Understanding Alternative Investments: Framework and Example

Face the Facts

Alternative Investments 101

Structured Settlements

Safely and reliably increasing your net worth has become very difficult.

Unfortunately, most people’s fears about the future are painfully accurate:

1. The world’s economy is going to be pretty rough for the next long while, and companies are not going to be worth twice as much in 10 years, which would be a 7% return. Dividend returns of 2.8% on the S&P 500 do not fix this problem.
2. Interest rates are very low – like 1% or worse at most banks – and with the economy likely to be lousy for a long time this situation is unlikely to change.
3. Everything costs much more than it did 10 years ago, and prices keep rising. The only price falling is the price of your house.

(If you want to know why things are such a mess, you can read my last essay on the explosion in the world’s debt.)

In this essay, I will show that your deep concerns are accurate, and then we’ll get down to business:  finding low-risk alternative investments that put returns back into portfolios. (skip ahead if you must)

Note from Brendan: If you’ve been enjoying my articles, please consider +1′ing me.

Investor beliefs in the 1980s/90s

Despite a decade of stagnation and some well-justified anxiety about the future, most people continue to invest like it’s the 1980s or 1990s.

Back then, you could believe some pretty simple things about the future.

1. Stocks return more than bonds over long periods, so I own stocks despite their painful volatility
2. Bonds will provide healthy returns over the next 10 years, just as they have over the last 20.
3. Inflation is a scary yet abstract concept that I can mostly afford to ignore because of my overall high returns.

Inflation is very real

The price of everything BUT stocks has gone up a lot in the last 10 years, since the tech bubble:

In fact, if we subtract the last decade’s 2.8% annual inflation from the “returns” of the bond and stock markets, we’ll see that your stocks are worth far fewer steaks, apples, and kilowatts than they were a decade ago.

Bonds run out of steam

The graph above makes bonds look pretty attractive, doesn’t it?  Unfortunately, bonds have had high returns because interest rates have fallen.

When interest rates fall, old bonds that pay at higher rates are worth more, giving a temporary boost to bond funds.  This boost delivers returns only as long as interest rates fall, and they are close to zero now.

This end to dropping interest rates means that the historic performance of bond funds cannot continue. Virtually ALL bond funds looked great over the last 10 years, but their forward-looking yields are much lower:

By now you should be even more convinced that you are right to be pessimistic, and – more to the point – that you can no longer square your actual beliefs with the assumptions that underpin a traditional portfolio.

So, let’s look at some alternatives.

Alternatives to stocks and bonds

Alternative investments vary tremendously. They have just two things in common:

1. Less liquidity. You typically cannot quickly turn these investments back to cash, and this is a good thing. Because liquidity is something people value, you can earn higher returns by sacrificing some liquidity in a portion of your portfolio.
2. More paperwork. While all investments are heavily regulated by the SEC, traditional investments like mutual funds or ETFs do not require your signature to buy them. Managers of alternative investments have more flexibility, but their regulations require more paperwork.

As a result of (2) especially, customers of wirehouse advisors like Merrill Lynch, Morgan Stanley, UBS, or Wells Fargo will never own alternative investments. The wirehouses don’t want to take on the paperwork, so investors can not access alternatives that trade liquidity for higher returns.

Bad vs Good Alternative Investments

Most alternative investments are hedge funds that promise to make money in up or down markets. These are highly risky, have a mediocre track record, and should be avoided.

The alternative investments that I like all take advantage of the current credit crunch:

• People who can’t get credit, but are creditworthy. You can loan them money or rent them something you own.
• People who can’t get credit, but have a long term asset and need money now. You can buy their asset at a steep discount.

Alternative Investments worth considering

The Alternative Investments that I like are all low risk.  When I trade liquidity away, I like to get higher returns in exchange while keeping risk low.

Completely tackling even this short list of examples in one essay would be too much. I’ll focus on one here: structured settlements.

Structured Settlements

A structured settlement is an annuity awarded to a victim from a personal injury settlement. Instead of a lump sum, the victim receives a stream of payments over a set period of time.

The loser in court purchases an annuity through a highly rated insurance company, and the winner (the injured party) gets paid over time by an independent, highly-rated creditor such as Met Life, Prudential, or Allstate.

Owners of these income streams often decide to sell part of all of them for ready cash.

Ever see one of those JG Wentworth commercials featuring people singing about how it’s their money and they need cash now?

Here are some stories to give you a sense of who might be selling a structured settlement and why:

• A child who receives a birth injury at a hospital might, 20 years later, choose to sell future payments to pay for college now.
• A construction worker who is injured on the job and receives a structured settlement with monthly payments for 30 years passes away unexpectedly, and their next of kin would prefer to have cash now for current expenses.
• A lottery winner is 65 years old and decides that they would prefer to sells the payments from years 15 through 30 to take a long-desired vacation or pay down their house.

