Reader Question: Is a 5% Return from a Secondary Market Annuity Too Good to Be True?

Reader PR writes in:

“Harry, what are your thoughts on secondary market annuities?  I’m looking for some higher returns for my savings.

Some of the SMA’s I’m looking at right now are returning 4 or 5%.  It seems like they are a pretty safe investment, but maybe I’m missing something.”

SMA_risky_investmentI’ll be honest, when I first got this question in my inbox, it took me a while before I remembered exactly what secondary market annuities were.  But whether you’ve heard the term SMA before or not, you’re probably more familiar with them than you think.  Here’s how the general process of buying a secondary market annuity works:

When someone wins a wrongful death lawsuit, or hits a $550 million powerball jackpot, the settlement is often paid out through an annuity.  For one reason or another, this person decides they need cash now(obviously they don’t follow this blog!).  They can sell their annuity at a steep discount to a specialty company called a factoring firm.  The factoring firm will then turn this stream of annuity income into a packaged security that can be brokered to investors like you and I.

Higher Return Always Equals Higher Risk

Secondary market annuities are probably most comparable to a fixed investment like a bond or CD since they ‘guarantee’ a certain return over a fixed period of time.  If we look at the first item on the list(11/28/12), we see a product yielding a 4% return over an 8 year period.  Conveniently, they also list the return of a 10 year treasury bond as 1.75%.  So why do these SMA’s return 2.25% higher than one of the safest investments in the world(treasury bonds are backed by the full faith of the US government).

Unfortunately, SMA’s are not some magic investment that guarantee a return of 4%.  There is inherent liquidity and legal risk to these investments that you need to be aware of.  You take on legal risk should a court find that for one reason or another, you are not owed the payments in question and liquidity risk since SMA’s cannot be resold.

Although these SMA brokers claim they have a team of lawyers review every contract, I would want my own third party verification if I was considering investing a large chunk of my money.  That’s obviously going to eat into your returns(lawyers charge a lot, trust me!).  I would personally never invest more than 5-10% of my portfolio in an alternative investment like this regardless of how safe it seemed.

Perfectly Illiquid

In addition to complicated legal risk, SMA’s are nearly perfectly illiquid.  That is to say, once you buy an SMA, you are stuck with it.  There is no secondary market for SMA’s.  On the other hand, treasury bonds are one of the most liquid investments on the planet, they can be bought and sold on the open market through banks and brokers or directly from the US government.

Even though the saying is older than ever, it still holds true: an investment yielding above average returns will always hold above average risk.  For some people, this 2% risk premium might be worth it, but for me, it’s most certainly not.  I’m going to stay far away from SMA’s until I see some genuine positive experiences from every day investors like you and I.  I think the biggest risk lies in the uncertainty factor of investing your money into a product that has so many intricacies that are beyond your control.  That’s what scares me most about SMA’s.

Readers, would you be willing to take on all this additional risk for 2% above a 10 year treasury bond?  If I’m going to take on all that risk, I want to see some way above average returns like with my Lending Club account(I’m still yielding 13% after 2.5 years).

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-Harry @ PF Pro

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Hi, I'm Harry, the owner and head writer for Your PF Pro. I started this site back in 2011 in order to create a place where young professionals could come and get all of their financial questions answered. On the site, you'll find articles on everything from asset allocation for retirement to saving money at Chipotle! So enjoy..

Comments

  1. says

    Hi Harry-

    You made a great point above about SMA’s being generally il-liquid- however that’s changed since the article was written. Readers viewing my inventory thru the link you put in the article should download our new buyers guide, because we’ve solve the liquidity issue with a new purchase procedure.

    We modeled what JG Wentworth has been doing for years, but applied it to the individual marketplace. Now, buyers through our new procedure can re-sell their SMA contracts in the future. like anything, there’s no guarantee of future values as those will fluctuate with rates current at the time you sell, but it’s a nice option now!

    Most of our buyers are either going long term, where a 6%+ guaranteed yield is good in any marketplace, or they are going short term expecting rates to rise. Regardless of your approach, SMA’s offer a good yield compared to other options, especially as they are now more liquid, and can close quickly with in stock inventory.

    worth another look!
    Nathaniel M. Pulsifer recently posted…New SMA Procedures Finally Unveiled!My Profile

  2. says

    We were talking about these the other day.
    People winning the lottery and taking the annuity payout, lifestyle catches up to them, they sell the income stream for a lower payout.

    They have people who will look for cases like this and work both sides of the case and whoever wins the money selling them a SMA.

    Very tricky investment.

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