J. Michael Bishop, JD
Smiley Bishop & Porter, LLP
1050 Crowne Pointe Parkway
Atlanta, GA 30338
Interest rates on bank CDs and money market funds have been at historic lows over the last several years. Sure, everyone wants to make more income from their assets. But always remember there is no free lunch. No matter what a salesman might tell you, with bigger returns come bigger risks.
In an effort to attract seniors’ retirement funds, Wall Street has introduced an array of increasingly complex products that promise investors higher yields than are available from CDs or government bonds. Unfortunately, most of these products carry the danger that an investor can lose most or all of his or her principal investment. In many instances, higher yielding investments are simply inappropriate for seniors seeking to preserve their assets and should not be recommended by stockbrokers, financial advisors or investment advisors.
Some recent examples of higher yielding investments that have been problematic or even catastrophic for senior investors are discussed below.
Reverse convertible notes— Reverse convertible notes are short-term bonds that pay comparatively high interest rates during their term. However, the big question is–will the investor get his or her principal back when the note matures? In many cases, the answer is no. A reverse convertible note’s principal repayment is linked to the performance of a specific stock or index, like Dell or the NASDAQ-100. If the price of the linked security falls below a predetermined level when the note reaches its maturity, the principal returned to the investor will be less than the face value of the note. If the stock or index appreciates during the note’s term, investors do not receive any of the gains; they just get repaid their principal. On the flipside, if the linked security’s price falls, investors may only get a fraction of their principal back. Many seniors learned the hard way in 2008 and 2009 that they had lost their principal when their notes matured at a time when the stock market was depressed.
Principal protected notes (PPNs)—Principal protected notes are “IOUs” to pay the investor at a guaranteed rate of return (and a possible upside) in one to ten years. These PPNs contain embedded derivatives that are tied to securities market indices, a stock, commodity, currency, or some combination of the above. They were marketed by many brokerage firms as if they were a virtual ‘no lose’ proposition—a guaranteed minimum rate of return, plus an upside, based on the stock market or other index. However, these notes were not the safe investment they were portrayed as being. Remember that a note is only as good as the financial strength of its issuer. If your broker sold you a Lehman Brothers’ PPN, Lehman’s bankruptcy in 2008 put an end to any illusion that your principal was really protected. Also, please do not believe that the fact that a bank is selling the PPN means it has FDIC protection; it doesn’t. These notes are complex instruments that come with loads of “gotchas” like arbitrary caps on upside gains.
High yield/Junk bond funds—Traditionally, “high yield” or “junk bond” funds have been largely comprised of lower rated “below investment grade” corporate bonds that pay a higher rate of return than AAA rated bonds or treasury bills. As yields on corporate bonds declined, a few portfolio managers sought to increase the yield of their funds by investing in higher risk esoteric “asset backed securities” like “collateralized debt obligations” (CDOs). Many CDOs owned pieces of subprime mortgages. These CDOs have been called financial meth labs. When the housing bubble burst in 2007, the risks of the complex products held in these bad funds were finally realized. Investors who could not afford to lose their funds sustained substantial losses.
Private placement investments— Under the federal and state securities laws, most securities must be registered with the SEC before they can be solicited or sold to the investing public. In the issuer’s registration statement and in periodic reports filed after a company goes public, the issuer of the security provides detailed financial information which investors and analysts can use to assess a potential investment.
Certain securities, however, do not have to be registered and are exempt from providing ongoing detailed financial disclosure. Under one particular provision of SEC Regulation D, private placements of securities sold to what are termed “accredited investors” are exempt from registration. In theory “accredited investors” have the financial resources and sophistication to perform their own assessment of the risks and merits of these securities. While many seniors have retirement accounts that may qualify them for the label “accredited investors,” money alone does not mean that an investor is sophisticated or has the financial acumen to evaluate a private placement investment.
Many seniors have been sweet-talked into placing their nest-egg assets into private placement investments in order to produce monthly income to meet living expenses. However, as the 2008 market downturn demonstrated, private placements can promise, but not necessarily deliver, higher yields than traditional regulated products such as diversified stock or bond index funds. Additionally, since they aren’t liquid, these investments can’t be easily sold. The lack of transparency in the private placement market has allowed it to become a fertile breeding ground for fraud. Private placements have generated large numbers of investor and regulatory complaints.
Why would my financial advisor sell me bad investments?
Shouldn’t he be looking out for me?
Investment advisors and stockbrokers owe fiduciary duties to their clients. Simply put, they have to put their clients’ interest ahead of their own and be diligent and competent in fulfilling their fiduciary obligations. They have to investigate the investments they recommend and inform the client about the important risks associated with the investment. They also have an obligation to only recommend investments to clients that are suitable for the client in light of the client’s risk tolerance, asset picture and investment objective. Some investments are not suitable for anyone, but others may only be appropriate for clients who have the sophistication and financial wherewithal to accept their risks.
Unfortunately, some advisors ignore their duties to understand the investments they sell, describe them honestly and only sell them to suitable clients. Sometimes they blindly rely on the issuer or their employer to inform them of the true risks. Other times they are unduly swayed by the large fees many of these exotic products pay them.
How can I protect myself?
First, check out the person and firm selling you an investment. Stockbrokers and brokerage firms are required to be registered with the Financial Industry Regulatory Authority (“FINRA”). FINRA’s BrokerCheck website (www.finra.org/Investors/ToolsCalculators/BrokerCheck/) allows investors to research the professional backgrounds of current and former FINRA-registered brokerage firms and brokers. For information on registered investment advisors, go to
If the person who is trying to sell you securities is not registered with FINRA, the SEC or your state securities regulator, stay away.
Second, always look hard at the fees and charges for potential investments. Ask your advisor how much he gets paid and check the internal costs of each recommended investment. The higher the fees and costs, the more you have to earn to break even.
Third, go online. Do a Google search for information about the investment product. Also, search for lawsuits or regulatory actions involving the type of investment being recommended to you. Learning from another investor’s mistake can keep you from making the same one.
Fourth, ask—how financially viable is the company soliciting your business? Does it have sufficient assets to pay you back if you are mistreated? Also, does the firm or its advisor have error and omissions insurance? While this may not cover you in the event of fraud, it can protect you if your advisor is negligent.
Fifth, if you believe that you have been taken advantage of, seek redress. Investors who do business with stockbrokers normally have the right to have a dispute resolved through FINRA arbitration.
Lastly, keep in mind that in difficult markets, complicated investments with less transparency seem to be the first to suffer declines in value. So if Wall Street tells you it has come up with a better mouse trap— remember that in most cases, it’s you who are the mouse.
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