Going to Google and searching for Structured Settlement pulls up a raft of buyers who bid on settlements. Buyers will do different things with the settlements they purchase.

Some buyers package settlements into large securitizations

The largest of these buyers convert huge pools of settlements into AAA-rated securities that they sell on Wall Street. Thanks to laws protecting the buyers of these settlements, the risks are very low, and the returns are higher than similar AAA-rated investments.

Here is the beginning of a recent JG Wentworth press release

Wednesday June 15th 2011, Radnor, PA – Specialty finance company J.G. Wentworth has completed a $265 million securitization of payment rights under structured settlement and fixed-annuity purchase contracts. J.G. Wentworth was the first issuer to securitize structured settlement payment streams in the asset-backed markets in 1997. Since then, the company has issued 23 securitizations backed by structured settlement and fixed-annuity receivables totaling nearly $3 billion.

For you research junkies, here is a link to DBRS’s rating of the issuance (28 page PDF).

Other brokers sell individual settlements directly to investors

Brokers such as Woodbridge or Catalina sell specific settlements to individual investors at higher rates.  Here’s how the rates compare:

Buyers of individual settlements can build their own portfolio, getting diversification while avoiding the huge Wall Street fees that strip yield from these otherwise attractive investments.

Types and Examples

Investments range from $25,000 to $500,000. Typical investors build a portfolio over time based on their particular criteria.

Immediate Income – Period Certain are very attractive for retirees. They typically start paying immediately at rates unmatched in the primary market for identical products. Should your payments outlive you, these become an asset of your estate and can be willed to your heirs.

Example: Prudential Life Insurance Company

• Three hundred and twenty four (324) monthly payments as follows:
• $700.00 from January 1st, 2012 till December 1st, 2038;
• Four (4) lump sum payments as follows:
• $25,000.00 due on January 1st, 2024;
• $37,500.00 due on January 1st, 2029;
• $50,000.00 due on January 1st, 2034; and
• $65,000.00 due on January 1st, 2039.
• Investment: $146,000 to yield 6.75%
• Total Payout: $404,300.

Deferred Income – Period Certain are attractive for people who have a sense of when they are going to retire in the future, but who have a higher tax bracket now. These result in effectively tax-free growth for an intermediate period before they start paying monthly.

Smaller Example: Metropolitan Life Insurance Company

• Three hundred and nineteen (319) monthly payments as follows:
• $268.00 from January 30th, 2021 till July 30th, 2047 increasing by 3% annually every August.
• Investment: $28,400 to yield 7.25%
• Total Payout: $129,582

Bigger Example: Mass Mutual Life Insurance Company

• One hundred and eighty (180) monthly payments as follows:
• $3,500.00 from December 1st, 2020 till November 1st, 2035 increasing by 2% annually.
• Investment: $236,000 to yield 7.25%
• Total Payout: $726,323

Deferred Lump Sum – Period Certain can be thought of as a highly illiquid CD with a very high rate. These are available with date ranges from 5 to 20 years, and can be very useful in any portfolio.  Because they are not taxed during intermediate years, they effectively offer tax-free compounding, which is very attractive.

Example: All State Life Insurance Company

• One (1) lump sum payment as follows:
• $289,115.05 due on December 4th, 2024.
• Investment: $108,815 to yield 7.75%

If you are retired now

For retirees who are staring at a shrinking portfolio and bottoming interest rates, moving part of your wealth to fixed income alternatives is a no-brainer.  Your only other option is to cut spending, reducing quality of life.

The way to begin is to liquidate some of your lower-performing assets and start with a few small dips into fixed income alternatives.

Making appropriate, conservative moves is the rule when you have a fixed set of assets from which to enjoy your retirement.  Your goal is to diversify across investments with expected yields of 7-10%.  This will likely double your current total yield, and at least triple your above-inflation yield.

If you are 10-20 years from retirement

For investors with a longer time horizon, reducing the number of eggs in the equities basket in favor of some fixed income alternatives will increase confidence in the doubling time for your portfolio.

While we all expect equities to eventually pull out of their decade-long slump, the driver of today’s bear market – massive public and private debt – will not easily disappear. Returns of 8% may sound boring, but that will double your wealth in 9 years. Do that a few times with some savings along the way, and maybe you can actually retire younger than your parents.

Next Steps

Usually this is where I tell my readers how to go do this stuff on their own using Vanguard funds or similar.  Unfortunately, structured settlements are probably not something you want to buy without help.  I have specialized legal counsel review every deal, for example. My next essay on Consumer Loans will offer an opportunity for determined self-investors.

If you do have a portfolio with your current advisor and want to create a set of side-investments with higher yields, then reach out, and I’ll see if I can help.