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 the author of "MarketPsych: How to Manage Fear and Build Your Investor Identity." He may be reached at [email protected].