In the classic sense, annuities are intended to be terminal vehicles. That is, they are inherently designed to provide guaranteed income for life and cease operating only upon death of the annuitant(s). Annuities are retirement-oriented financial instruments, geared toward the final phase of life.
In spite of these traits, annuities may fail to meet the needs of some holders. Unforeseen circumstances may evolve that induce them to exchange the annuity (or, more precisely, annuity rights) for cash or some other form of wealth. In the last twenty years or so, annuity sales have become one common way of making such an exchange.
In practice, an annuity sale is most likely associated with a structured settlement annuity. Conventional annuities usually have cash-surrender provisions and surrender penalties for reclaiming principal in the early years of the accumulation period. They also provide a measure of liquidity by allowing limited, penalty-free withdrawals of principal. This is often sufficient to cope with annuityholder demands for liquidity. Conventional annuities are retirement-oriented, and retirees are normally reluctant to reverse an arrangement that was intended to last them through their remaining life. In contrast, a structured settlement is governed by the terms of a legal agreement and is much less flexible than a private annuity – a sale may well be the only way of retrieving wealth tied up in a structured settlement annuity. Moreover, recipients of structured settlements can be young, with more time and reason to encounter liquidity demands.
Selling a Structured Settlement Annuity
In 1982, a change in the IRS Code made the income and investment gains from structured-settlement annuities tax-free. This created a structured settlement-industry virtually overnight. By the late 1980s, another industry had sprung up, consisting of small-to-medium-sized firms who specialized in “cashing out” the rights to future income streams. A process in which one firm consents to pay out the present value of the stream of future payments, which are then assigned to it, is called “factoring.” Structured-settlement annuitants form a key segment of this market.
Warning to Would-be Sellers of Structural Settlement Annuities
The IRS changes that created an overnight proliferation of structured settlement annuity awards were deliberately designed to confer sizable, stable benefits on plaintiffs. In the past, so the thinking went, insurance companies and attorneys had exploited vulnerable, inexperienced plaintiffs by offering cash settlements that fell short of the true economic extent of damages due. The willingness of plaintiffs to accept these settlements testified to their ignorance and to the necessity for paternalistic government action designed to level the playing field in tort litigation.
Although there is no doubt that insurance companies enjoyed advantages over lay plaintiffs, there is reason to doubt that this required government to place its thumb on the scales of justice. (The recourse by the plaintiff’s bar to forensic economists capable of calculating the discounted present value of lost income and other damages is one example of countervailing power wielded against the insurance companies.) Leaving aside the merits of the IRS changes, however, their effect is unquestioned.
Receipt of an annuity that pays income free of federal, state, and local taxation (including income, FICA and Medicare taxes) is a tremendous benefit. Similar considerations started the current stampede of future retirees opting to convert to Roth IRAs, a retirement plan that trades current for future tax-free status of income. This is operational evidence of the value of prospective avoidance of taxes. General acknowledgement that taxes are sure to rise in the future only reinforces and strengthens this point. This tax-free status was expressly designed to make it unattractive for inexperienced plaintiffs (whose competence to manage their own assets was in question) to accept a lump-sum cash settlement in preference to an annuity. It also makes it unattractive for plaintiffs to cash in that settlement for cash.
A structured settlement is a legally-binding enactment that can be abrogated, modified, or transferred only by permission of the court. Sales of structured settlement annuities are subject to review by the court that first supervised the settlement. This process can be lengthy. Again, this arrangement was expressly designed to make it difficult for (allegedly) untutored plaintiffs to sell the rights to their settlement for cash.
Reasons for Selling a Structured Settlement Annuity
Given the structural disincentives and obstacles to selling a structured settlement annuity, why would anybody want to do it? Any seller exchanges one form of wealth for another – in this case, the right to receive tax-free income in the future is exchanged for cash today (or relatively soon). Obviously, the seller needs cash badly. It is worth distinguishing between two likely reasons for this.
First, the timing of the cash flows may be the determining factor in the decision to sell. The next annuity payment may be sufficient to solve the cash-flow problem, but payment receipt may be too far in the future to do the recipient any good.
