I take a break from my five day commentary on the structured settlement industry to instead cover the issue of interest rates and trying to sell structured settlements at what are effectively zero rates, a calculation arrived at by the average yield on structures being 3% to 4% and the effective rate of inflation running at the same 3% to 4% as well. I felt compelled to write this due to the bashing that Bill Gross, the brilliant bond manager of PIMCO is taking in the press for his Cassandra like warnings earlier this year for people to get out of US Treasury Bonds and long term fixed bonds in general due to the inevitable impact of the end of the administrations policy of pouring debt in to the bond market.
A lot of financial writers and bond managers keep talking as if the trillions in debt being issued, and brought, by the US Government and the resultant low interest rates, are here to stay for awhile, when the facts are that we are likely in for a swift and rude awakening regarding interest rates, the value of the dollar and the rate of inflation once this Ponzi Scheme, (Gross’ term, not mine) comes to it’s inevitable conclusion.
For those of us who are somewhat mathematically challenged, you arrive at the effective rate of return on an investment by taking the actual yield on a bond or structure, lets use 4%, and then measuring the actual or projected rate of inflation during the duration of the payments. By both established and colloquial measurements of inflation, we are seeing the cost of living in areas such as gas, insurance, food, commodities, utilities, etc, running well north of 4% right now. When matched against the yield on most structures of 3% to 4%, thanks to the continued plunge in interest rates toward zero, it is clear that most clients obtaining a structured settlement right now is essentially realizing a zero return on their allocation of funds.
Painful to admit, but intellectual and financial honesty require it.
That said, this situation will likely end soon, and change course quickly and dramatically, once the Federal Reserve and the US Treasury end the Quantitative Easing, i.e. QE II, and the Fed no longer buys 70% of the US Treasury Debt being issued like a flood into financial markets.
The point being is that while I don’t pretend to be a market genius, I am pretty good at listening to the people in our midst who are the true geniuses, such as Bill Gross and Jim Druckenmiller, both of whom see this as the looming disaster it is about to become. Therefore, for those of us in the settlement profession who are advising people on allocating their one time settlement proceeds into structured settlement we need to be exceptionally careful about long term commitments at these rates and use designs that allow for reinvestment of funds in the near future when rates are higher.
We also need to be exceptionally careful to warn clients to NOT utilize outside managers for their funds who are buying bonds, bond funds, or any investment vehicle that would be impacted by a rise in rates. The carnage in bond funds that is about to occur, as well as asset value loss in a long bond’s market value, is going to be brutal.
The solution that we are recommending to clients who are receiving settlements and have to do SOMETHING with the money they are awarded, is to carefully structure payments monthly payments over the short and medium term to cover living costs, but then provide for lump sums to be reinvested in non-qualified accounts over 3 to 7 years at what are certain to be higher interest rates. While they will theoretically give up some of the tax advantage of a structure on the reinvestment, it is my experience that most of our clients are in a no tax or low tax rate scenario due to a very low real income and what they need more than tax free money is maximum cash flow and return from a highly secure investment. ( Ideally a non-qualified immediate annuity if suitable.)
The net result should be insuring the bills are paid today, no long term interest rate risk or exposure and large sums to reinvest when rates are higher. Not a perfect solution but one that works for the vast majority of our clients.
In summary, don’t be fooled by todays rates and the media reports of a resurgent economy. Interest rates have been cynically kept so low that people were forced to move funds into bonds and stocks, but the result over the next few years is that unless those stocks are in companies that benefit from inflation and the bonds are VERY short term in duration, those portfolios are going to be hammered. My advice is get liquid, cut debt and prepare to reinvest when the rates jump up dramatically in the next six to 12 months.
We won’t be selling zero yield structures for too much longer but in the mean time we need to prepare todays clients to reinvest when rates or risk further alienating our current and future clients through poor planning.