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  • The Psychological Value Of Annuities

    February 7, 2012 by Frank Murtha

    February 06, 2012

    Instead of being an impediment to higher returns, strategically framed annuities can become, paradoxically, the vehicle that allows clients to achieve them.

    By Frank Murtha

    We all remember the dreadful plunge of the equities markets in 2008 and 2009. How could we not? It was nothing short of traumatic, and naturally rekindled investors desire for safety and dependability. The behavioral response manifested itself in a flight to that bastion of security in an insecure world—precious metals. Yet a financial vehicle whose hallmark is safety and dependability has not enjoyed nearly such a renaissance. In fact, it still seems to engender a startling level of venom by its detractors. I’m speaking of course of annuities.

    This resentment is perhaps misplaced. An annuity is an investment tool—the financial equivalent of a hammer or screwdriver—that is morally neutral and bad or good depending upon for what it is used. Like any tool, it is designed to accomplish certain jobs and is not appropriate for all tasks. There are some tasks for which it is especially well suited, such as retirement.

    As you can probably tell, I’m a product agnostic who believes the right way to invest is the way best suited to the client’s goals and personality. This article is meant to highlight the psychological value of annuities and why the tool may have a place in the financial advisor’s toolkit.

    Save Me… From Myself!

    Every werewolf movie has one classic scene. The “wolfman,” knowing the full moon is approaching and the carnage he will cause when it arrives, insists on being locked in a room for his own protection and the good of the village. The scene captures the conflict between the character’s noble nature and the destructive impulses he can’t control.

    Investors struggle with this conflict as well. We all seek to invest with prudence, governed by our better, more rational nature. But then the markets begin to rise like a full moon, illuminating the inadequacy of our portfolios. Then they rise more, fully exposing the meagerness of our returns. It is around this time that we’re forced to listen to our jackass neighbor brag about his latest purchase. (“I was going to go with the Sea Ray 540 Sundancer, but then I thought, ‘What’s the point of having a small boat?’”) That tears it. Our more primal investing nature begins to seize control.  We can’t help ourselves. We crave performance.

    But investors are not like socially responsible werewolves.  They don’t recognize the investing lunar cycle and say, “Lock me in this well-reasoned, long-term portfolio and do not let me out until I retire!  Do you understand? No matter what you hear, no matter how I try to convince you, you must not let me out.  For the love of God, man!  Do as I say!”

    Investors need less dramatic ways of fighting their baser instincts—such as annuities. Annuities contain not only financial safeguards, but also behavioral safeguards that discourage the destructive human impulses that erode performance. Keeping money “locked away” is often cited as a negative for investing. Yet it is precisely what is needed to help investors get through the “full moon” market periods, when frenzy and terror supplant our better judgment. In retirement, such moments of weakness can prove disastrous, and the psychological value of annuities can be even more important.

    The Aggressiveness Paradox

    Another advantage of annuities as an investment vehicle is what we at my firm, MarketPsych, call The Aggressiveness Paradox—the tendency of investors to get more aggressive as their asset allocations get more conservative. It’s useful to think of asset allocation on two levels when implementing a risk-laden investment plan.

    First is the financial level of asset allocation— that of the investments themselves. There must be sufficient risk/reward vehicles in the portfolio to provide the desired upside returns. Then there is the client’s emotional level.  Regardless of what the holdings actually are, if the client does not have sufficient emotional diversification (investments that meet their emotional needs for safety as well as returns), the portfolio will fail. These two levels rarely coincide.

    Think of it this way: Portfolio construction is like building construction. The higher you want to build, the more essential it is that you build on a solid foundation. You can construct a portfolio with the upside of a soaring tower. But if you do so without a sufficiently solid emotional base, the building is doomed to come crashing down.

    Annuities strengthen the investor’s emotional base so more upside risk can be taken. The power and predictability of guaranteed income can allow a client to take on the risk necessary to meet diverse financial goals.

    The effect is even more powerful when combined with what behavioral finance calls “mental accounting”—the mental segregation of funds and budgeting of money for different purposes. Knowing that their bills, mortgage, and medical needs will be safely met, clients can allay some of their greatest fears and gain a sense of control over their futures.

    Instead of being an impediment to higher returns, strategically framed annuities can become, paradoxically, the vehicle that allows clients to achieve them.

    The Optimization Trap

    Much of investing theory assumes people will be rational and act in a way consistent with their financial self-interest. Daniel Kahnemann won a Nobel Peace Prize in economics for proving this is a false assumption. Moreover, behavioral finance shows how pursuing the “rational” goal of achieving optimal returns is often counterproductive.

    One of the biggest complaints about annuities is that they are sub-optimal choices. “You can do better if you just…” is a common theme in annuity critiques. These critiques have merit, but they fail to adequately account for the behavioral biases crucial to success.

    Perhaps this natural desire to get the best returns you can is what causes many financial advisors to look at annuities as a waste.   The same—or even better—returns, they argue, can be had in more efficient or cost-effective ways. This mentality is laudable. It means that an advisor is seeking to do right by his or her clients.

    Yet with all the emphasis on investment performance, it is easy to overlook investor performance. It is this latter factor that is more controllable and in fact more important.

    Think of financial health as physical health. A quality, diversified portfolio is the same as a healthy, balanced diet. In an effort to get in better shape, clients may be presented with the ideal plan to help them achieve their goals. This plan no doubt could accomplish its goals splendidly.  But the client will be back on pizza and Krispy Kreme donuts in no time if it is mismatched to his or her real life proclivities.

    The Zen philosopher Basho once said that a flute without holes is not a flute. And a good plan that cannot be followed… is not a good plan.

    The Optimization Trap does not only affect advisors, of course. The instinct against wasting money and for optimization leads clients to have major objections to using annuities. A long-term income vehicle like an annuity will be a waste if they die too soon.  This is a curious form of reasoning, which boils down to, “Sure, the annuity is worth it… if I live.” It’s as if, in dying, they would somehow experience regret and dissatisfaction with their decision. Does this make sense? We don’t know. I imagine the only way for researchers to get data is by holding séances:

    Psychic Medium: “Uncle Irving, do you regret purchasing that annuity?

    Uncle Irving: “Well, I didn’t recoup the value in real dollars, but I felt a lot less of stress in the last few years.”

    Psychic Medium: “Could you describe your satisfaction on a scale of 1 to 7?”

    Uncle Irving: “I dunno… a 4?  Look, can we wrap this up?  I’m on a date with Rita Hayworth.”

    Are annuities optimal? In theory, no. But clients aren’t theoretical. They’re real live people with all the imperfections for which financial planning must account.  Predictability.  Reliability.  A guarantee.  These are powerful psychological drivers of behavior.  Powerful enough to drive people off of other, more “optimal” plans.

    Ultimately annuities are a tool, fit for some tasks (e.g., retirement income), and ill suited for others.  Over and above their purely financial value, there is a place for them in the professional’s toolbox for their psychological value.

    Frank Murtha, Ph.D., is a co-founder and managing partner at MarketPsych LLC, the first behavioral finance consultancy in North America. He has specialized in helping financial advisors apply behavioral finance to improve client profiling, relationship management and asset gathering for more than ten years. He is also author of “MarketPsych: How to Manage Fear and Build Your Investor Identity.” He may be reached at fmurtha@marketpsych.com.

    Originally Posted at Financial Advisor Magazine on February 6, 2012 by Frank Murtha.

    Categories: Industry Articles
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