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Ponzis and Pyramids Explained

Most financial advisers do not have a wealth of sympathy with clients who allow greed to cloud their judgment when a scheme which sounds “too good to be true” becomes available.

In the past month we saw a huge surge in FAIS Ombud determinations. Of the sixteen cases published, only one was not related to “investments” or “property syndications”. The common denominator in these cases was that the financial adviser was held liable for the loss as a result of his or her failure to conduct a due diligence on the investment vehicle.

In one case, the respondent pointed out that, at the time of the transaction, the FSB itself was under the impression that the product did not fall under its jurisdiction. The Ombud did not respond to this argument in the determination.

The Actuarial Society recently published an article to assist the general public to understand how Ponzi schemes work, and why they are bound to fail. Below are some extracts from the article, and links to an English and Afrikaans version of the full article to help you educate and protect your clients against themselves.

A Ponzi and a pyramid scheme are essentially the same, with both relying on contributions from new investors to pay existing investors the promised returns. These are usually totally unrealistic and not comparable to returns achieved by legitimate savings and investment products. While investors in a pyramid scheme know that they need to recruit new members to maintain the flow of funds, Ponzi schemes claim to make legitimate investments, but instead use the funds to enrich founders rather than for any legitimate business purposes.

Mike McDougall, CEO of the Actuarial Society of South Africa, says:

“It can be stated with absolute certainty that these schemes will eventually collapse, leaving many people financially destitute, while only the founders and a few early participants make considerable gains.” There are essentially two reasons for this. Firstly, if a scheme is paying out more than is being earned, it will run out of money. Secondly, such schemes need continuing growth in new members to sustain payments to existing members, and the reality is that they will ultimately run out of new investors,” he explains.

“The only uncertainty is when the collapse will happen, which depends on how quickly the fund is growing and how much bigger the declared yields are than the actual investment earnings on the funds invested.”

To demonstrate, McDougall points to the simple example of a scheme that begins with 100 members who each invest R1000 with a promised return of 30% per month. Every month 100 additional members join the scheme and each invests the same amount until the scheme collapses. Members receive their first payment the month after they make their investment. In this example, the scheme begins with 100 members and total funds of R100 000. In the second month, there are 200 members and the fund closes with R170 000 after paying dividends of R30 000 to the founding members.

The total dividends paid rapidly escalate each month as the membership base increases, until the scheme reaches its seventh month. In its seventh month, the scheme begins with R70 000 and receives an additional R100 000 from new investors. However, the scheme must now pay total dividends of R210 000 to its numerous members, leaving it in debt of R40 000. Instead of R300 each investor only gets R243 and the scheme collapses.

Month Investors Starting
fund
balance
(R’000)
New
money
Dividends
(R’000)
Closing
fund
balance
(R’000)
Inception 100 0 100 100
1 100 100 100 30 170
2 100 170 100 60 210
3 100 210 100 90 220
4 100 220 100 120 200
5 100 200 100 150 150
6 100 150 100 180 70
7 100 70 100 210 -40

Using the same example of a scheme as above, McDougall put the numbers together to demonstrate the difference in returns between early joiners and late joiners of a pyramid scheme.

If you were a member who entered the scheme at its inception with an investment of R1000, you would have earned total returns of R2 043 by the seventh month when the scheme fails. This means that your return would have totalled an overwhelming 22% per month.

However, if you had only joined the scheme in its sixth month, you would only have earned R243 back on your investment, representing a loss of 76%. If you had entered in the seventh month as the scheme collapsed, you would have lost your entire investment.

Before entering into an investment, or making an ‘online donation’ with the hope of high returns, McDougall suggests you ask the following questions:

  1. How are returns generated? Legitimate investment schemes are transparent. You should be able to understand the scheme’s underlying assets. Even when derivative structures are used, you should be given enough information to understand your risks and potential returns.
  2. How aggressively are you being pursued to join? Legitimate investment schemes generate returns from invested assets, where fraudulent schemes rely heavily on funds from new members to pay existing members.
  3. How do returns compare with other similar products? If returns are unusually high, be very cautious.
  4. How is the scheme regulated and audited? Regulators and auditors are not foolproof, but the lack of a solid regulatory structure means that no one can hold your scheme accountable for its practices or returns.

If you are uncomfortable with any of the answers to your question, rather walk away.

If I may add to that: If it sounds too good to be true, speak to your adviser. If he tells you to go for it, consider changing your adviser.

Click here to download the full media release.

Kliek hier vir die Afrikaanse media vrystelling.

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