Structured settlement annuities are specialized annuities issued by insurance-company affiliates to compensate plaintiffs in personal-injury tort litigation. They are the artifact of two institutions: the court system and the tax system.
Prior to 1982, personal-injury plaintiffs were commonly awarded lump-sum cash settlements. In practice, these were usually too low to fully compensate the plaintiff (in legal parlance, make the plaintiff “whole”). They often dovetailed poorly with plaintiffs’ needs and substituted badly for the loss of periodic earned income. In 1982, an amendment to the IRS Code accorded tax-free status to payments and investment gains from annuities awarded to personal-injury plaintiffs. This revolutionized personal-injury compensation.
The Structured Settlement Annuity Concept
Consider the example of a factory worker who is injured in an auto accident caused by the negligence of the opposing driver. The factory worker can no longer work. The worker’s economic loss can be rather easily calculated as the present discounted value of future wages (adjusted for inflation and productivity gains). Providing this income in a lump sum would impose a burden on the plaintiff – investing the money in order to provide lifelong income. Instead, the court may require the negligent party to purchase an annuity with income payments designed to replace the lost income. The similarity between level, periodic annuity payments and the periodic earned-income paychecks that the worker needs to replace are what make the annuity option attractive.
As with ordinary annuities, structured settlement annuities are issued by insurance companies and sold by affiliated marketing companies – in this case, the marketing arms are called “assignment companies.” The name derives from the fact that a defendant assigns his or her obligation to make periodic payments to the plaintiff to the insurance-company affiliate. Technically, the annuity-purchase transaction occurs between the defendant and the assignment company, with payment going directly to the company. This separation of the plaintiff from the annuity purchase insures that he or she does not take “constructive receipt” of the payment proceeds, which in turn preserves the tax-free status of the annuity benefits.
The structured settlement annuity also benefits both the defendant and the court. The law requires the defendant to “make the plaintiff whole,” which might otherwise require the defendant to guarantee the payments by raising the absolute amount of money necessary to make each payment over the plaintiff’s working lifetime. The annuity concept allows the defendant instead to pay the discounted present value of those working-lifetime payments. A defendant who is found guilty of tort liability might well not be considered sufficiently responsible to stand good for these payments, but the annuity concept allows the responsibility to be shifted to the insurance company. The court will consider the insurance company much more likely than the defendant to fulfill financial obligations.
The Inflexibility of Structured Settlement Annuities
Ironically, the virtue of the structured settlement – provision of periodic income in a manner that mimics earned income rather than in the form of a lump-sum increment to wealth – may also be a drawback. In essence, the structured settlement annuitizes the plaintiff’s wealth, making it difficult to access. True, the plaintiff might be “retired” due to inability to work, but is more probably younger than retirement age. The existence of family, transportation, and residential expenses may create the need for liquidity. Moreover, the injury giving rise to the settlement may have left a residue of medical problems requiring large infusions of cash. Thus, the plaintiff may want to “cash in” all or part of the structured settlement.
In the late 1980s, a small but significant secondary market developed in structured settlements, serviced by small consumer finance firms. These companies pay a lump-sum of cash in exchange for the rights to receive all or (usually) part of the plaintiff’s structured-settlement payments.
In 2001, federal legislation established procedures for the sale and purchase of structured settlements. They are done under court supervision. In order to avoid paying a prohibitive excise tax, the seller must await court approval of the transaction. The court exercises a duty to the seller, including acquainting him or her with financial alternatives and an admonition to seek professional advice, identifying the seller’s best interests and those of any dependents of the seller.
Non-Level Annuity Payments
Because structured settlement annuities are not normally retirement instruments per se, recipients have an incentive to alter certain standard features of annuities. Foremost among these is the level payment characteristic of the life annuity. A personal-injury plaintiff may be quite young, facing “lumpy” expenses such as mortgage downpayments or repayments, college tuition, planned or unplanned medical expenses, and contingencies of various kinds. Fortunately, there is no requirement that the structured settlement incorporate level payments. The payout can be customized to meet the plaintiff’s personal circumstances.
Safeguarding the Interests of Structured Settlement Annuity Recipients
In recent years, financial-planning credentialing organizations have gained attention and prestige. A structured-settlement analogue to these organizations is the Society of Settlement Planners, which can provide objective advice to plaintiffs regarding prices, payouts, and settlement offers.
Nowhere does objective advice come in handier than when a plaintiff is confronted with assurances that alternative investments can outdo the real rate of return provided by a structured settlement annuity. The annuity is free of all state, federal, city, Social Security, and Medicare taxes. Cashing in the structural settlement annuity and reinvesting in conventional assets would probably expose the annuityholder to a high rate of marginal taxation. Selling all or part of a structural settlement annuity for investment reasons only should require the alternative investment to meet a heavy burden of proof.
Like most annuities, a structured settlement annuity is issued by an insurance company. Like other annuities, this type is also only as good as the assets that underwrite it. Any plaintiff pondering this product should verify the soundness of the issuing insurance company.
Summary
Structured settlement annuities are most-often used as compensation for personal-injury plaintiffs. Defendants purchase them from insurance-company affiliates to provide plaintiffs with a superior alternative to lump-sum settlements. Both the annuity payments and investment gains are tax free in accordance with 1982 legislation modifying the IRS Code. This legislation revolutionized the compensation of personal-injury plaintiffs.
In most respects, structured settlement annuities resemble conventional annuities. One departure from standard practice is the ability of plaintiffs to receive customizable income streams rather than level payments, in order to fund such lumpy expenses as home, college, and medical expenditures.
Structured settlement annuities are a form of wealth annuitization. This inflexibility can be inconvenient. In the late 1980s, a secondary market for the sale and purchase of rights to structured settlement payments developed. This allows plaintiffs to trade all or some of their future payments for present cash, albeit at a discount sufficient to insure the purchaser a profit. Given the considerable value of the tax-free status of these annuities, the decision to cash in all or part of a structured settlement annuity is not a decision to be made lightly. Objective advice regarding structured settlement annuities can be had from the Society of Settlement Planners, a professional organization.