Ask the Analyst: Are CD Ladders a Good Retirement Strategy?

In this Ask the Analyst series, I’m answering your questions about investing, personal finance, and retirement planning. Today’s question:

Is building a ladder of CDs in a retirement portfolio a good investment idea?

A CD Versus a CD Ladder

Let’s start with some definitions. Certificates of deposit are savings instruments that offer a set interest rate over a specified period, or maturity date. When you cash in a CD at maturity, you receive the money back from the original purchase plus accrued interest. CDs issued by a bank are insured up to $250,000 (per depositor, per bank). When you buy a CD directly from a bank, you generally can’t cash it in before the maturity date without paying a penalty. (Brokered CDs, which are CDs offered through brokerage firms, are an exception: You can buy and sell them at the current market price, but trading costs may cut into your profits.)

Building a CD ladder involves buying CDs with staggered maturity dates (such as five separate CDs maturing in one year, two years, three years, four years, and five years). As each rung of the ladder matures, you can use the proceeds to cover living expenses or reinvest in a new CD to maintain the original ladder. A CD ladder is appealing to many retirees because of its safety. You’re guaranteed to get your money back, and any changes in prevailing interest rates won’t affect the amount of interest you earn. In other words, you know exactly how much you’ll get back in principal and interest as each CD matures.

The ladder structure also means you can take advantage of higher yields on longer-maturity CDs without subjecting your portfolio to swings in value from interest-rate risk.

Disadvantages of a CD Ladder

However, a CD ladder isn’t the right fit for every retirement portfolio. It’s basically a savings tool, meaning that it won’t help your portfolio appreciate over time. A CD ladder doesn’t protect your portfolio from inflation, either. The value of each CD at maturity is set, but higher costs for goods and services will probably erode the value of that purchasing power over time. And if your spending needs change, it’s more difficult to access the funds in a CD ladder before maturity than it is to get money out of a high-yield savings account, for example.

A retiree could set up a similar ladder with Treasury Inflation-Protected Securities that would offer the same type of predictable cash flows but is guaranteed to keep pace with inflation.

Tax issues are another consideration. If you’re buying CDs within a tax-deferred retirement account such as a traditional IRA, the interest income won’t be subject to taxes. In a taxable account, though, the interest income will be subject to both federal and state taxes. The interest paid on TIPS, on the other hand, is generally exempt from state and local taxes, but TIPS are subject to federal income tax on both the interest and the inflation adjustment to principal.

Finally, building a CD ladder can be somewhat labor-intensive. You could go to your local bank to set one up, but the annual percentage yield (APY, or the amount you earn on a given CD each year) offered may or may not be competitive.

Major brokerage platforms such as Fidelity, Schwab, and Vanguard offer CDs from a wide variety of banks, but you’ll need to sift through many different options to find the APY and maturity date you’re looking for. And you can’t always just “set and forget” a CD ladder. In some cases, the issuer might automatically roll over the proceeds into a new CD, which could leave you without the cash in hand you need to cover spending.

Overall, I think CD ladders are a decent option for conservative retirees, but inflation risk is a major negative. TIPS ladders are more compelling because they’re guaranteed to keep up with inflation and currently offer real yields of about 2.3%—a healthy margin above inflation and one of the highest levels over the past 20 years.

Have a Question for Me?

In this column, I answer questions from readers about investing, personal finance, and retirement planning. (Note: I’m focusing on questions that are of general interest to many of our readers, not personalized tax advice or portfolio recommendations.) You can submit one by filling out this quick survey.