Financial Endurance
As an occasional insomniac, I’ve watched some riveting 3:00AM infomercials over the years. As a survivor of the 1970s and 80s, I marveled at products like the Pocket Fisherman and Ginsu Knives (“It dice, it slices, it even purees… But wait there’s more!”). And the ‘90s were even more exciting with Couvre, the spray-on hair for receding hairlines like mine. The 2000s brought us Vince with his ShamWow towels and Phil Swift with Flex Seal which can turn old screen doors into seaworthy vessels.
While my enthusiasm to “act now!” wore off by morning, I do recognize that many of these products can be useful even if they don’t change your life forever as promised. Well, maybe not so much the spray on hair product.
All joking aside (I promise), an example of “too good to be true” promotions that are more relevant for this “Financial Endurance” column are radio and TV ads, such as... “Are you tired of gambling your retirement savings on the ups and downs of the Wall Street casino? What if we told you that you can make money when the market goes up but not lose your investment when the market falls?”
What I’m referring to are provocative sales pitches from providers of Indexed Annuities and other types of “Outcome-Driven Investments,” commonly known in the financial industry as “Structured Products.” While there may be some seeds of truth within these hyperbolic statements, let’s unpack and put them into a more practical context.
“Structure Products” comprise a broad category of financially-engineered investments that often use derivatives and/or leverage to target a specific range of investment outcomes. So, for example, if you are concerned about market volatility and cannot tolerate the risk of a significant loss of value, you may be willing to forego some of the market’s upside potential as tradeoff in order to buffer at least some portion of the downside risk.
These fairly complex vehicles come in a number of flavors, each with an almost infinite potential for customization based on an investor’s risk tolerance, time horizon and financial needs. Among the more common categories of Structure Products are Structured Notes, Indexed Annuities and Market-Linked CDs.
Structure Notes are essentially a debt security, like a bond, issued by a financial institution. They typically carry some degree of principal protection guaranteed by the issuing institution. The differentiating characteristic is that the interest earned on the notes may be based to some extent on the performance of a market index, such as the S&P 500, or other securities, currencies or commodities.
An Indexed Annuity (aka Fixed-Indexed Annuity or Equity-Indexed Annuity) is similar to a Structured Note but is “wrapped” into an annuity insurance contract. The annuity structure also provides some benefits such as tax-deferral of the income earned (as with all tax laws various limits and exclusions apply) and, in some case, may provide a death benefit and some protection from creditors. Unlike Variable Annuities which allow annuitants to invest directly in an array of investment funds, Indexed Annuities are generally not regulated as securities. Their performance is somewhat linked to a market index depending on the specific annuity contract. As with more traditional Fixed Annuities, Indexed Annuities carry a life insurance company’s guarantee to return the principal (aka premium) and accrued interest at the end of the contract term. However, the accrued interest is typically based on some function of a market index’s performance over a specified period of time and typically subject to specified limits.
Market-Linked CDs are similar to Structured Notes and Index Annuities in that they too accrue interest based on some portion of the performance of a specified market index, basket of securities, currencies or commodities. The difference here is that these are certificates of deposits (CDs) which carry a bank’s guarantee and often with FDIC insurance protecting your principal (up to standard FDIC limits). Perhaps you have seen advertisements for Gold-Indexed CDs which base their rates on a formula somewhat linked to the performance of gold.
So what could possible wrong with earning a capital market return on your money while enjoying a bank’s or life insurance company’s guarantee, you ask…
Well, for starters, as a buyer of a Structured Product you do not have an ownership interest in any index or other funds, stocks, bonds, currencies or commodities. But instead, you own unsecured guarantees from the Structured Product’s issuer that they will fulfill their contractual obligations. The strength of those guarantees, of course, depends entirely on the creditworthiness of the issuer.
Therefore, you are not entitled to many of the benefits typically enjoyed by investors in mutual funds and marketable securities, including daily or real-time market liquidity, transparency of fees and expenses, voting rights, and readily-available valuation of your investment. For example, Structured Products cannot readily be traded or redeemed before their expiration dates, you are not entitled to any dividends paid by index funds or individual securities, and it can be extremely difficult to comparison shop Structured Note, Indexed Annuity or Index-Linked CDs given their uniqueness.
So given all their complexities, illiquidity and high embedded costs, why does this article’s title imply that these products “May be good enough”?
Well, Structured Products can be used as a tool in managing investment risk and may, in some cases, have a place in an investor’s portfolio. So as an advisor who aims to help clients accumulate, protect and enjoy their wealth, I like to keep up to date on various tools that may help in achieving an individual client’s goals and aspirations.
“But wait, there’s more! …”
In the coming weeks, in this column, I will share information and knowledge on many more “Financial Endurance” topics. Among those include:
