Understanding Annuities With The Help Of Behavioral Finance

(Forbes) In the few weeks since the House of Representatives passed the bipartisan Secure Act , there has been an outpouring of impassioned and polarized opinions about how Americans should best save for retirement. If the Secure Act becomes law, it could ease the burden of retirement planning for many people, by allowing more businesses to offer 401(k) plans that include increased options for annuities. 

Because annuities are controversial products that are often misrepresented and misunderstood, Americans should use the time before a new retirement bill becomes law as a window of opportunity to learn more about retirement options such as annuities and how to leverage emerging behavioral finance research to make the most sensible investment and risk management decisions possible. 

An annuity is a long-term risk management product purchased through a life insurance company that protects people from outliving their retirement savings by guaranteeing fixed periodic income payments for life. Annuities can be beneficial safeguards in many people’s retirement plans, but – like most aspects of financial planning – it can be difficult to vet sound information amind a deluge of sensational headlines that polarize positive or negative extremes.

As an experienced financial and retirement savings planner, I believe the best way to understand annuities is through a moderate or middle-ground approach. In fact, a large part of my job involves recognizing how an individual client’s mindset might impact their financial choices for better or worse and helping them get out of their own way when reactionary emotions override rational decision making.

Most of this work involves being able to gain a sense of a client’s loss aversion ratio. “Loss aversion” is a tenet of decision theory that describes the phenomenon of experiencing loss more acutely than an equivalent gain in the overwhelming majority of the population. On average, most people feel the negative impact of loss 2.5 times greater than the positive impact of gain, but many people have even higher loss aversion ratios, and this disproportionate fear of losing money can easily derail someone’s financial planning.

For example, annuities are a form of “decumulation,” or breaking down and distributing savings accumulation into a retirement income. Because annuity payments are based on average life expectancy, the older you are when you purchase an annuity and/or start receiving payments, and the longer you live past your average life expectancy, the better your rate of return will be. However, depending on the type of annuity you purchase, if you die before life expectancy, your insurance company will collect the remaining annuity and your estate will take a loss. 

This aspect of decumulation is why people with higher risk aversion ratios are less likely to purchase annuities, even if an annuity would otherwise be a good fit that’s likely to yield them a high return. And while it may be difficult or impossible for someone to change their deeply ingrained response to risk, it is possible to overcome those negative biases by recognizing them and establishing a mitigative investment strategy.

When it comes to making the best decision about whether or not to purchase an annuity, the mindset of financial planners and insurance representatives is just as important as the client’s. There are already a growing number of annuity plans; under the new proposed retirement legislation, diversity and accessibility of annuity contracts will likely continue to increase. This is why it’s crucial, now more than ever, for people to assemble trusted financial planning teams that are thoroughly communicative and transparent.

Dave Ramsey put it best when he said that those seeking financial advice “should always look for a person with the heart of a teacher, not the heart of a salesman.” Good representatives and advisors know how to educate clients about all of their options without overwhelming them with information or selling them on anything. Because annuities are attached to commissions, it’s often up to the client to understand exactly how representatives are being compensated.

Consider vetting your financial planners with the same care you use to select your healthcare practitioners. Just as you would solicit second opinions and multiple treatment plans for important medical conditions, you should explore several retirement portfolio options and clearly establish how advisors may be compensated or affiliated. 

Your financial planner is someone with whom you and your family should expect to have a fruitful, long-standing relationship. They should be communicative and collaborative with you, the client, as well as your CPA (certified public accountant) and estate attorney. Multiple specialized advisors should be willing to work together, with the end goal of achieving not only the highest level of financial security for each client, but also the best peace of mind.


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