A structured settlement is a a financial or insurance agreement that a claimant accepts in the case of personal injury, rather than taking a lump sum payment. Settlements usually arise from some legal claim, and provide a person with a specific amount of capital for a fixed period of time. But what about emergency situations in which the structured payments aren't enough to cover expenses? Although structured settlements can provide comfort for a period of time, this method of payment may create problems for people who require liquidity in order to take care of current financial obligations.
Due to the number of structured settlements assigned annually, a secondary market has evolved that allows owners of these settlements to manage them as their financial needs require. These options, although potentially beneficial for people experiencing short term financial issues, should be considered as last resorts. (Find out how to sell your life insurance policy to avoid high premiums. Read Rid Yourself Of Unwanted Life Policies.)
Types of Structured Settlements
A structured settlement is usually a method of compensation paid to a plaintiff who has been awarded a large monetary sum from a civil suit or an insurance claim. To fund the obligation, the party responsible for paying the claim generally uses one of two common methods:
- The buy-and-hold method: The party purchases an annuity from a life insurance company.
- The assigned method: The settlement obligation is assigned to a third party, which in turn purchases an annuity.
Installment payment arrangements are highly-structured agreements that pay periodically. These periodic payments vary in form.
1. Yearly Payments: Payments that are divided into equal amounts and distributed for the duration of the agreed-upon period.
2. Inflation Hedging: Payments that are made in inflation hedging can fluctuate over time, depending on inflation or deflation in the economy.
3. Monthly Indexed Installments: Payments that can change in amount due to some financial index that is tracked over time.
4. Differed Payments: Payments that are paid in unequal amounts over a fixed period of time in order to cover expected expenses over the contract period.
5. Measures for the Future Care of the Recipient: Payments that are made to cover such things as periodic medical or housing expense that may vary from period to period.
Annuity Payment Pros
The greatest advantage of receiving annuity payments is the tax benefit. Many structured settlements are not taxable, or may significantly reduce a beneficiary's taxes as compared to a lump-sum distribution. Even those structured settlements that are deemed taxable can provide tax benefits. Income taxes can be deferred to the period in which the payment is made, as opposed to paying the lump-sum tax in the period in which the award is made.
This is the reason lottery winners are given a choice between receiving their winnings as an annuity or in entirety. In some cases (usually in the case of minors or people deemed unfit to manage their own finances), a lump sum is not awarded by design. (Learn about the hidden costs of lottery winnings in Winning The Jackpot: Dream Or Financial Nightmare?)
Annuity Payment Cons
Once the arrangements of distribution in a structured settlement are made, they cannot be changed. Depending on the legal structure of the settlement, the beneficiary may or may not use a structured settlement as collateral for a loan or another investment option. This is especially true if the payments are not taxable, since federal law prohibits the encumbrance of these tax-free benefits.
Are Structured Settlements Right for You?
Structured settlements are a proven method for solving the financial issues of many personal injury claimants and other beneficiaries of large money claims. Above and beyond the tax benefits and security of receiving periodic annuity payments, structured settlements are beneficial for people who don't want the burden of investing their proceeds or who have limited competency for doing so.
Structured settlements may be right for people who:
- are temporarily or prematurely disabled (For more, read Special Trusts For Special Needs.)
- have limited financial expertise
- are minors or unable to handle their own financial affairs (For more, read Don't Forget The Kids: Save For Their Education And Retirement.)
- require savings for housing, education or other large future obligations
- have been injured or have ongoing medical expenses (For more, read Failing Health Could Drain Your Retirement Savings.)
The Settlement Market
The need for people to turn future payments into current cash has led to a secondary market for these income streams. Companies that deal specifically in assisting beneficiaries in converting their structured settlements are becoming more common. Still, the cost of redistribution of funds can be costly.
Those who have received (or are still receiving) annuity payments are well aware of the unsolicited proposals from individuals and companies hoping to take advantage of mismanaged finances. The more unscrupulous of these companies have discounted the future annuity payments by as much as 40%, locking in a sizable risk-adjusted return. Due to this situation, about two-thirds of U.S. states have enforced restrictions surrounding tax-free structured settlements.
Also, some insurance companies will not assign or transfer annuities to third parties in order to discourage the sale of structured settlements. (For more on the secondary annuity market, read Break Out Of Annuity Prison.)
Some institutions will allow the partial sale of future payments. A majority of structured settlement sales are arranged in this manner, in which beneficiaries sell only the minimum portion of payments necessary to cover the most immediate of circumstances.
If you're considering selling all or a portion of a structured settlement, study the reputation of the company providing the payments. Don't get involved with a company that might become insolvent before paying out your buyout money. Also, consult with an attorney and a tax advisor before entering into any transactions. Approach potential buyers through a structured settlement broker who can compare and contrast differing offers for you and has the resources to provide legal and transaction guidance.
Other Things to Consider
- The commissions and fees required to set up the settlement can be significant and can take a large amount of principal.
- Beneficiaries should ensure that they understand the benefits of lump-sum awards versus annuities.
- Conflicts of interest can be avoided by confirming that there are no relationships between lawyers and annuity companies – lawyers can often receive monetary compensation for selecting certain annuity companies.
- Life expectancy of the claimant should be considered when arranging payment options.
- Diversification of the amount to be paid, among various insurance companies, can protect you from insolvency to a degree.
The Bottom Line
A structured settlement is an excellent method for investing large monetary claims. The tax benefits and ability to be structured against inflation can create a long-term income stream for beneficiaries. Because of heavy legal restrictions on assignment and transfer of structured settlements, anyone looking to execute or purchase one should investigate the ramifications of doing so, and seek out legal counsel.