The collapse of financial markets has left people nearing retirement in a state of high anxiety. Many portfolios 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. Or, perhaps, "Welcome back."

In a recent study entitled, 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, argues 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—people 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," says Mitchell, who doubles as executive director of the Pension Research Council at UPenn and who co-authored the latest study with scholars from Goethe University in Frankfurt, Germany.

Annuity ladders share an advantage with bond ladders, notes Goethe University's Raimond Maurer, a co-author of the study. You reduce the risk of locking in low interest rates—and payouts—because you 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.

BUILDING THE LADDER

Here's how a laddered investment works. Say you have a 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.

Jerry Golden, president of MassMutual's income management strategies division, suggests this hypothetical scenario: Assume Joe is a 64-year-old widower. In October 2007, Joe had $1 million in assets, two grown children, six grandchildren and a pressing desire to retire at 65. Joe invested 65% in stocks and 35% in bonds, hoping to withdraw $40,000 a year in retirement. He planned to give himself a 3% annual raise to account for inflation.

By October 2008, of course, Joe's investments were a disaster. His stocks were down 38.1% and his bonds were down 9.1%, leaving him with just $719,850. Had Joe left matters alone, he would be facing a 32% chance of exhausting his resources by age 86, his life expectancy.

But suppose, back in October, Joe had taken a third of his assets, $237,551, and purchased an inflation-adjusted income annuity that accepted multiple premiums of $17,141. He could risk shifting the balance of his assets into equities and draw the remainder of his $40,000 target income from that portfolio as required. Each year, for nine years, he would buy more annuities, reaching his required payout of $40,000 per year in nine years. At that point, Golden says Joe could have well over $500,000 left for his heirs—even more if inflation stays under 3%.

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," says 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 advisor, you could argue that the client could move more invested assets into equities," he says. 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 explains. 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.