Last Updated Jun 30, 2011 6:49 AM EDT

A blog reader recently asked me for my opinion on investing in structured settlements. I asked my Right Financial Plan co-author Tiya Lim for her thoughts, as she analyzes these types of investments for our firm. Here’s what she had to say.

A company sent the reader a few proposals, which all promised high yields with cash flows backed by highly rated insurance companies. One specific example was structured like this:

Insurance company: Prudential Life Insurance (A+ Rating)

Initial investment: $38,731.58

Payouts:

• March 11, 2024 — $60,000
• March 11, 2027 — $30,000
• March 11, 2030 — $15,000

Yield: 7.75 percent

A yield of 7.75 percent sounds great in today’s interest rate environment. but is this really a good investment? Let’s look a little deeper.

What’s a structured settlement investment? When plaintiffs are awarded settlements, they’re often paid in lifetime or periodic installments. If the recipients need all the cash now, they can sell the structured settlement for a lump sum payment and give up future rights to the cash flow of the settlement. The company that purchases the structured settlement can then sell cash flows to investors, such as the reader who submitted the above proposal.

Would I recommend this product? No.

First, not only is the maturity of the product long (almost 20 years), but the product is also illiquid. While there may be a secondary market to trade structured settlements, liquidity is unlikely to be as robust as it is in the bond market. When you invest in illiquid assets, you should expect a liquidity premium. When one isn’t present, you’re simply taking risk without being compensated for it.

Also, although the credit rating of insurance company is strong, there’s certainly credit risk in relying on cash payments over the next 20 years from a single insurance company. Does AIG ring a bell? Proper diversification can greatly reduce this risk.

Finally, if you compare the Prudential structured settlement to a corporate bond index, the case for structured settlements becomes even less appealing.

The higher yield looks pretty substantial. However, keep the following in mind. If the duration of the index were extended to match the Prudential product’s duration, the yield gap would be much smaller. Then, the question becomes: Is the additional yield worth the additional risks we discussed earlier? Given that the main role of fixed income is to dampen the risk of the portfolio, it doesn’t seem worth it.

By going for higher yield, you’re accepting more risk. Remember, there’s no such thing as a free lunch.

Photo courtesy of Vectorportal on Flickr.

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