Structured Settlements
Many personal injury lawsuits are settled by the purchase of an annuity contract that pays the injured party in increments over time, rather than in a single lump sum. In some cases, state law even requires that a verdict be satisfied by the purchase of such an annuity, rather than by a lump-sum payment. It is important that a client who is considering a settlement offer understand just what is involved in "structured settlements".
First, clients should realize that these structures are favored by the courts and even by the government: as a result of several factors including effective insurance lobbying, annuities used to fund structured settlements receive favorable tax status, for example. If an annuity is purchased by the Defendant and not purchased by the injured person or his agent(s), the income earned post-settlement by the insurance annuity company before it is paid out in scheduled payments to the recipient, is tax free to the injured person. If the injured person put the same money into his own account or investments at the time of settlement, every dollar it earned would be taxable to him. All other matters being equal, this would result in a smaller investment return for a cash settlement.
Several well-publicized studies have suggested that four out of five injured parties receiving a lump-sum settlement will have exhausted it completely, no matter how large it is, within five years. Further, many persons who receive large settlements are, by definition, catastrophically injured and may not have the intellectual resources to manage a large settlement. By contrast, money invested by a large insurer with a good track record will probably be well managed and carry a modestly good guaranteed return (after the insurer pays itself a management fee).
Finally, where children or mentally incompetent people are involved in a settlement, there is a long history of family members or trusted advisers occasionally mis-managing or even stealing funds that they were to husband for a loved one.
As a result, the judges who must approve of settlements involving death claims or injuries to legally incompetent people favor a structured settlement where the principal corpus of the settlement cannot be abused or wasted.
By the same token, cash settlements paid to incompetent persons, if more than $5,000.00, will be subject to strict management and reporting requirements through the Probate or "family" court. This level of protective consideration has even led to a series of state statutes that require court approval if an injured party proposes to sell a settlement-funded annuity contract to one of those TV advertisers who pay pennies-on-the-dollar to buy the annuity. Michigan has such a statute, and frankly it is essential public policy. Most clients who sell their future annuity rights for up-front cash do not receive the "fair market value" of their annuity from the buyer.
Whenever a structured settlement is discussed, negotiated or sold, the injured person and his or her family must carefully investigate the question of fair market value. This is related to the "opportunity cost" of money, and can be boiled down to a few simple axioms. First, money paid in the future is not worth as much as the same amount of money paid today. [By investing the money paid today, it will have earned additional interest by the future payment date and be worth more.] Second, it is possible to compute what a future payment is worth, by investigating how much money would have to be safely invested today in order to yield that payment on the future due date. While these issues are complicated in computation, conceptually they are based on simple principles that anyone can understand.
When a structured settlement is under discussion, the injured party's attorney must work with a financial adviser to assess the "present value" of the future payments being offered. This is the amount of money that a party would have to pay in the open market place in order to secure the future payments being proposed. Important subsidiary issues are whether the payments are to be paid in a reliable form and whether any of the payments are "guaranteed".
Reliability is measured by the size and trustworthiness of the insurance company promising to fulfill the contractually obligated promises of future payment. There are several rating companies who have investigated particular insurers and documented their reliability. An annuity should only be purchased from a very reliable insurer, although sometimes slightly larger future payments may be promised by an insurer with a poorer track record, as an inducement to lure purchasers. Further, in some situations, additional insurers or parties may stand behind the promise to pay benefits, or particular assets may be identified to the promise to pay future payments, thereby adding to the reliability of the promise.
In addition, the State of Michigan currently stands behind a modest level of future periodic payments, and the State of New York warrants certain annuities purchased from New York companies.
These indices of reliability must not be confused with "guarantees" of payment. When payments are "guaranteed" in a structure, this term of art refers to the promise to pay payments even if the injured recipient has died. Many annuities are designed and structured to pay benefits for the life of the recipient (or the recipient and a spouse), but then guaranteed for a particular duration. It is common for benefits that would be paid for a life expectancy of 25 or more years to be "guaranteed" for the first twenty years, for example. In this way, if the recipient suffers a statistically exceptional early death, the insurer does not gain a windfall and the family of the recipient becomes the annuity beneficiary. A guarantee of this nature may reduce the amount of benefits paid to the injured person, since it may increase the actuarial cost of the contract by confirming payment for a certain time period, regardless of early deaths in the actuarial "pool" of recipients.
The injured person must also think about and discuss with legal and financial experts the design of the annuity that best fits his needs--in other words the manner in which payments will be made (i.e., immediately to replace or supplement wages, or later to supplement retirement. To fund education or a home purchase? Monthly or with annual or periodic lump sums?). Should payments be delayed until age 18 in the case of a child? Delaying payments allows for a larger structured payment, if all other considerations are the same, since the income earned during the interim will increase the corpus before it begins to pay money out. It may also reduce administrative costs of management or probate supervision.
Thus, all of these issues must be discussed and fully understood:
1. A safe annuity payor must be confirmed. In considering this issue, the injured person may have to evaluate how much risk he or she will assume based on different potential payors, and the impact of lump sum and periodic payments on the entitlement to governmental or other benefits.
2. The actual market value must be independently confirmed. Regardless of what will be paid downstream, is the current value of the settlement a fair value?
3. The proposed fee paid to the attorneys, if contingent, must be calculated BASED ON THE PRESENT VALUE OF THE ANNUITY--NOT ON THE TOTAL OF FUTURE PAYMENTS.
4. The annuity must be designed to meet the injured person's anticipated present and future needs. Again, this may require consultation with a financial expert to assess the interaction of the settlement with other issues such as governmental entitlements and liens, trust or estate issues. This discussion must also address "spend-thrift" issues: in other words, are there special reasons why this injured person is more or less at risk of "wasting" the corpus of the settlement.
5. The injured person must decide whether to purchase a higher level of "guarantee", usually at a modest cost, in order to protect his family in the event of early death.
6. The injured person must identify the proper beneficiary for any guaranteed payments.
7. If the settling insurer is insisting on the use of a less-than-optimal annuity payor (usually a captive, or a subsidiary--allowing the insurer to make money on the settlement transaction), the injured person must weigh the loss in potential market value against the tax advantages inherent in a structured settlement. For some injured taxpayers, this tax advantage is negligible and a cash settlement may be preferable to a safe but underachieving annuity. For other injured persons, a settlement with a less-than-perfect captive annuity may still be the wiser choice.