Don’t Believe Everything You’re Told…

November 15, 2013

In one of the cooler things I’ve read lately, law enforcement authorities conducted a sting operation to nab a world infamous pirate.  They had to draw him to them since they had very little chance of getting past his protectors. So, they created a fake premise of asking him to be an adviser to a movie about Somali pirates. He took the bait, went to them and was arrested. I’m guessing he is regretting that choice!

I’ve seen a whole lot of advertising lately about investments that “guarantee” a rate of return that sounds too good to be true.  In a world where banks are paying less than 1% for savings accounts and CDs, the economy isn’t exactly firing on all cylinders and there is a lot of uncertainty about our government and governments around the world, it sounds too good to be true for an investment to give a guaranteed 6-8% rate of return. What’s the old saying?  If it’s too good to be true, it probably is!

A few days ago, my mother called me to ask if I’d review something for one of her friends who was pitched a guaranteed 7% investment by her financial advisor. I, having been incredibly fond of the Curious George book series as a kid, was intrigued and wanted to learn what was behind this “too good to be true” guarantee. So, I said yes.  I asked that all the marketing materials and a prospectus (if one existed) be sent to her friend via email so it could be forwarded to me and I could chime in with my $.02 worth.

It turns out that the guarantee exists only in certain circumstances, and not just a general guarantee.  The 7% guarantee is called a “guarantee for income.” What does that mean? Well, in this case it meant that the initial investment would be credited at a 7% growth rate in a special “income account” which was simply an accounting mechanism.  So, a $100,000 initial investment would be worth ~$197,000 after 10 years in the income account.

But if the underlying account didn’t grow at all, it could still be worth the initial $100,000 amount.  If after 10 years, you wanted to transfer that account to another firm, you’d only get the $100,000 “real account value” not the $197,000 “income account value.” That surprised my mother’s friend!

So then, what’s the use of the “income account?” The $197,000 value could be used to generate a monthly income (at any point, not just at the 10 year mark), but that income is limited to a 4% annual withdrawal. (The reason for the 10 year view is that if she chose to sell the product at any point during the first 10 years, there is a back-end “surrender charge” that would be due and would eat away at the real value of the account.)

Access to any more principal than that reduces the account value and re-sets the 7% guarantee value, so the “gains” accrued in the income account are only accessible to a very limited degree. For investing $100,000 and waiting 10 years to touch it, she was only able to have access to less than $8,000 per year from this product. After understanding what the phrase “guaranteed for income” means for that product, she is going to choose not to invest in this product. Losing 10 years of liquidity for a guarantee that isn’t as awesome as a 7% guarantee sounds like in this investment climate was not worth the limitations.

All she heard initially was that the investment was guaranteed to return 7% every year.  Fortunately, she slowed down enough to hear the rest of the words and do a little homework.  Whether you are an investor looking for ways to boost your preparedness for retirement or a Somali pirate, it just might make sense to not believe everything you think you hear!