An investment study recently found that investors generally do not select the lowest cost investment. This has important implications in the selling of annuities. Three different groups were shown four S&P 500 Index mutual funds offered by four different fund families. They were given summary sheets showing performance, stocks held and fees. Keep in mind that the stocks held by each fund were identical because they each duplicate the S&P 500. The only difference is the annual management fee charged.
As rational economic beings, if two products are identical we would buy the least expensive product, but 81 percent of the participants in this study did not choose the cheapest fund.
Why did these bright people typically choose to pay more? They did not know how to compare returns.The investors largely based their decisions on the annualized return since the fund began and on the last 12-month return period reported by the fund. Yet there are problems with these timeframes. If one fund’s inception was at the beginning of the last bull market their returns look good, but if another fund began at the beginning of a bear market the overall returns would not look as good. It turned out the higher fee index funds happened to have start dates that included more up stock years than the lower fee funds, and thus had higher returns since inception.
The other problem was the 12-month periods were different; some showed the last calendar year, another used a September 30th close, and so on.
To see how much the end date matters consider the 12-month return for the S&P 500 was 3.5 percent for calendar year 2007 but it was 14.3 percent for a year ending September 30, 2007. I believe the main reason for the mostly poor choices in the study was due to “vividness bias,” wherein humans are subconsciously disposed to respond most favorably to what they see as the biggest stimulus, in this case the largest number observed.
This study reinforces what index annuity marketers already know, and which is that people are inclined to buy the annuity with the highest rate or cap. Even though participating in 60 percent of the point-to-point index gains would result in better performance than getting 100 percent of the averaged annual gain, we respond more favorably to the averaging method because 100 is larger than 60.
It also means higher fees may be masked by cherry-picking periods to showcase one annuity over another. As an example, an index annuity showing performance since 2002 should have a higher annualized return than another showing annualized returns since 2000 (which would include the millennium bear market).
When intelligent consumers are presented with the data and need to make good decisions, they often fail to do so because of a reliance on “whatever looks biggest;” often not a good basis for the decision. Consumers benefit from having knowledgeable counselors to help them make the best choice and to see past their biases.
Don’t miss Jack Marrion at Senior Market Advisor Expo, Aug. 20-22. Visit www.seniormarketexpo.com for details.