The collapse of financial markets has left clients nearing retirement in a state of high anxiety. Many portfolios have shrunk 40% in the past year, and the crisis may be far from over. Even the notion that investing in equities will outperform bank deposits over time is being challenged.

Enter the concept of laddered annuities.

In a recent study, "Variable Payout Annuities and Dynamic Portfolio Choice in Retirement," published in the Journal of Pension Economics and Finance, Olivia Mitchell, a professor of insurance and risk management at the Wharton School at the University of Pennsylvania, argued that by laddering the purchase of immediate annuities — or buying annuities gradually over time while keeping the rest of a portfolio invested in a mix of equities and bonds — clients can substantially increase the likelihood of meeting their retirement income goals. The product used is a "fixed immediate annuity," and the payment rate you get for what you buy with a single premium is based on the client's age at purchase and current interest rates.

"What we've found in this and earlier studies is that people facing retirement want guaranteed income and liquidity, so purchasing annuities over a period of time, even into retirement, makes sense," said Mitchell, who doubles as executive director of the Pension Research Council at Penn and who wrote the study with scholars from Goethe University in Frankfurt.

Annuity ladders share an advantage with bond ladders, said Goethe University's Raimond Maurer, another co-author of the study. Investors can reduce the risk of locking in low interest rates — and payouts — because they are buying the annuities at different times and different interest rates. However, when interest rates are particularly low, as they are now, clients should probably hold off.

Here's how a laddered investment works. Say an adviser has clients who are husband and wife, each 60 years old, who plan to retire at 66 on $200,000 in savings and $40,000 a year from Social Security.

They want an additional $20,000 a year, so they buy a $14,000 cost-of-living-adjusted immediate annuity, investing the remaining $186,000 of their funds in 65% equities and 35% bonds. Every year, until they are 66, they purchase another $14,000 annuity until the combined payouts reach their income goal of $20,000. Six years later, if the equity and bond markets perform at even close to historical norms, the couple will still have a substantial investment in securities in addition to a $20,000 income from the annuities for life.

Conventional wisdom has been to invest client portfolios in a mix of equities and bonds, with equities providing the long-term growth and bonds dishing up security, predictability and income. According to this model, the portfolio's allocation shifts more weight into bonds as retirement approaches. But many risk-averse retirees are wondering if they can follow conventional wisdom anymore.

"Annuity laddering is particularly effective relative to investment-based strategies," said Chris Rahm, head of the retirement income practice at Ernst & Young. The annuities can act as a client's most conservative investment, the bond portion of the portfolio. Then "if you were an aggressive adviser, you could argue that the client could move more invested assets into equities," he said. That way, clients can gradually build guaranteed income while maintaining liquidity and growing their assets.

An added advantage of laddering annuity purchases: As the buyer ages, the "survival credit" rises. Essentially, the older the buyer of an annuity, the higher the payout for a given premium, Mitchell said.

According to John Harrell, managing director of sales at Symetra Financial, immediate annuities may also enjoy tax advantages over certain bonds. The annuities have unique exclusion ratios, which means a portion of the income stream is considered a return of principal and thus free from taxation while the client is alive.

Jerry Golden, president of MassMutual's income management strategies division, said it has back-tested laddering, examining 181 different time periods from 1965 to 2006, and comparing several annuities strategies to a typical stocks-and-bonds investment strategy. In almost every case, the annuity strategy outperformed a portfolio of only stocks and bonds.

Though buying even a single immediate annuity at the outset proved better than investing purely in stocks and bonds, Golden said that the laddered approach, on average, tripled the original client asset by the end of the test period, regardless of the economic environment or the period selected. "Laddering annuities allows retirees to stay longer in equities," said Tom Modestino, a senior analyst at the research firm Cerulli Associates. "And that's a good idea."

In bank programs, a laddering strategy may also help ensure that annuities work in concert with other fixed-income solutions such as certificates of deposit. Harrell said income annuities have sometimes suffered from the notion that they represent a one-time commission for the adviser and the potential loss of future fee revenue or CD sales for the bank. However, by also incorporating period-certain immediate annuities into the ladder, advisers can protect clients from locking in low rates while setting the stage for CD reinvestment later.

The main downside to annuities is their complexity. "The financial adviser has a lot of explaining to do to the client," Rahm said. When a client buys an immediate annuity, the payment is a premium, not an investment, and is no longer an asset controlled by the client. "It may not be what they are used to," Rahm said.

Lisa Plotnick, associate director at Cerulli, said that while she likes the idea of laddering annuity purchases, it might not be wise to get locked into one issuer. "With annuities, products are always evolving, and you may find better products or more attractive riders offered by different issuers," she said. "Financial advisers should always shop around to find the best fit for their clients."

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