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.