By Patrick Farber & David Meyerowitz, reprinted from SFTLA’s The Trial Lawyer, Winter 2014
A new investment product is showing up at settlement conferences. Often referred as “refactored annuities” or “secondary market annuities,” these are made up of structured settlement payments that have been previously transferred by an injured party to a factoring company, and then either sold individually, or are pooled and sold as repackaged structures in the secondary market.
These refactored annuities are being offered as a future payment option at settlement conferences alongside traditional annuities and other investments. However, tax issues and other concerns make refactored annuities far riskier to injured parties than structured settlement annuities and government Treasury securities.
Refactored Annuities Come Full Circle
When a refactored annuity becomes part of a settlement discussion, it means that the underlying individual or pooled annuities within the refactored annuity have come full circle. The story of a refactored annuity begins when an individual or multiple injured parties receive a settlement in the form of traditional annuities with guaranteed, predetermined, tax-free payments over a set period of years. The annuities are issued by highly-rated insurance carriers such as New York Life, MetLife, Pacific Life and Liberty Mutual. State and federal solvency standards and regulations provide annuity policyholders with a number of checks and balances to protect their investments.
Let’s say the injured parties later decide they need all or a portion of the settlement money. They reach out to factoring companies that are only too happy to take an assignment of the rights to receive the payments and, in return, pay the injured party a discounted cash payout. There are some factoring companies who seem to take advantage of the injured party’s need and there are others that provide the same service but not in a predatory way.
All state structured settlement protection acts (California included) require that these discounted cash payouts become effective only with court approval, and that such approval can happen only when and if a court finds that a factoring transaction is in the “best interest” of the structured settlement recipient. Tougher approval requirements were put in place in California on January 1, 2010 (Senate Bill 510) in response to reports of factoring companies exploiting injured victims in factoring transactions. Courts now have more specific, stringent guidelines to follow before transferring the payment rights and allowing a factoring company to receive the injured party’s future payment rights.
If the transfer meets the court guidelines and is approved, the factoring company can re-sell (or re-factor) the income stream(s) from an individual or number of structured settlements to the public–and in some cases–to injured parties as part of their settlement. Thus, a “refactored annuity” is born. The original injured parties get their lump sum, the investor (or in some cases, an injured party during settlement negotiations) gets a seemingly above market return and the factoring company and sales representatives make a profit. Factoring companies can usually afford to offer attractive yields on refactored investments because they purchased the original annuity-funded structured settlement payment rights from the injured parties at discounts.
One important benefit of traditional annuities for injured parties is the tax-free aspect of all current and future annuity-funded payments. Principal and interest are tax-free. Refactored annuities are essentially cash investments, just like stocks or corporate bonds. This means they are subject to any applicable federal, state or local taxes. They fall into the category of an after-settlement investment–without the unique tax benefits of structured annuity-funded payments or even a lump sum payment negotiated during a settlement or mediation hearing.
The tax law on insurance policy income has been clear for over 60 years. In People’s Finance & Thrift Co. v. Commissioner, 184 F.2d 836 (5th Cir. 1950), the court held payments generated from a health or life insurance policy are only free from federal taxes when the payments are made “as compensation for personal injuries or sickness” in accordance with Section 104 of the IRC. Payments received in the annuity secondary market do not qualify and so are fully taxable.
This means that injured parties who opt for a refactored annuity as part of an injury settlement will owe taxes on each periodic payment received. Why would an injured party agree to a refactored annuity instead of a traditional annuity when faced with the negative tax consequences? The main draw is that most refactored annuities sold in the secondary market today are earning higher rates of return before taxes than currently available annuities–sometimes as high as 5 to 7 percent compared to 2 or 3 percent returns on traditional annuities. Here’s an example of how it works.
An injured party approaches a factoring company and says he needs a large amount of cash immediately from his injury settlement. The original settlement created a plan in which the injured party would receive $1,000 a month for 20 years from an annuity for a total of $240,000. If a judge agrees to the annuant’s request, the annuitant is paid a lump sum at a sizable discount , the factoring company and sales person pocket a fee and commission and the remaining annuity income stream is sold to an investor (or as part of an injury settlement).
When determining the best investment options during settlement talks, injured parties may be enticed by the higher rates of a refactored annuity, but when determining the real rate of return after taxes, actual income can be similar to or even lower than a traditional structure depending on the injured party’s tax bracket.
Many life companies will not allow factoring companies to re-direct annuity-funded payments to investors or other third parties after those payments have been factored and sold. Therefore, payments from the life insurance company continues to flow to the factoring company even after they are sold to investors or packaged in a future settlement. Injured parties who choose a refactored annuity may end up receiving their income stream from the factoring company, not the life company (although the life company is still obligated to make the original payments).
In a re-factored transaction, the investor is taking on some transactional risk and relying on the factoring company doing a good job. The investor is one step removed from the insurance company, whereas in a primary situation, the payee has contracted directly with the insurance company so there is no intermediate transaction that could go wrong
Comparing traditional structured settlements with refactored annuities is like comparing apples to oranges. Tax and safety concerns that can come with refactored annuities are typically not what injured parties want or need when seeking long-term financial security for themselves and their families. Refactored annuity investments should be evaluated thoroughly and vigilantly with full disclosure of their pros and cons to an injured client before they are considered as part of a settlement.
Additional Reading & Information:
In June 2012 the NSSTA Board wrote to the membership to clarify that engaging in or promoting the marketing or distribution of payment rights previously acquired in a structured settlement factoring transaction are activities that are inconsistent with NSSTA’s mission. Recent developments have led to renewed questions about use of recycled payment rights as an investment vehicle and even as a means of funding future settlement payments. This memo recapitulates some of the reasons for this conclusion.
Read NSSTA Board Memo