Some Structured Settlements Are For Suckers

Steve Pomeranz: I was speaking with some potential clients the other day, as they were doing their due diligence to choose an adviser, and they mentioned to me that one adviser that they had talked with had recommended structured settlements as a good investment. Now, that’s not something you hear about every day.

So, when something like that comes to my attention, I think this would be a good segment for the show, to find out more about structured investments and to help everybody understand them. So, I called a thought leader in our industry, Larry Swedroe, to talk about this with me.

He had written an article some years ago about that. Larry is Director of Research at Bam Alliance, which is a large RIA located in St. Louis, and he’s well known in the industry. He’s the author or co-author of 13 books on investments and planning, including his most recent book, Think, Act, and Invest Like Warren Buffett.

Hey, Larry, it’s good to talk to you again.

Larry Swedroe: Good to talk to you, Steve.

Steve Pomeranz: So, let’s get into this. I said this term, structured settlement. What is a structured settlement?

Larry Swedroe: Well, what can happen is, say Steve, you are in an automobile accident. You get hit by a truck and the insurance company offers you a settlement and to pay that out over a long period of time.

Now you’ve got that, and now, you decide you’d rather have the cash up front. So, somebody, in effect, pays you to the cash, and now they own that structured settlement, that series of cash flows. And they, of course, want to profit from that, and they look for retail investors who are willing to pay, say, a higher price than they did.

And so, that’s what you’re doing; you’re buying, basically, a stream of income. Typically, it may be, say, for 20 years. It’s not for life, and you have the credit risk of the insurance company, who is typically the back of these.

Steve Pomeranz: All right, well, let’s get into that in a minute.

So, this is kind of like the lottery, in a sense; how you can get a lump sum or you can get these cash flows of throughout 20 years or lifetime. Let’s take 20 years as an example. So, let’s say, a person, in this case, has an accident and gets these cash flows.

They decide, “Hey, I’m sick of the cash flows, I want the money. I want as much money as I can in a lump sum.” So, along comes an investor, and then they buy this from the insurance company. They pay a certain lump sum which they give to the owner of the policy, so to speak. And then they kind of mark it up and then they sell it to retail investors. Did I get that right?

Larry Swedroe: Yeah, that’s exactly right. The question you might ask is if it’s such a good deal, why is it being offered to you? Why isn’t Goldman Sachs buying it and putting it in their portfolio? Generally, a good way to think about these things, what makes you so special?  If it’s so good, why isn’t the Yale Endowment investing in it? A really smart sophisticated investor?

Steve Pomeranz: Yeah, good point, that’s an excellent point. Now these kinds of investments seem attractive because the amount of cash flow you get is relatively high relative to safe investments like treasuries and CDs.

Isn’t that accurate, and if so, why is the yield so much higher?

Larry Swedroe: Yeah, that’s certainly…the yield’s going to be higher, and it’s going to be higher for a few reasons. First of all, there is credit risk you’re accepting here because you’re getting that cash flow from the insurance company.

So, the comparison that you should make should not be with treasuries or CDs but, let’s just use a particular name, let’s say Prudential Insurance. If that’s the issuer here, you’re taking their credit risks, and let’s assume it was a 20-year structure. What you should do is look to see what interest rate you could earn by buying a Prudential 20-year bond. Or better, of course, it would be safer—at least it would be diversified—buy a mutual fund that owns lots of bonds with the same, let’s say, double A credit ratings, assuming Prudential…and that’s the comparison I would make. But even then, you should get a large premium above that, by that, I mean a higher yield because it’s the mutual fund, you bought that, you would have daily liquidity, number one, so if an emergency came up, you could sell it and get it liquid. Second thing is, if it was in a taxable account, if rates went up, you could harvest and take a loss on it, while it’s your only structured settlement from Prudential, it’s totally a liquid

Larry Swedroe: Nothing pretty much to do with that without taking a very large loss and a secondary market transaction, which means you’re also then losing this ability to harvest losses that you get with a mutual fund.

So, that’s why the yields are higher, and in general, my rule of thumb is this: If you hear the word structured note or structured settlement, you should run extremely quickly away because you could be certain the structure is done in a way that it benefits the issuer, and not the buyer.

