Buying Behavior: How 2011 Will Affect Annuity Sales in 2012

Although we like to think that we make completely rational decisions there are 25 biases that often get in the way and result in a less than optimal choice. Four are especially prevalent in the financial world and will have a big impact on the way consumers make decisions this year. The biases are:

Projection Biastaking what happened yesterday and today and thinking it will be repeated tomorrow.

Herding–following what other people do.

Loss Aversion–distaste for an actual or potential loss.

Anchoring–basing our decision on a particular starting point.

Here's how these biases will affect consumer annuity buying decisions.

Interest Rates

The above chart shows what happened to 10-year U.S. Treasury Note yields in the last eight months of 2011 and its shape mimics what consumers are seeing on their money market accounts and renewing certificates of deposit. Looking at the chart, where do you think consumers think interest rates will go in 2012?

The answer is projection bias will cause most consumers to think that rates will continue to fall (even though they're near zero). It tells them that the bank is not going to be a good place for higher yields. The duration of the interest rate drop–CD rates have been falling for five years–may be causing more consumers to lock in longer-term vehicles for the higher rates rather than rolling over short-term CDs in case rates head up. Themessage for the fixed annuity world is projection bias is telling consumers that the bank is a bad place for good yields.

Investments

This chart (below) shows how the S&P 500 moved in the last eight months of 2011. Looking at the chart, where do you think consumers see the stock market heading in 2012? The answer for many consumers is they don't have a clue. The past doesn't show a pattern so projection bias doesn't help decisions. Without a pattern consumers then rely on another rule-of-thumb which is to follow the herd.

Herding behavior goes back to those prehistoric days when if you saw members of your tribe running you ran too, because they were either fleeing from danger or toward food. Many studies have pointed out most consumers invest the same way. The problem with 2012 is the herd is hearing from too many drovers, all going in different directions. Are stocks undervalued or overpriced? Does the lower price of gold mean the bubble has burst or this is a buying opportunity? Consumers can't use projection bias or herding behavior to help with their decisions, because the patterns aren't strong enough, which means the impact of other biases is more pronounced.

Losses

Loss aversion can be a fear of losing what we have–an actual loss. But it can also be a fear of missing out on a gain–an opportunity loss. Usually both of these aversions are equally strong. Which fear do you think is greater in the consumer's mind today? Based on what I'm seeing the fear of actual loss is driving consumers and that is good for index annuities.

Part of the problem with presenting the index annuity story in the past is there were often limitations on the gains due to participating in less than 100 percent of the upside or having a cap placed on the gain credited. The specter of missing out on potential gains loomed large and caused many consumers to forgo the market protection FIAs offered, but this had changed. The 2008 financial crisis and its aftermath have vividly shown the effects of actual losses, but many consumers have been unable to avail themselves of fleeting opportunities. Consumers have shown Wall Street–by dumping mutual funds–that protecting what they have is more important to them than missing out on some new gain. One result is Wall Street players that once dismissed index annuities are beginning to offer them.

Biased for FIAs

Banks rates won't get better (projection bias); the pundits and prognosticators offer conflicting views so I don't know what to think (herding); and it isn't worth losing what I have to try to squeeze out an additional couple percent of gain (loss aversion). These are the mental anchors used as decision-making starting points going into this year and it creates an extremely favorable environment for index annuities.

The FIA points that enhance the effects of this anchoring are the higher potential yields; that both principal and credited gains are protected from market risk; and that the design of the index annuity protects you regardless of how the herd moves because you participate in index gains, but also the gain calculation resets to give you a fresh start if the index drops. Normally biases get in the way of making a good decision, but in 2012 they support the decision to purchase an index annuity, which is a completely rational one in these uncertain times.

In summary: