How Retirees Can Use the Fixed Deposit Laddering Strategy to Manage Their Liquidity Needs?

December 14, 2021 Mutual Fund

To earn optimal returns and minimise risk, it is essential to invest in worthy investment avenues and construct a sound financial plan. Fixed income instruments such as fixed deposits offer stability and assured returns. It has been a popular choice of many risk-averse investors as the returns are not market-linked; on the contrary, it is fixed in the form of interest rate you earn.

However, the interest rates on fixed deposits (FDs) have been at multi-year lows, with banks and NBFCs having slashed rates consequent to the Reserve Bank of India (RBI’s) monetary policy actions to tackle inflation and support growth amidst the COVID-19 pandemic.

Nevertheless, things could change, sooner or later if inflation readings come in higher and the GDP data supports an increase. In such a scenario, those investing in bank fixed deposits (FD), particularly retirees, could benefit.

Until then the retirees should ideally use the fixed deposit laddering strategy to earn respectable returns and manage their liquidity needs without having to prematurely withdraw their bank FDs.

What is Fixed Deposit Laddering?

Fixed Deposit laddering is a simple investment strategy, wherein you spread your investment in FDs over multiple maturity tenures or maturity buckets instead of locking your funds in just one single FD. Doing this facilitates you to potentially earn a higher return on the bank FD and even address your liquidity needs.

The FD laddering investment strategy ensures that you have one fixed deposit mature at the end of every year. The maturing FD can either be used to meet liquidity needs and/or be reinvested, depending on your requirement and the prevailing interest rate scenario.

In the current interest rate scenario, where interest rates are expected to rise in time to come, the FD laddering strategy makes even more sense. It would save you from the possible reinvestment risk and optimise the returns for you.

In other words, if you do all your investments in one single FD at one go and soon later interest rates on deposits move up, you could lose out on the returns, had you not invested in a laddered manner across maturity buckets.

For instance, instead of depositing your funds in one single fixed deposit you can divide a fixed deposit of Rs 5 lakhs into 5 parts by depositing Rs 1lakh in each fixed deposit of different tenures of 1 year, 2years, 3years, 4years and 5years. After each year when the FD matures you can renew it, again and with this exercise your ladder will be ready. It ensures that not all your deposits are locked at a lower interest rate at the same time.

However, interest rates may go up in the future. If you lock your entire fund for the long term in a single fixed deposit at current rates and the interest rates do go up after a few years, you will lose the opportunity to earn better interest on your investment.

By using the laddering strategy, you could average out your interest rate movements and yield respectable returns from a bank FD.

How Fixed Deposit Laddering is useful to Retirees?

Laddering is very useful for retired people who depend on interest income to meet their day to day expenses. You could choose the monthly interest pay-out or quarterly interest pay-out, depending on your retirement. But if you do not require interim cash flows in the form of interest, then the cumulative plan makes sense to compound wealth.

Given that, interest earned on a bank FD is taxable, you may submit a declaration under Section 197A of the Income Tax Act in Form 15-H (for senior citizens) to the bank, so that tax is not deducted at the source. This form can be submitted to banks online (through their official website) or physically at the bank branch.

Laddering will free up the capital as and when required, giving you access to funds during an emergency. As you will be spreading across the maturity dates in case of an emergency you may not require to prematurely withdraw the fixed deposits.

It is an effective method of managing liquidity. All you need to do is break up the lump sum contribution into smaller chunks and diversify them out over different maturities. Rather than investing your entire lump sum amount in a single FD, split your money rationally and invest it in a variety of FDs of varying maturities.

Let us see, a table that explains how you can allocate your investment in fixed deposits across maturity dates:

The interest rates considered are currently those offered by SBI for senior citizens.
(For illustration purpose only)  

Laddering your fixed deposit also helps you take care of the re-investment risk. If all your money is invested in one go, then you may be losing out on a higher interest rate if in the future the interest rate cycle reverses on the way up.

In addition, you may also consider investing in different Bank FDs. This will diversify your investment across leading banks and provide better risk-adjusted returns. It will reduce your exposure towards a single bank and offer diversification across multiple Bank FDs. That said, choose a bank carefully, do not simply zero in on banks offering higher interest rates on fixed deposits.

If you thoughtfully invest in bank FDs by following the laddering strategy and with the necessary financial discipline, you can benefit from it. Looking at the current scenario, spreading your investments across banks, multiple FDs and maturities, you will have a chance to gain from rising interest rates. It would average out the changes in the interest rates over time. With regular maturity proceeds year after year, liquidity will be taken care of and you may not have to prematurely withdraw your FD in case an emergency arises.

Therefore, if you are a retiree looking for liquidity by investing in bank FDs and earning decent returns, you may practice the laddering strategy. It will help you to get the best out of your investment in the bank FDs and will build a respectable corpus with stability, growth and low risk.

Frequently Asked Questions (FAQs):

1. What is FD laddering?

FD laddering is a simple investment strategy, wherein investors park their money in multiple FD instruments of varying tenures to mitigate their risk. The strategy essentially involves dividing one’s funds and investing them in separate FDs, instead of locking in the entire corpus in a single fixed deposit.

2. How FD laddering strategy is beneficial for investors?

FD laddering allows investors to gain from increases in interest rates since the investor is able to reinvest a portion of his or her capital each year at market rates.

3. Does FD laddering offer liquidity to investors?

FD laddering is an effective method of managing liquidity with regular maturity proceeds year after year, liquidity will be taken care of and you may not have to prematurely withdraw your FD in case an emergency arises.

4. Should retirees consider FD laddering strategy?

Laddering is very useful for retired people who depend on interest income from fixed deposits to meet their day-to-day expenses. You could choose the monthly interest pay-out or quarterly interest pay-out, depending on your retirement.

5. Should I consider FD laddering in the current scenario?

Looking at the current scenario, spreading your investments across banks, multiple FDs and maturities will offer you an opportunity to gain from rising interest rates.

This article first appeared on PersonalFN here