And the reason that’s all you need to know is that, if Prudential could raise money at a lower cost of capital, it would sell a bond directly.

Steve Pomeranz: Yeah. All right. I want to get back to this term liquidity because this is vitally important when investing. So, there’s good and bad of everything, right?

One of the good things about having a liquid bond market—having a bond market where you can buy and sell bonds all the time or stocks all the time—is that you could get to turn this investment into cash on a given day at a given price. The price isn’t necessarily guaranteed, but the ability to turn it into cash is—I wouldn’t say guaranteed—but it’s a very, very high probability that you’ll be able to do that.

When you’re dealing with these structured investments, you basically stuck for the whole period of time. So, you better be sure that you can handle not having this lump sum back for 20 years in case there’s an emergency or some kind of event that was unforeseen. Now you mention that you could sell these in a secondary market, meaning that there are buyers who will come in and buy this from you.

But it’s not a very well developed secondary market, so the price you’ll get will most likely be much lower than it’s really, really worth. So, in effect, you still lack that liquidity we’re talking about. So, when you don’t have liquidity, you should expect a higher yield because there’s never a case where you get something for nothing.

If the yield is higher, there’s got to be some catch. You want to add to that at all?

Larry Swedroe: No. Basically, that’s exactly right. Now, that doesn’t mean you should never invest any of your money in a less liquid asset. Yale Endowment knows it’s not likely to spend more than say, 6% or 7% in any one year.

So, it can take some portion of its portfolio, maybe 20% or 30%, and invest it in highly illiquid investments like a rubber plantation, say, in Indonesia that won’t pay out for 20 years as the trees grow, but they can do that. Now as you have the ability to put some small portion of your portfolio in a very illiquid investment, you might consider it.

But in this case, I don’t believe you’ll ever find that it will be attractive for the reasons I gave you and the cost to get out of it, isn’t going to be like 1% or 2%. It might be 8% or even 10% if you could get that.

Steve Pomeranz: Right.

Larry Swedroe: So, I would say for most investors, this is not a good illiquid investment; there are ones that actually we do recommend and I personally invest in.

Steve Pomeranz: So finally, this falls under the fixed-income category of your investment portfolio. These are bond-like. So, I think the idea though, that is the bond part of your portfolio should be the safe part of your portfolio.

So, in a sense, this investment also may violate that tenet of correct investing. Would you agree with that?

Larry Swedroe: There are many people who have different opinions, Steve. But you and I are on the same page. And I wrote a book, The Only Guide You’ll Ever Need For Fixed Income Investment.

And in there, we state, my co-author and I, that we believe that bonds should be the safe portion, as you stated. In other words, you want to have a sufficient amount of safe bonds that will do well, generally, when equities are doing poorly so it adds stability to your portfolio and doesn’t allow your portfolio to experience a greater loss than your stomach can handle.

In that case, you panic and fell. And so, what I point out is in 2008, while things like high-yield bonds, preferred stocks, junk bonds, emerging market bonds, REIT’s, all have higher yields than the safe treasuries or AA, AAA rated municipal bonds we recommend; in ‘08, they went down from as little as about 25%, as much as 60% or 70%, while the same bonds we bought were generally up in the low double digits.

That’s a huge benefit when your equities are dropping 40% to 60%.

Steve Pomeranz: Good point.

Larry Swedroe: So, we would never recommend investing in products such as these.

Steve Pomeranz: My guest is Larry Swedroe, Director of Research for the Bam Alliance. Larry, let’s switch gears here because I love to talk about investments and I know you do as well.

I know you’re a strong proponent of index investing as am I. So, I want to get into that in a second, but what I want to talk about is this fact that I keep getting calls from clients who just really feel like they want to cash out because they read articles about the market being very, very, over-valued or too risky because of the current politics, and they want to know, “Should I get out? Can I get out before the market goes down? Steve, can I go to cash now, we’ve made all this money. Can I go to cash now?” Do you think the market is too over-valued, Larry?

Larry Swedroe: [LAUGH] Great question, and it’s actually one I address, Steve, in my column on ETS.com, so the readers could find it there.

