As interest rates remain low, investors - especially retirees - struggle to find yield wherever they can. Unfortunately, though, the necessity of earning a required return to fund financial goals becomes the mother of invention for a wide range of investment strategies, both legitimate and fraudulent. A recent offering of rising popularity is structured settlement annuity investing, often offering "no risk" rates of return in the 4% to 7% range. In general, the opportunity for "high yield" (at least relative to today's interest rates) and "no risk" is a red flag warning. But the reality is that with structured settlement annuity investing, the higher returns are legitimately low risk; the appealing return relative to other low-risk fixed income investments is not due to increased risk, but instead due to very poor liquidity. Which means such investment offerings can potentially be a way to generate higher returns, not through a risk premium, but a liquidity premium. But the caveat, however, is that the investments are so illiquid and the cash flows so irregular, they probably should at best only ever be considered for a very small portion of a client's portfolio anyway.
Tuesday, March 6. 2012
The inspiration for today's blog post has been a series of inquiries I've received from other planners over the past month, whose clients are being solicited to invest in structured settlement annuities, but have been understandably wary of the purported "high fixed return with low risk" offering. After all, most returns that seem "too good to be true" for their risk are in fact too good to be true, and entail higher risk than what is first apparent. Yet due to the unique way that structured settlement annuities work, the reality is that higher yields are not actually a high risk premium, but a low-risk low liquidity premium.
To understand why, it may be helpful to review exactly what a structured settlement is. A structured settlement arises most commonly when a plaintiff wins a lawsuit - for instance, due to injury as a result of medical malpractice - and the payment for damages is awarded as a series of payments over a period of time. This is often done to coincide with certain key ages - for instance, the structured settlement for an injured child might be timed to have the bulk of the payments made after the child turns 21, while the structured settlement of an injured 45-year-old adult might include annual payments for the next 20 years and then a lump sum at age 65. Each situation is unique. However, to avoid the financial risks involved by having the plaintiff waiting on the defendent to make payments over the span of many years or decades, the defendent (or the defendent's professional liability insurance company) often purchases an annuity from a quality insurance company to make the obligatory payments to the plaintiff, allowing the defendent to resolve his/her end of the settlement with a single lump sum payment.
So where does structured settlement investing come into play? The opportunity arises when the plaintiff who is receiving the structured settlement annuity payments finds a want or need for more liquidity. Or as the infamous J.G. Wentworth (a company that buys structured settlements) commercials put it, "If you have a structured settlement but need cash now, call J.G. Wentworth, 877-CASH-NOW"! So the individual receiving payments contacts the company to explore selling the structured settlement income stream.
In practice, though, most such companies that buy structured settlements do not keep them in their own investment portfolio; they then re-sell the structured settlement annuity payments to an investor, pocket a small slice or charge a markup as a commission, and seek out another structured settlement annuity to buy and repeat the process. Which means ultimately, the company needs to find both an ongoing stream of people who have structured settlement annuities to sell (not surprisingly, easier to find in these difficult economic times), and investors who are willing to buy the seller's unique annuity stream of payments.
So what does this look like from the investor's perspective? Because each structured settlement was arranged for the winning plaintiff's particular circumstances, no two structured settlement annuity investment options are the same. One might offer $2,000/month for the next 18 years; another might provide for a single lump sum payment of $200,000 in 10 years and another $100,000 5 years after that, with no intervening payments; another might provide for a series of $1,000/month payments for 10 years, then a $100,000 lump sum at the end of 10 years.
How does the return work with such irregular payments? From the investor's perspective, this is similar to buying an original issue discount bond that matures at par value. For instance, if the structured settlement provides $200,000 in 10 years and another $100,000 payment 5 years thereafter, then the lump sum required for the investor might be $170,884; if you do the math (it's a standard IRR/NPV calculation for any financial calculator or spreadsheet), "investing" $170,884 today for $200,000 received in 10 years and another $100,000 received in 15 years equates to a 5% internal rate of return. However, it's important to note that you don't receive any kind of ongoing 5%/year payments (unless that happens to be what the annuity offers); your 5% return is solely attributable to the fact that that's how much money would have grown for the future value the investor gets from the annuity payments to equal the lump sum the investor paid today to get them. So the return is legitimate, but it's not comparable at all to the ongoing cash flows from a 5% coupon bond.
