by Patrick C. Farber | California Lawyer, March 2015
Structured settlements have helped injured individuals and their families obtain financial security even in the face of lifelong medical challenges. According to the National Structured Settlement Association, more than 25,000 such arrangements are drawn up every year.
These settlements came to prominence more than 30 years ago when Congress enacted the Periodic Payment Settlement Act of 1982. The act established favorable tax treatment for periodic payments for damages that resulted from physical injury or sickness. Qualifying payments can be excluded from the recipient’s taxable income. (See 26 U.S.C. § 104(a)(2).) Structured settlements are designed to protect the settlement funds from the uncertainties of investment markets, thereby ensuring that the injured party has adequate funds for future medical and living expenses.
Structured settlements are funded with annuities purchased through an insurance company. The instruments underlying the annuities are investment-grade bonds or, in some cases, government securities. Of course, these investment vehicles historically have offered low rates of return. A 30- year U.S. government bond, for example, currently yields less than 3 percent per annum.
With such low returns, it’s worth evaluating whether injured parties would do better to accept a lump-sum settlement and invest the proceeds in potentially higher-yielding investments outside the confines of a structured settlement. Consider the pros and cons.
One argument for the lump-sum option is that the injured party can invest the funds in stocks, many of which offer higher dividends than the conservative bonds found in an annuity portfolio. In addition to being able to take advantage of the current bull market, the settlement recipient can purchase real estate, precious metals, and other investments that are strong but unavailable in a structured settlement.
As a practical matter, however, many injured parties don’t have the expertise to maneuver in today’s volatile markets or the experience to select an appropriate investment advisor who will look out for their best interests. There’s an abundance of horror stories about people coming into large amounts of money only to see it disappear – through bad investments or because of advice from unscrupulous “friends” or family. Funds that were supposed to last a lifetime are quickly gone. And significantly, even if these lump-sum investments are in the black, any earnings will be taxable.
By comparison, these days structured-settlement annuity yields are similar to those of ten-year Treasury bonds (about 2.2 percent). Depending on the individual’s tax bracket, the actual return can be 1 to 2 percent higher for a long-term structure because of compounding and the double (state and federal) tax advantage.
And recipients can be confident that various insurance laws regulate the type of investments that life insurance companies can place into an annuity. In the Golden State, carriers must meet the approval of the California Department of Insurance. They are subject to mandatory annual audits and other financial compliance requirements.
For injured parties and their families who face the stresses of medical or rehabilitative treatments, knowing that a AAA-rated life insurance company will deliver on-time annuity payments over the life of a structured settlement – regardless of market fluctuations or economic downturns – can offer peace of mind.
Best of Both Options
Not every dollar of a structured settlement needs to be paid over time. A schedule can be set up so that the injured party receives a portion of the settlement at the outset, followed by periodic payments. This way, individuals can use the up-front cash to invest outside the structure if they so choose.
More important, this cash can be kept available for emergencies. Then if an unexpected expense arises, the injured party will be less likely to succumb to an offer from a “factoring” company to purchase all or part of their settlement at a deep discount.
Planning for Inflation
Eventually, interest rates will increase in response to inflation. To anticipate this, annuities can be structured so payments increase over time – typically by 3 percent annually. This approach is most common for younger injured parties with decades of payments ahead. If the injured party is over age 50, the inflation component is usually not included because of the shorter remaining life expectancy.
The key is to remain flexible and address the particular needs of each case.
Clients need accurate information to make the right decision for their financial future. Their attorneys can help by explaining the relative rates of return and the investment-diversification options in and out of structured settlements.
With low interest rates, a fixed payout of damages over time may make sense.
Patrick C. Farber, a structured-settlements broker with Atlas Settlement Group in Santa Ana, provides advice and structures for a variety of tort cases.