It’s an August 23rd piece, and it’s called “Wait And You’ll Likely Miss Out.” So, let’s first address the issue that, going back to as far back as 2013, we have people like Jeremy Grantham and John Hussman, two well-known gurus, saying the market was as much as 60% to 70% over-valued.

And they were warning you to get out and obviously if you got out, you missed pretty good returns over the last four years. There is no one that I’m aware of who has a clear crystal ball and has a good track record on market timing. That’s what the research shows, but I would add this, would you rather listen, Steve, who do you think your listeners should listen to?

Gurus on CNBC or Warren Buffett when it comes to investment advice?

Steve Pomeranz: Hang on, let me think about that. Yeah, so obviously, we know Warren Buffett is the answer, what does Warren Buffett say about that?

Larry Swedroe: Right, and since the great anomaly that people idolize Buffett, and most people actually not only ignore his advice, they do exactly the opposite.

And Buffett has said, he hasn’t even read or listened to economic or market forecasts in 25 years because he knows they have absolutely no value. And they tell you nothing about where the market is going, though they tell you a lot about the person. So, let’s just touch briefly on this.

There was an interesting study that was done which I wrote up on the paper. So, let’s assume you’re convinced we’re going to get a 10% correction, and you believe it’s going to happen in the next three years. And, by the way, that happens 54% of the time that in any three-year period, you will get at least a 10% correction. And if you’re right, you get out now, you benefit 10% by doing so—that’s the average benefit.

Steve Pomeranz: Okay.

Larry Swedroe: On the other hand, there is 46% of the time, my memory serves, that you’re incorrect. And when you’re wrong, you lose on average 30%. Okay, so clearly, on a risk-adjusted basis, you are way better off staying invested because roughly, it’s 50-50.

But when you’re right, you make 10% and when you’re wrong, you miss out on 30. And that’s because you can get a 10% correction but not from today’s levels. I’m sure Grantham and Hussman will eventually be proven right, like a broken clock that’s right twice a day. But they’re going to be four or more years too early and you missed out.

Steve Pomeranz: Yeah, well, it’s interesting because Grantham just changed his tune and he says that he’s now bullish on stocks and he’s been a bear. And I have to be honest about Hussman. I followed him for a long time. This guy is always bearish. And I can’t imagine that he’s made any money during the years because he’s never in the market, according to what he says in his writing.

So, I guess the idea is, look, we can’t foretell the future. But we know that internally, the companies that are sitting in these indexes, over time, on average, are creating more wealth for themselves and for their shareholders and, eventually, that gets reflected in the price of their stock.

And if you average all of that, all the winners and the losers by staying with the plain old index, with low expenses, you’re going to capture that. And those returns over time have shown and will probably continue to be superior to those of fixed-income investments.

Larry Swedroe: You sound almost like Warren Buffett there-

Steve Pomeranz: I know.

Larry Swedroe: Steve, let me just add this. While the US market is highly valued, if you make proper adjustments to the earnings numbers, which I’ve written about on my blog at ETF.com, they are really only about 10% or 15% above appropriate adjusted historical levels.

And given the exceptionally low level of interest rates, stocks don’t look that expensive to me. They look highly-valued, but not out of the realm of reason like we were in 1999, early 2000. But I would add this, while US stocks are more expensive than their historical average, international stocks are no more expensive and may be cheaper and certainly, that’s been the case also for emerging markets. And investors, unfortunately, tend to dramatically underweight those. And that’s a big mistake, a home country bias. My personal recommendation is 50% US and 50% international. And of the 50% international, I would have three-eighths developed and one-eighth emerging, and the reason is, that’s how the global market capitalization works out. And I don’t think I’m any smarter than the markets, in general, and I don’t believe there is anyone else out there.

Steve Pomeranz: Larry, we’ve got to stop you there. We are out of time. My guest, Larry Swedroe, Director of Research for the Bam Alliance.

If you have any questions or any comments, and you’d like to get in touch with us, don’t forget to find us at stevepomeranz.com. Thanks, Larry, thanks for taking your time.

Larry Swedroe: My pleasure, Steve.