So why are the returns as high as they are? It's not due to risk; as noted earlier, the annuity payments are generally backed by highly rated insurance companies that are anticipated to have virtually no risk of outright annuity payment default (after all, that's what the original structured settlement payment recipient was counting on for those payments in the first place, and the court wouldn't have approved it if the annuity provider wasn't sound!). And the payments are generally guaranteed and fixed to the dates that are assigned; unlike lifetime annuitization that planners may be more familiar with, the payments from structured settlements generally are not life contingent (i.e., the payments will continue, even if the original annuity dies). Instead, the returns are due to sheer illiquidity. After all, how many people out there really want to buy an arbitrary structured settlement payment of $200,000 in 10 years and another $100,000 to arrive 5 years later, with no intervening cash flows? The answer is, not many. Yet in many cases, the structured settlement recipient really needs the liquidity for some reason, and can't wait long. The end result: the structured settlement recipient becomes willing to give up a healthy discount rate to get that lump sum of cash now.
So where does this fit for the financial planning client? The internal rate of return on many structured settlement payments are pretty appealing in today's marketplace; rates of 4%+ are pretty common (although notably, that's not a huge spread relative to the yield on comparable long term bonds). But most clients are unlikely to find a structured settlement that actually provides cash flows that line up with exactly when the client may need them, and there are only so many to choose from at any given time (for instance, here's a sample rate sheet from one provider) - which means at best, this should only be done with a small enough portion of the portfolio that it won't create a liquidity problem for the client investor. Otherwise, the client could themselves become the seller, and be forced to go through the same discounting process - bearing in mind that the structured settlement broker needs a cut too, so if the "cost" to generate a 5% return is $170,884 in the earlier example, the seller is going to get something less than that amount. This means that a buyer who becomes a seller will likely experience a loss of their own, as they essentially absorb both sides of what is a very wide bid-ask spread. Which means to say the least, this is for "long-term money" only! And of course, basic due diligence on the broker arranging the structured settlement and affirming the rating on the underlying insurance company is important, as always.
It's worth noting as well that structured settlement annuity investing is not just something that clients are being solicited for. Some of the structured settlement brokers involved are now reaching out to work with financial advisors directly as well (as a way to get access to more investment dollars), and in some cases advisors can actually be compensated and share in the commissions for helping to arrange such investments (not unlike how registered representatives are paid for many forms of annuity investing). However, this requires the broker/dealer to review and approve the offering (so that the registered representative doesn't get in trouble for selling away). And in practice, it seems that broker/dealers themselves are mixed on these offerings. At least one company I know of doesn't want to allow their representatives to do structured settlement annuity business not because they're unsound or risky, but because the broker/dealer is afraid that if more investor dollars flow into this space, it will encourage structured settlement annuity firms to be more aggressive and potentially even predatory in trying to persuade structured settlement recipients to part with their guaranteed payments in exchange for quick and easy cash now (as typical structured settlement annuity recipients are unlikely to "do the math" on the internal rate of return being used to discount their payments!). On the other hand, part of the reason for the high returns in structured settlement annuity investing is because there are so few investors involved that the market is highly illiquid and inefficient; in theory, if there were multiple companies competing for a structured settlement recipient's payments, there would be more competition, resulting in a higher price that both delivers more money to the seller and provides lower ("more competitive"?) yields for the investor.
In the end, structured settlement annuity investing can only go so far. There are just only so many structured settlement annuitants receiving payments out there, although in recent years this "industry" has expanded to also buy the annuity payments from lottery winners, and even some annuity payments from individuals who simply bought a commercial immediate annuity product and now want to liquidate it. Nonetheless, there is clearly some capacity constraint in how much this particular investment strategy can grow. But for the time being, the yields would suggest that the seller demand exceeds the buyer interest, which creates an opportunity for the client investor who can tolerate the illiquidity and has otherwise done the due diligence.
