Annuities and Structured Settlements

    Annuity and Structured Settlement

    You’re unlikely to reach retirement age without somebody asking you about annuities. They want to know whether you considered buying one, and if they work for an insurance agency, they’re likely to try to sell you on the benefits of a lifetime income that annuities can provide.

    So, what exactly are annuities? Annuities are an insurance policies that behave like investments.

    Annuities offer a hedge against something bad happening to your money, like a huge loss in a stock market collapse. Instead of personally managing your money and assuming risks inherent in stocks and mutual funds, you buy an annuity that guarantees a steady monthly income for decades or even a lifetime.

    Annuities are contracts between investors and insurers designed to meet long-term retirement goals for investors. Money can either be invested in a lump sum or through a series of payments. In exchange for the investment, the insurer agrees to make periodic payments to the investor beginning at a specified date.

    Just like a life insurance policy, which guarantees a lump-sum payment to your heirs, an annuity is a contract with an insurance company that pays you, slowly in most cases, while you’re alive, and often provides a payment to a beneficiary when you die. Annuities come with large initial costs. Many purchasers put a substantial part of their retirement savings into an annuity, giving them comfort that no matter what happens, they’ll always have an income. In addition, the amount you invest grows tax deferred until it is withdrawn.

    Types of Annuities

    Retirement annuities, properly called deferred annuities, come in three varieties, fixed, indexed and variable. All are tax deferred and will pay your beneficiary a specified minimum amount when you die. Periodic payments are made to you for a fixed period or a lifetime, and payments can continue after your death to your spouse.

    Variations of Annuities:
    • Fixed Annuities. Returns are based on a fixed interest rate that you agree to when you purchase the annuity. The insurance company will also make regular payments of a certain amount on each dollar your invested.
    • Indexed Annuities. These base your payouts on the performance of a financial index like the S&P 500 with the stipulation that you will never receive less than a minimum payment amount each month. If the index performs strongly, your return could be greater than the investment, but if it’s weak, you will never receive less than the specified amount.
    • Variable Annuities. These use investments such as mutual funds to determine your return. The rate of return on your investment, and the amount of periodic payments you receive, depends on the performance of the funds you choose. Variable annuities typically pay a death benefit to someone you designate. That person can receive all the money remaining in the account or an agreed upon guaranteed minimum.

    Annuities come with two payout plans. Immediate annuities begin paying immediately after you purchase them. These products are often sold to retirees who want to convert savings into guaranteed income streams. The other variety is deferred-income. This model allows you to buy an annuity now to receive payouts in the future. If you are in your 50s and don’t envision needed annuity income until you’re 70, this model lets you build value before payouts begin.

    You should also remember that unlike savings in government regulated banks, annuities are insurance products that aren’t insured. If you are uncertain about the condition of the company issuing the annuity, you probably ought to rethink making the investment since a corporate failure could eat your retirement savings.

    History of Annuities

    The concept of annuities dates to ancient Rome, but the first record of annuities in America comes from the Colonial period. In 1759, a company formed to provide a secure retirement for aging Presbyterian ministers and their families. In 1812, the Pennsylvania Company for Insurance on Lives and Granting Annuities received a charter to sell annuities to the public.

    The current era of annuities began in 1952 when the educators’ retirement fund, TIAA-CREF, first offered a group variable deferred annuity. Annuities today are mostly used to provide for an individual’s retirement, usually on a tax-deferred basis. Americans bought more than $117 billion in annuities in 2016, according to LIMRA Secure Retirement Institute, and the nation held nearly $2.3 trillion worth of polices.

    Structured Settlements and Annuities

    Structured settlements are linked to annuities because they’re considered an effective way to deliver money to people who need it but also need the discipline of a monthly or yearly payout. Congress in 1982 passed the Periodic Payment Settlement Tax Act, which established structured settlements to provide long-term financial security to accident victims and their families.

    The idea was to replace lump-sum payments awarded to personal injury claimants with periodic payments. The government’s aim was to decrease the number of personal injury award recipients who went through their funds too quickly and were subsequently forced to rely on public assistance. In addition to personal-injury claimants, structured settlements are frequently set up for those who win big liability and damage judgments, for lottery winners and for lawyers and law firms who are owed large sums in fees.

    Because annuities can be designed to offer timed payouts, guarantees on principal, as well as investment gains, and were already being offered by insurance companies, they quickly became the preferred vehicle to implement structured settlements. To encourage their use, the new law made any interest or capital gains earned on the annuity within a structured settlement tax free.

    Pros and Cons of Annuities

    The primary reason to own an annuity is security. In addition to ensuring a continuing stream of income during one’s retirement, many annuities are guaranteed for a minimum rate of return, meaning that not only can their principal be protected against loss; their earnings can be, as well. In some cases, by annuitizing the contract, the owner of an annuity can even receive a life-long stream of income, far more than his or her original investment.

    Annuities also offer predictability. Fixed annuities – ones tied to an unwavering interest rate – are especially attractive to investors who want to know how much money they will have years, or even decades into the future. They generally offer rates superior to money market accounts or certificates of deposit (CDs), and come with similar built-in protections and guarantees.

    Conversely, variable annuities – ones tied to rising and falling rates – offer the possibility of returns equal to those achieved via stocks or mutual funds, but with greater flexibility, more protections against loss, and certain tax advantages.

    Other things to consider: Annuities come with fees, often high ones. The broker who sells you an annuity usually receives a commission, and the company that manages the annuity charges an annual maintenance fee. If the annuity is invested in mutual funds, the funds’ fees become part of the cost.

    Since annuities are insurance products, their structure reflects the risk the insurer assumes. For instance, the value of a variable annuity invested in mutual funds varies with the value of the funds, which can go down. If the annuity guarantees a minimum periodic payout, the annuity costs will reflect the risk the insurer takes, and that risk is a premium built into the cost of the annuity. Some annuities also lock in your gains after a certain take, which also adds to the risk the issuer incurs. Again, that risk means extra fees built into the annuity.

    The biggest con for annuities is that you must be 59 and a half to with draw the gains from an annuity and not have to take a 10% early withdrawal penalty. There also will be a surrender charge if you try to withdraw early. The charge goes own over time, but if you need the money now, you will pay a penalty.

    Another negative for owning an annuity is that many of them charge higher annual fees, especially on variable annuities than those charged on managed mutual funds or stocks. Also, the current interest rates are so low that inflation could easily go up faster than the return on interest you would receive with an annuity.

    There are negative tax implications associated with annuities. Gains on annuities are taxed as ordinary income, meaning you could pay twice as much in taxes on it as you would from the capital gains on stocks or mutual fund investments. Another tax penalty comes if you pass along annuity benefits to your survivors after your death. They will have to pay taxes on it as ordinary income.

    Questions You Should Ask

    If you’re considering an annuity to cover retirement costs, ask yourself questions. Remember there are other ways to pay for retirement, including withdrawals from independent retirement accounts and 401(k) plans. You should consider the alternatives and get solid advice, perhaps from a certified financial planner.

    If you are leaning toward an annuity, consider:
    • Are you willing to accept the risk that your value could decrease if you invest in a variable annuity?
    • Do you understand all the fees and expenses connected with the annuity?
    • Do you plan to keep a variable annuity long enough to avoid surrender charges if you decide you want to redeploy your money?
    • Are there elements of a variable annuity, such as long-term care insurance, that might be purchased less expensively elsewhere?
    • Have you talked to a tax or financial adviser about the tax consequences of an annuity?

    Structured Settlements Using Annuities

    To pay the financial obligations owed to an injured party, a defendant – or more usually, his or her casualty insurance carrier – will purchase one or more annuities from a life insurance company, or delegate its periodic payment obligations to a third party, which in turn would purchase a qualified funding asset – either an annuity or a government bond.

    About $5.5 billion in structured settlements were issued in 2015, according to LIMRA Secure Retirement Institute.

    The payments are then structured, or scheduled. An insurance company agrees to pay the injured individual a predetermined amount of cash for a fixed length of time or for the duration of the life of the claimant, depending on the terms of the settlement agreement.

    Structured settlements are governed by both federal and state laws and must be closed under court order. The process is highly regulated by the courts. Some states also require the hiring of an attorney as a precondition to acquiring a structured settlement annuity.

    Pros and Cons of Structured Settlements

    The biggest advantages to structured settlements are predictable, secure income for the owner and the fact the total amount of money you receive will be greater than what you would get from a one-time lump sum payment. If you receive a structured settlement as part of a personal injury settlement, the payments are not subject to taxes.

    Structured settlements offer advantages to both sides in a personal injury case when damages are awarded. Most important to the plaintiffs is their built-in protection against having settlement funds dissipate too quickly based on bad financial decisions. An injured person who has long-term special needs or loss of income due to an accident will often benefit greatly from having monthly payments to meet daily expenses, as well as periodic lump sum payments with which to purchase medical equipment, modified vehicles, etc.