Second, the magnitude of the annuity payment may be utterly insufficient to resolve the seller’s problem. In effect, the seller may need current access to multiple future payments (perhaps even the entire payment stream) rather than just one.
This distinction could be vital in choosing the right course of action.
Tips for Sellers of Structured Settlement Annuities
1. Don’t do it.
A structured settlement annuity provides a unique and valuable benefit. True, the seller can sell all or part of the rights to receive those payments for cash. The intrinsic value of those future payments is their discounted present value. No buyer would pay that much for them, however, since the buyer’s entire purpose is to gain from the transaction, not just break even. (For example, a factoring company raises financial capital by paying a return to its investors, who expect to receive a market-competitive return on the money they commit to purchasing annuities. This requires paying them an amount at least equal to the payments received by the annuitant, which in turn requires paying the annuitant less than the discounted present value of those payments.)
Technically, an annuityholder’s willingness to trade off future income for present income depends on his or her time preference. Given the unusual benefits of structured settlement annuities, a potential seller would require quite an elevated time preference in order to gain from a sale.
Of course, it is easy for anybody to give advice on solving a problem that they do not themselves face. How is the would-be annuity seller supposed to satisfy his or her need for quick cash?
The first thing to do is to make a comprehensive financial inventory of assets, liabilities, and net worth. This might require the assistance of a financial planner. The purpose of the review is to establish beyond all doubt the timing and magnitude of needed cash flows.
Once a need for liquidity is identified, the next step is to enumerate all alternative options to cashing in the structured settlement annuity. These probably include tapping family, friends, or financial institutions for a loan. This is where the distinction between problems of timing and magnitude enters. A timing problem is most susceptible to solution without a sale, since it implies that the problem is solvable either by waiting or by securing a short-term loan. The magnitude of the liquidity need is such that a loan can be paid off by future annuity payments. In contrast, larger needs may indeed be soluble only through sale of annuity rights.
2. Sell Only Part of the Structured Settlement Annuity
The need for liquidity has been confirmed. Its magnitude precludes satisfaction via a short-term loan. Nonetheless, it may still be possible to sell a portion of the rights to receive structured settlement annuity payments and retain the rest. Once again, this points up the importance of conducting the financial review and separating timing from magnitude issues.
3. Canvass the Market for Structured Settlement Annuities to Obtain the Best Quote
Once the magnitude of the need is known, the next step is to find the highest cash settlement obtainable. Here again, the services of a financial professional might ease the task of locating a satisfactory sampling of quotes. Only the direst necessity would justify accepting the first quotation offered.
4. Get Professional Help
If not already involved in the process, a financial planner or attorney would be a good person to engage at this point. Since the preliminaries have already been completed, those services might be obtainable for an affordable hourly rate. Since the structured settlement is a court proceeding, formalities and paperwork will abound from here on out. The first item on the agenda: the court will have to approve the sale.
5. Be Prepared to Wait
Since the whole idea of selling a structured settlement annuity is to get cash ASAP, it may seem perverse to advise patience. Anyone familiar with the legal process, though, will testify that courts do not move quickly. Resignation to this fact will be important to preserve the seller’s mental health.
Structured settlement annuities are marketable financial assets whose payment-receipt rights can be sold in whole or in part. They are so uniquely valuable, however, that this sale should be treated with great care and deliberation. A would-be seller should develop a financial plan to verify his or her financial status. The liquidity need should be pinpointed as primarily due to timing or magnitude. This may open up the possibility of resolution through a short-term loan from family, friends, or a financial institution. It will also ease the decision as to whether to sell part or all of the annuity rights.
Once the necessity for sale is established, the market should be canvassed to obtain the best quotation for a cash payment. A financial planner or attorney can help with this process and the succeeding one of completing the necessary paperwork, including getting approval for the sale from the court.
The virtues of patience will never be better demonstrated than when waiting on the courts – notoriously deliberate in their actions – to complete their review and approve the sale.