The Costs of Illiquidity

Liquidity is underrated.  What’s that, you say?  You are earning nothing on your slack cash balances?

Well, welcome to the club.  I am earning nothing there as well.  To earn money on short duration assets in this environment means taking risks, like Pimco does with its ETF with the ticker MINT.

Now, many will offer yield in an environment like this, but at a cost — a long surrender charge.  The long surrender charge hides the transfer of future yield to the present.

I am talking  about more than annuities here.  There are other illiquid investments being proffered today that offer a high “yield,” notably fixed payment streams from insurance companies that are life-contingent.

This is the deal:  There are some annuitants who would rather have a lump sum than a payment stream.  Some firms will buy the payment stream at a price attractive to them.  Then they try to sell the payment stream to an investor at a higher price, thus eliminating their risks on the annuitant prematurely dying.  But how good as an investor would you be at evaluating the risks?

  • You do realize that you aren’t buying a bond here — at the end you are not getting your principal back.  So what’s the yield? — it isn’t the annual payment divided by the purchase price because part of each payment is an uncertain partial return of principal.  Do you have your own actuarial consultant to calculate the yield, or are you blindly trusting the seller?
  • So you bought out the annuity of another person.  How certain are you that he will live a long time?  Why are you smarter than the seller regarding  his own life?
  • Unlike an annuity on your own life, the payment stream may end before or after you die — a classic asset/liability mismatch.
  • Is there any possibility that you will not get paid?  Is your contract illegal?  Have you retained your own counsel in the matter, or are you trusting the seller?
  • Do the IRS immediate annuity tax rules apply in this situation?
  • If you need cash, you will have a hard time selling this — one of the few potential buyers is the friendly guy that sold it to you.  The price spread between selling and buying is huge, and not in your favor.
  • You do realize that unlike an annuity on your own life, this is not judgment-proof.

There are all manner of illiquid investments offering yield, but almost all of them lock the investor up for a time.  Think of them as quirky Certificates of Deposit, minus the FDIC.  Particularly egregious are EIAs with long and high surrender charges.  (The agents are paid a lot to sell those.  Never trust an insurance agent who is receiving a large commission to sell you an annuity.  Note: if they won’t disclose the commission, know that it is roughly the size of the initial surrender charge.)

The Cost

Illiquidity means a loss of flexibility.  If your money is tied up during a fall in the market, you will not be able to take advantage of what could be a 30-50% return over one or two years when the market bounces back.  That is a lot to give up for a little bit of yield.  Personally, I prefer flexibility.

The costs of illiquidity are quiet.  The extra yield seems free until there is a need for ready cash, whether to spend or to take advantage of investment bargains.  Personally, I’ll take the loss of income, and keep the flexibility.

Also, avoid unusual investments that are hard to evaluate unless you have expertise greater than that of the seller.  Don’t buy what someone wants to sell you; buy what you have researched and want to buy.

PS — this is another reason why I encourage people avoid “sales loads” in investing.  Mentally, it ties your hands, because you want to recoup the load, or not incur the surrender fee.

Full disclosure: I have one client that owns MINT in his portfolio with me as a cash substitute.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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