    Minors can benefit from a structured settlement in that their futures can be financially insured to point. Their structured settlements can provide certain payments during childhood, additional disbursements to pay for college, etc.  Defendants enjoy structured settlements because they free them from any future liability claims made by the injured party. Settlements can be purchased at a discount, as the plaintiffs will be earning tax-free gains on the capital used to purchase them.

    The cons of structured settlements are the lack of flexibility; the low annual return and the fact that payments could cease if you die. There are some parts of a structured settlement that can be taxed.

    How to Sell a Structured Settlement

    Sometimes those who receive structured settlements wish to claim their cash awards sooner than a payment schedule allows. This typically follows a significant change in someone’s life situation. Financial situations can change, and more money than an incremental monthly income is needed: to pay medical bills, to buy a house, to pay off debts, to fund a college education, etc.

    In these situations, someone with a structured settlement agreement can negotiate to sell the rights to their future settlement payments. They can sell these rights in whole or in part, although a judge must agree to the terms and the sale before the sale can happen.

    Finding a buyer for your future settlement payments could be as easy as visiting review sites online and view the comments by others in your situation.

    Prospective buyers should have some or all of these characteristics:
    • Offer full explanation of the fees and exactly how much you will receive for the annuity
    • A staff of lawyers available to help make the sales process a smooth one
    • Helpful customer service representatives able to explain the process and answer any questions
    • Offer fair rates and cash advances
    • Prepare paperwork and allow time for you to review it before signing
    • Allow you to use your own attorney to review contract

    Individuals do not negotiate with the owner of the structured settlement (usually an insurance company) but do so with a third party willing to buy all or part of the remaining settlement, known as the funder.  The structured settlement rights holder must provide a legitimate need for the money and calculate the requested payout amount so that the best interests of the seller and any dependents are recognized and upheld.

    When selling a structured settlement, it’s important to find a reputable funder, who bids on your structured settlement. Locating a funder is only part of task. To sell your structured settlement you must prove that you have a legitimate need for the settlement money in a lump payment and calculate what that payment might be. In most cases, it requires judicial approval. The need can’t be something frivolous or discretionary. Generally, the desire to buy a new car or a diamond ring won’t win approval, but a cash out agreement might be acceptable to cover an unexpected medical expense, job loss or some other urgent financial demand.

    In most cases, structured settlement holders only sell part of their annuity. Typically, the funder will ask for a discount rate of between 6% and 29% of the settlement’s value. There are other costs, including surrender charges of as much as 10%, and if you sell the annuity before you reach the age of 59 ½ you will pay federal tax penalties.

    Before selling a structured settlement, policy holders should weigh the financial losses they might incur against the need they have for an immediate payout.

    Check on line to learn if the broker has customer complaints, and check that the broker is listed with the Better Business Bureau. Determine that the funder has never defaulted on a settlement purchase, has been in the business at least three years, is registered to do business in all 50 states and is based in the United States. The funder should also have a policy of offering the best price and be prepared to complete the transaction within two months.

    Steps for Selling a Structured Settlement

    When you decide you want a cash payout from a structured settlement, estimate how much money you’ll need. Typically, this will only be a portion of the settlement’s value. Then,
    • Research funders to find several reputable ones.
    • Contact the funders and ask for quotes on potential payout and costs.
    • Choose a funder and complete required paperwork.
    • Work with funder to set a court date to seek judicial approval.
    • Arrange for the payout to be deposited in your bank account.

    Qualifications of a Trustworthy Buyer

    The sale of an annuity or structured settlement can be stressful if you’re not familiar the financial product and its value so don’t rush into it.

    There are plenty of companies that specialize in buying these products. Most of them can easily be found on the internet or buy consulting your financial adviser. Sever companies may be interested in buying your product so don’t jump at the first offer.

    Some of the qualifications buyers should meet for you to negotiate with them include:
    • Suggest the seller be represented by attorney or accountant
    • Encourage the seller to compare with other buyers
    • Make sure you’re given time to read and understand paperwork
    • No high-pressure sales tactics
    • Have their own staff of attorneys available to facilitate the sale
    • Have verified customer reviews on their websites
    • Offer discount rate

    State and federal laws protect the sellers because this hasn’t always been a fair process. The most important thing for sellers to remember is that you must prove to a state judge must you’re your reason for selling is in your best interest and those of your dependents.

    Once you’ve done that, let a few companies make offers for your annuity or structured settlement and determine if any of the deals meet your needs.

    Bill Fay

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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