicely addressed by a “4 by 5” ladder. Think 20 Five Year 5% CDs spread out over the Four Quarters across Five Years. Lets use an Emergency Fund of 100k$. That should cover most emergencies I can think of. Every quarter, you have a 5k$ CD that comes due and you roll it over. Should an emergency come that requires tapping the fund, you just break the last CD. Usually the penalty is just the interest. Some banks will even give you a loan at a very cheap rate, pledging the CD as collateral. It’s a little hard to crack into them, so you’re less likely to call an emergency that isn’t a true one. Since you’d lose money by doing anything with them, you’re motivated to figure out an alternative. But, if you need them, they are there. I like borrowing against them as opposed to cashing them.

Entry into the program is relatively simple. When starting, we bought five “First Quarter” (i.e., 1, 2, 3, 4, and 5 years), a Ninety Day for “Second Quarter”, a One Eighty Day for the “Third Quarter”, and a Two Seventy Day for the “Fourth Quarter”. Then, at each quarter, we “exploded” the roll over into the five “children” (i.e., 1, 2, 3, 4, and 5 years). Hardest part was to explain to the Bank Folks what we wanted. We had to be very focused. Exiting from the program is just stopping the roll overs.

You may need to be a little tactical in getting to the target distribution. Banks usually have “special deals” for odd terms. Recently, when we were setting up the previously described “4 by 5”, the Bank had a “sale” on some odd terms at significantly higher rates. In looking at the odd terms, it was possible to “steer” them into giving us what we wanted.

Opinion: These are essential for old retirees. But of limited usefulness for young workers, except for use as emergency funds and for the savings layer of their financial pyramid, where they serve very nicely.

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