A structured settlement annuity (SSA) that pays at a predefined periodic frequency is often employed (in lieu of lump-sum payout) in resolving personal injury cases. SSAs have received wide support from various organizations, including American Association of People with Disabilities, Congressional Structured Settlements Caucus, National Consumer League and the trial bar. The use of these SSAs, in high-damage cases, is widespread to the extent that some in legal professionals are of the opinion that not considering structured settlement is bordering on malpractice. The indiscriminate use of SSAs raises questions about adequate consideration for the inherent risks in SSAs while touting the benefits to individual plaintiffs. This article highlights certain elements of SSAs that should be considered in conjunction with the plaintiffs’ needs before subscribing to an SSA.
The compensatory damages in personal injury cases often qualify for tax exemptions under Internal Revenue Code § 104 (a) (2) if taken either as a lump sum or in periodic payments structured through a qualified assignment. Under a qualified assignment, a structured settlement company is assigned the liability of making periodic payments to the plaintiffs by the defendants or their insurer. The periodic payments in the future, including gross income earned on the initial amount, benefit from tax exemption under I.R.C. § 130. Thus, qualified SSA provides a conduit to save taxes on gross income earned on the compensatory damages. The punitive damages, on the other hand, are generally taxable when taken in lump sum, but through a nonqualified assignment a structured settlement company could postpone the tax burden by domiciling itself outside the U.S. The periodic payments, including the gross income earned, however, are taxed as ordinary income in the year it is received.
Advantages of a Structured Settlement Annuity
An SSA provides a number of benefits to the plaintiffs including (1) providing tax exemption or deferral (depending on qualified or nonqualified SSA) on the gross income earned on damages, (2) offering guarantee for future periodic payments that may go of for tens of years, and (3) assigning an independent party with the obligation for the payments. Furthermore, the SSA can be structured and modeled around specific needs of the plaintiffs, thereby providing flexibility both in terms of the timing and the amount of periodic payment.
Courts have considered SSAs favorably because it locks the payout and thus avoids early dissipation of such funds. Lawyers, often relying on a structured settlement financial adviser, think that by creating a structured settlement for the plaintiff they have performed their fiduciary duty in securing the best possible settlement and selecting the best possible investment option. While this is generally true for plaintiffs that need a guaranteed periodic payment in future to sustain, this may not be best option for all plaintiffs due to disadvantages that are inherent in such SSAs.
Disadvantages of a Structured Settlement Annuity
There are several disadvantages to SSAs for certain plaintiffs depending on their needs, risk-bearing capacity, and the contemporaneous economic conditions in general. I have listed a few key factors that one should consider before entering into an SSA. These include:
1. Liquidity: If the settlement amount is locked in an SSA, then it would be difficult to meet any unanticipated liquidity needs that may arise in the interim. For example, if an SSA recipient needs money to buy a house, start a new business, or pay for certain medical emergencies, then she may have to pay a steep price to sell the structure and receive money that she is entitled to. The discounts to sell SSAs typically range between 8 percent and 18 percent, depending on the structure, but may reach as high as 30 percent according to industry participants.
2. Current Economic Environment: The promised rate of return on an SSA depends on the contemporaneous economic environment and is generally proportional to the U.S. treasury rates. The 2008 financial crisis and the Great Recession that followed has resulted in historic low rates for U.S. treasuries, thereby depressing the rate of returns on SSAs. Locking these historically low rates of returns for the next decade or more in a structured annuity may not be a prudent investment for everyone. A related economic factor that is of concern is the inflation. Locking in a periodic payment through an SSA often handicaps the recipient and exposes her to future inflation shocks, especially concentrated in certain segments of the economy such as medical costs. One should pay close attention to the inflation estimates, if any, that are made in the periodic payments and the exposure one may have with SSAs.
3. After-Tax Payout: The tax incentive that we discussed may not be as appealing for all recipients for SSAs. For example, consider a case of a young adult receiving a taxable settlement who then rolls it into a nonqualified SSA. The tax-deferred benefit of the SSA becomes an additional liability for the adult because if he receives periodic payments in the months and years to come, the ordinary income tax that he will be paying on his wages and salary would be increased. Instead the individual could benefit from receiving a lump sum, paying taxes, and then investing the after-tax proceeds in a tax-efficient manner that may include: taking advantage of lower capital gains and tax-free appreciation of 529 plans, and using active tax-loss harvesting strategies. SSAs are, therefore, not always a prudent investment from a tax-savings perspective and in certain cases, there may be compelling reasons to take a lump-sum settlement.
4. Risk Appetite: The choice of SSA as a prudent investment for everyone ignores the risk-bearing capacity of the individual. Continuing with our example of a young adult who is expected to work and earn fair wages, there is less need for certainty of periodic payment. Therefore he does not have to compromise on earning lower return on the structured settlement in lieu of guaranteed payments. The rate of return that can be expected to generate from a long-term investment in a well-diversified portfolio could be higher than that being offered in an annuity. Of course, there are additional risks in investing in certain securities, say equities, but in this case, the individual is capable of handling such a risk. Investing in subpar return security that does not match the risk-bearing capacity of the individual should not be considered a prudent choice, just because the returns are safe or guaranteed.
5. Financial Innovation: Locking the monies in SSA limits the ability to take advantage of financial innovation in the future that can reduce risk, increase returns and lower management fees.
6. Risk of Insolvency: Though rare, there is a finite possibility of the structured settlement company becoming insolvent, thereby losing some or all of promised payments. Not only that, the recipient may have to incur additional litigation expenses to recover these lost monies.
Conclusion:
The choice of structured settlement depends on multiple factors, including understanding the individual’s needs and the risk-bearing capacity. If SSA is a prudent choice, then one should consider using qualified damages first before considering the nonqualified or taxable damages, primarily due to tax implications. In many cases, a lump-sum amount may be a more prudent choice for the individual than opting for an SSA, and law professionals may better serve their fiduciary duty by examining the benefits and risks of all possible choices rather than opting for an SSA as a safe choice.
Dr. Rahul Surana is a director in the securities practice of Navigant Economics. He is an expert witness and has testified in U.S. court on structured settlement annuities. He has been practicing litigation consulting for 12 years and has consulted on several valuation, risk analysis and technology-related issues. He is also a FINRA arbitrator and sits on a panel to hear investment-related disputes and award judgments.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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