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.”

I’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