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.