So what do you think? Have your clients been approached regarding structured settlement annuity investing? Did you counsel them to invest, or not? Have you considered getting involved with the brokers that offer such investments? Would you consider it to be a good right for the right client situation?
(Editor's Note: This post was included in SenseToSave's Carnival of Personal Finance #352.)
Tracked: Sep 23, 17:18
The defendant wants to make a single payment. The plaintiff wants to receive a single payment. So who agreed to the stream of payments in the first place, and why?
One set of middlemen (including possibly a financial planner) are being paid a hefty spread to collapse a payment stream that was telescoped by another middleman (the annuity provider). Meanwhile, the injured party loses in both transactions.
Am I the only one who smells something peculiar (if not downright rotten) here?
The point is not that the plaintiff wants a single payment. It's that the plaintiff took a stream of payments, and some number of YEARS later, changed their mind.
In some cases, the decision is not even made by the defendant. It's made on behalf of the defendant by someone else (e.g., in the case of a minor), who prefers a different arrangement upon reaching the age of majority.
The point here is what happens when someone wants to "undo" a stream of payments years after they're originally established (either due to changing one's mind, or due to the fact that the decision wasn't made by the recipient in the first place).
I'm not sure I follow. Where's the "immediate hit"?
This would be equivalent to buying a AAA-rated 5% zero coupon bond that the client can commit to holding to maturity. Obviously, the client would need to be able to manage the illiquidity, but in exchange for that liquidity (NOT risk) premium, the client is getting a high-quality-rated fixed income 5% yield that legitimately is not high risk.
In point of fact, David Swensen at Yale has written extensively about investors generating better returns not by investing for risk premiums (which is obviously a risky way to higher returns) but for liquidity premiums (which increase returns without increasing risk, but by reducing liquidity). Clearly, that requires proper liquidity management itself, but we're only talking about doing this with a very small piece of a portfolio anyway.
Granted, advisors that run an AUM model probably won't find this appealing anyway, especially because the size of the typical deals mean clients would have to be investing on a one-off basis anyway.
The primary purpose of this post was to explain the situation and the lay of the land for advisors whose clients are being solicited to buy these and are trying to figure out whether they are legitimate or not. As it turns out, notwithstanding all the scams out there, these (when properly done) are actually a legitimate way to capture higher returns without higher risk (but with much lower liquidity).
Indeed, if you were able to find a particular annuity payment stream for sale that happened to have ongoing payments of an appropriate dollar amount relative to the client's overall portfolio, that would certainly work as well!
Metropolitan Life Insurance Company "A+" rating (936903)
One hundred and one (101) monthly payments as follows: $740.34 from March 30th, 2012 till July 20th, 2020.
Investment: $60,885.13 to yield 5.25%
The gain on your investment would still be taxable. It functions just like purchasing a discounted bond that matures at full value, where the gain is fully taxable.
The original payee of the structured settlement does have an annuity contract from an insurance company and has a degree of protection via the State guaranty associations.
When another person buys that structured settlement it is purchased from the original payee through a "broker" or factor, not from the insurance company or even through that insurance companies licensed agent. Therefore the relationship between the purchaser of the structured settlement and the issuing insurance company is not exactly the same as a relationship between an insurance company and an original owner /purchaser of the annuity.
I suspect that the insurance companies legal obligation to the buyer of the secondary annuity may be substantially less than to the original owner. This is not a bond trading as a security and under sec rules.
Also if the insurance company failed I have doubts that the state guarantee association would be obligated (and if so in what state?)
Where can I find the definitive answers?
Generally the sale of a structured annuity results in the transfer of the actual annuity contract. As a result, the new owner would have all the same rights and protections of any annuity owner.
I'm sure somewhere out there some deals are arranged differently, so I can't quite characterize that as universal, but this isn't like buying some electronics equipment and wondering about the transferability of the limited warranty. There is no "void if transferred" attached to state guaranty funds; they exist to back annuities, not annuity owners per se, and it's still an annuity.
If you're concerned about a particular structured annuity transaction, then you would need to investigate the details of whether/how that particular deal with transfer to the contract to you as the new owner.
I hope that helps a little!