Types of Structured SettlementsA structured
settlement is usually a method of compensation paid to a plaintiff who
has been awarded a large monetary sum from a civil suit or an insurance claim. To fund the obligation, the party responsible for paying the claim generally uses one of two common methods:
- The buy-and-hold method: The party purchases an annuity from a life insurance company.
- The assigned method: The settlement obligation is assigned to a third party, which in turn purchases an annuity.
Installment payment arrangements are highly-structured agreements that pay periodically. These periodic payments vary in form.
1.
Yearly Payments: Payments that are divided into equal amounts and distributed for the duration of the agreed-upon period.
2.
Inflation Hedging: Payments that are made in inflation hedging can fluctuate over time, depending on inflation or deflation in the economy.
3.
Monthly Indexed Installments: Payments that can change in amount due to some financial index that is tracked over time.
4.
Differed Payments: Payments that are paid in unequal amounts over a fixed period of time in order to cover expected expenses over the contract period.
5.
Measures for the Future Care of the Recipient: Payments that are made to cover such things as periodic medical or housing expense that may vary from period to period.
Annuity Payment ProsThe
greatest advantage of receiving annuity payments is the tax benefit.
Many structured settlements are not taxable, or may significantly reduce
a beneficiary's taxes as compared to a lump-sum distribution.
Even those structured settlements that are deemed taxable can provide
tax benefits. Income taxes can be deferred to the period in which the
payment is made, as opposed to paying the lump-sum tax in the period in
which the award is made.
This is the reason lottery
winners are given a choice between receiving their winnings as an
annuity or in entirety. In some cases (usually in the case of minors or
people deemed unfit to manage their own finances), a lump sum is not
awarded by design. (Learn about the hidden costs of lottery winnings in
Winning The Jackpot: Dream Or Financial Nightmare?)
Annuity Payment ConsOnce
the arrangements of distribution in a structured settlement are made,
they cannot be changed. Depending on the legal structure of the
settlement, the beneficiary may or may not use a structured settlement
as collateral for a loan or another investment option. This is especially true if the payments are not taxable, since federal law prohibits the encumbrance of these tax-free benefits.
Are Structured Settlements Right for You?Structured
settlements are a proven method for solving the financial issues of
many personal injury claimants and other beneficiaries of large money
claims. Above and beyond the tax benefits and security of receiving
periodic annuity payments, structured settlements are beneficial for
people who don't want the burden of investing their proceeds or who have
limited competency for doing so.
Structured settlements may be right for people who:
- are temporarily or prematurely disabled (For more, read Special Trusts For Special Needs.)
- have limited financial expertise
- are minors or unable to handle their own financial affairs (For more, read Don't Forget The Kids: Save For Their Education And Retirement.)
- require savings for housing, education or other large future obligations
- have been injured or have ongoing medical expenses (For more, read Failing Health Could Drain Your Retirement Savings.)
The Settlement Market
The need for people to
turn future payments into current cash has led to a secondary market for
these income streams. Companies that deal specifically in assisting
beneficiaries in converting their structured settlements are becoming
more common. Still, the cost of redistribution of funds can be costly.
Those
who have received (or are still receiving) annuity payments are well
aware of the unsolicited proposals from individuals and companies hoping
to take advantage of mismanaged finances. The more unscrupulous of
these companies have discounted the future annuity payments by as much
as 40%, locking in a sizable risk-adjusted return. Due to this
situation, about two-thirds of U.S. states have enforced restrictions
surrounding tax-free structured settlements.
Also, some insurance
companies will not assign or transfer annuities to third parties in
order to discourage the sale of structured settlements. (For more on the
secondary annuity market, read
Break Out Of Annuity Prison.)
Some
institutions will allow the partial sale of future payments. A majority
of structured settlement sales are arranged in this manner, in which
beneficiaries sell only the minimum portion of payments necessary to
cover the most immediate of circumstances.
If you're considering selling all or a portion of a structured settlement,
study the reputation of the company providing the payments. Don't get involved with a company that might become insolvent
before paying out your buyout money. Also, consult with an attorney and
a tax advisor before entering into any transactions. Approach potential
buyers through a structured settlement broker who can compare and
contrast differing offers for you and has the resources to provide legal
and transaction guidance.
Other Things to Consider
- The commissions and fees required to set up the settlement can be significant and can take a large amount of principal.
- Beneficiaries should ensure that they understand the benefits of lump-sum awards versus annuities.
- Conflicts of interest can be avoided by confirming that
there are no relationships between lawyers and annuity companies –
lawyers can often receive monetary compensation for selecting certain
annuity companies.
- Life expectancy of the claimant should be considered when arranging payment options.
- Diversification of the amount to be paid, among various insurance companies, can protect you from insolvency to a degree.
The Bottom LineA structured settlement is an
excellent method for investing large monetary claims. The tax benefits
and ability to be structured against inflation can create a long-term
income stream for beneficiaries. Because of heavy legal restrictions on
assignment and transfer of structured settlements, anyone looking to
execute or purchase one should investigate the ramifications of doing
so, and seek out legal counsel.
