Structured settlements are a type of financial arrangement negotiated from a legal settlement, which guarantees the recipient a series of financial payments over a defined number of years. They usually arise after a plaintiff wins an accident lawsuit resulting in injury, or a medical malpractice lawsuit. The defendant’s insurance service provider then makes the payments, thus, they are shouldering the risk. They are tax-free or tax-deferred fixed annuities that provide security and a financial safety-net to the settlement recipient.
Every structured settlement is different and dependent on the circumstances of the case. In some instances to guarantee the payments and mitigate risk, insurance companies enter into reinsurance deals with reputable third-party insurers. The reinsurer then makes all or part of the structured settlement payments in exchange for structured annuity payments. For example, Warren Buffet’s Berkshire Hathaway is one of the largest reinsurers of structured settlements in the world.
Structured settlement investment opportunities arise when the recipient wants liquidity in a lump sum and are willing to sell the structured settlement income stream. This is referred to as a structured settlement factoring transaction, wherein, the payment stream for a set number of years can be transferred in exchange for a single discounted payment. Any structured settlement factoring transaction first requires the approval of a judge to abide by the local state structured settlement protection act and IRC 5891. In recent years, the market has further expanded to also buy the annuity payments from lottery winners. Numerous companies specialize solely in purchasing payment streams from structured settlements, then resell said payment streams at a discount to investors, pocketing a commission.
A Brief History of Structured Settlements
The concept of structured settlements first originated in Canada during the 1960s with the notorious case of Thalidomide. The drug was widely prescribed to pregnant women as a means of quelling morning sickness, however, it subsequently caused severe, often life-threatening birth defects in thousands of children. Because of Thalidomide’s deleterious effects, these children had lifelong specialized healthcare that no lump-sum settlement would efficiently cover.
In the United States, structured settlements began to be used in the early 1970s as an alternative to lump-sum settlements for injury and medical malpractice cases. Several Internal Revenue Service (IRS) rulings were passed. These rulings stated that if certain stipulations were met, then the payments would be tax-free.
In 1982, Congress passed the Periodic Payment Settlement Tax Act. This piece of legislation encouraged the use of structured settlements as a means of providing financial security to plaintiffs in injury or medical malpractice cases.
Henceforth, structured settlements have become an integral part of the American judicial system. They have consistently been codified and strengthened by several other IRS rulings and acts passed by Congress. The National Structured Settlements Trade Association (NSSTA) was formed and subsequently assisted in the creation of the Congressional Structured Settlement Caucus, a bipartisan group whose mandate was to increase awareness of the financial agreements. In addition, many associations and advocacy groups, including several of the most prominent disability advocacy groups such as the American Association of People with Disabilities, champion structured settlements. Annually in the US, tens of thousands of people are recipients of structured settlement agreements.
The Benefits of Structured Settlements Investing
One of the principal reasons investors are drawn to structured settlement investing is the high rate of return – normally between 4% and 7%. Yet, because every structured settlement is unique, no annuity investment option is alike. Irrespective, the potential for such a high rate of return holds considerable appeal for investors.
In addition, seeing as the settlement payments are governed by court order, investors have the peace of mind of guaranteed payments, which are fixed to the assigned dates. Structured settlements are also independent of the recipient surviving the set period of the agreement, meaning they are not life contingent.
Structured Settlement Investing With an IRA
One method of structured settlement investing is with an IRA. It is important to note that the IRA custodian, not the investor, makes the investment. The IRA purchases the payment stream at a discount, which provides payment streams made by an insurance provider. Considering the annuity is different for every structured settlement, some investors choose to invest in more than one, dependent on individual retirement and investment goals.
Certain parameters must be adhered to when investing in structured settlements with an IRA. For instance, the investor must obtain a court order changing the payment stream to the IRA, in addition to an amortization schedule detailing the principal and amount of interest. Likewise, it is imperative that all funds used to invest in a structured settlement come directly from the IRA, and all future payments go into the retirement account.
Additionally, to mitigate default risk, it is crucial to ensure that the insurance company making the obligatory future payments is financially secure and reputable. Insurance companies highly regulated by the US Department of Justice, usually hold structured settlement investments, so this often not a concern but something to be mindful of when investing in structured settlements.
Concerns With Structured Settlements Investing
A major concern regarding structured settlements investing is the issue of illiquidity. In essence, once an investor’s money is tied to the product for the entire period, it is difficult to retrieve the funds. An investor must be able to manage that illiquidity, seeing as they are subject to the details of the structured settlement’s payment schedule.
When choosing to invest in structured settlements, only a small portion of a portfolio ought to be allotted to the product, lest the investor, in turn, experiences a liquidity issue. If unforeseen circumstances transpire and an investor must sell long-term investments, finding a buyer in an illiquid market may not be that easy. Additionally, if they manage to sell the investment, the investor is subject to the same discounting process as the original recipient of the structured settlement. Thus, said individual will likely experience a financial loss of their own.
The Issue of Credit Risk
Another concern with investing in structured settlements is the issue of credit risk. Although the insurance companies which manage structured settlements are highly regulated and usually the largest and most reputable, they are still subject to market conditions. Case in point, American International Group, Inc. (more commonly known as AIG). AIG was one of the key players in the financial crisis of 2008, and was bailed out by the federal government to the tune of over $180 billion. The subsequent investigation into why the company failed, concluded that AIG sold humungous amounts of insurance without hedging its investment. The AIG bailout is evidence that even the most reputable (the company was founded in 1919) insurance providers can fail. Thus, proper diversification can greatly reduce the risk of an investor losing money.
The Issue of Inflation
A further concern with investing in structured settlements is the fact that the settlements are connected to inflation (as are so many other entities) and seldom can keep pace with the rate of inflation. Consequently, the investment’s value depreciates over time, especially if the payment term is for multiple decades.
While by and large, structured settlements are regarded as a low-risk method of investing what for being fixed income investments, there are still concerns that must be factored. The high illiquidity, coupled with credit risk and the inflation component are all issues that must be considered. As a result, investors would be wise to only allocate a small percentage of a portfolio to structured settlements. As with any diversification strategy, always do your due diligence before deciding what are the best options for your investment and retirement goals.