Annuities & Structured Settlements

Annuities come in three types: fixed, variable and fixed indexed.
A fixed annuity accrues interest at a fixed rate for the duration of the accumulation period. Compared with other types of annuities, the interest rate of a fixed annuity is likely to be quite low, often just above the rate applied to a standard CD account. However, since the interest rate is fixed, it isn’t tied to the performance of stocks, shares or mutual trusts. This may deny investors the potential of higher earnings, but it does protect them from the risk of losing their capital and can therefore be a reliable source of supplemental income during retirement. There is a small risk that they could lose money in real terms should inflation outpace investment growth.

Fixed annuities are also easy to budget for because the payee knows exactly what they will be receiving and when.

As detailed below, fixed annuities can be either deferred to accumulate interest or immediate, providing fixed payments based on the size of the annuity and the age of the investor.

The principal invested in a variable annuity accrues interest at a rate that is tied to the performance of a portfolio of mutual funds. The investor will normally be presented with a selection of funds from which to choose. Compared with a fixed annuity, the rate of interest is unpredictable, and returns will vary depending on the performance of the investor’s chosen fund. Any interest the annuity accrues is paid into a separate sub account.

Investors will usually choose a variable annuity to benefit from deferred tax and the higher returns they can expect from a well-performing fund. However, since the interest rate is neither fixed nor guaranteed, the investor is at risk of underperforming inflation or losing their capital altogether if the associated fund falls in value. There also tends to be withdrawal restrictions imposed during the accumulation phase (e.g. one withdrawal per year).

Variable annuities are also difficult to budget for because the payee doesn’t know what he or she will receive and when.

As with fixed annuities, variable annuities can be deferred to provide a regular income later in life or immediate, providing an income stream straight away.

A fixed indexed annuity blends the properties of fixed and variable annuities. A portion of the fixed indexed annuity accrues interest at a fixed rate for the duration of the accumulation period. This protects the investor from the risk of losing their capital and helps with budgeting because the payee knows the amount of the minimum payment and when they will receive it.

The remaining capital in the annuity accrues interest at a rate tied to the performance of a capitalization index (e.g. the S&P 500). As with a variable annuity, the rate of interest for this portion of the fund is unpredictable although investing in an index is not as risky as investing in separate funds.

Investors will usually choose a fixed indexed annuity to ensure their capital is safe while still providing the potential to receive higher returns. However, these annuities can look better than they are. Through a combination of interest earning caps and hefty fees, the return on fixed indexed annuities can be disappointing.

Annuities are also categorized based on how soon they are annuitized.

Annuities are usually annuitized a number of years after purchase. These are called ‘deferred annuities.’ One of the advantages of opting for a deferred annuity is that you can treat the annuity almost like a flexible savings account, earning tax-free interest while making occasional withdrawals when needed. Only when the policy is annuitized do you lose that freedom.

A longevity (or ‘advanced life’) annuity is a subtype of deferred annuity which is annuitized at a future date and then continues to pay out for the rest of the investor’s life.

As the name suggests, a single premium immediate annuity is a policy that is annuitized immediately after funding. In a sense it is an exact reverse of a life insurance policy. Instead of paying regular premiums in return for a lump sum on death, the policyholder pays a lump sum in return for regular payments to use as an income stream.

Finally, annuities are also categorized based on whether they will pay out over a specific period (a fixed term or temporary life annuity) or for the rest of the annuity holder’s life (a life contingent annuity). A third type, the joint and survivor annuity, will automatically switch the payments over to the surviving party (usually a spouse) when the first party dies. There may also be a third beneficiary (often a child) who will receive the balance of a minimum number of payments should both parties die early.

In life contingent annuities, the payments are usually lower since the insurer is taking on a greater risk (known as longevity risk).

Fixed term annuities usually pay out over five to ten years, but some provide payments over as few as three or as many as twenty years. After the final payment, a lump sum ‘maturation amount’ is paid.

Structured settlements are commonly set up to manage payments due to a claimant following a personal injury case. The most serious cases, those involving catastrophic injuries, can run into millions of dollars. Structured settlements are recommended where the claimant is likely to need ongoing medical care for the rest of their life because there is evidence that most lump sums are spent within five years of settlement. This can lead to the injured party having to rely on financial assistance. Since the passing of the Taxpayer Relief Act in 1997, earnings from structured settlements are tax exempt depending on the person’s income. The hope is to incentivize this kind of investment and reduce the burden on the taxpayer.

When selling structured settlements, the tax-exempt status is almost always preserved providing the correct legal procedure is followed and there are no changes made to the settlement.

Employees can sue for Workers’ Compensation (WC) when they have been injured at work or contracted an occupational disease. WC is a ‘no fault’ system which means that the injured party is eligible even if the accident or injury was due to their own negligence (unless they were drunk or taking illegal drugs at the time).

WC cases may be settled before court in the same way as any other personal injury suit. When WC was explicitly included as tax-exempt in the Taxpayer Relief Act of 1997, structured settlements became a popular instrument for providing long-term support and security to injured workers. These are sometimes referred to specifically as Workers’ Compensation settlements.

Whether a circumstance comes under WC varies by state and the relevant statutes will need to be consulted.

A plaintiff can bring a medical malpractice claim against a medical professional or institution if they believe that the defendant has caused them (or a loved one) injury. As in personal injury cases, compensation can cover immediate and ongoing medical treatment in addition to loss of earnings.

Grounds for medical malpractice include flawed treatment plans, inaccurate diagnoses and errors in aftercare. The claimant needs to be able to prove that there was medical negligence or omission during treatment and to have this confirmed by an independent medical expert.

There is a specific provision in law made for those people who believe they have been harmed when receiving a vaccination. The no-fault National Vaccine Injury Compensation Program and associated Trust Fund was set up in 1988 as an alternative to the normal tort provision for medical negligence.

A person can sue for wrongful death if they believe that a loved one’s death was caused deliberately or was due to a preventable accident. The suing parties are referred to as ‘Real Parties in Interest’ and include immediate family members, dependents and, in some cases, more distant family members (e.g. if a grandparent was acting as a guardian for the deceased). Real Parties of Interest are defined by each state individually.

In order to be successful, the claimants need to establish that there was negligence or deliberate intent; that the defendant breached their duty of care; that the action or omission caused the death and that the death has led to negative consequences for the suing parties.

For tax purposes, damages awarded for wrongful death are treated as exempt. However, if additional punitive damages or damages for emotional distress are added to the award, these would become liable for taxation.

Individuals suing their employer for workplace discrimination, sexual harassment or wrongful dismissal may also be awarded a structured settlement, either during mediation or at the order of a judge post-trial. A discrimination case may be filed on the grounds of gender, race, sexual orientation, age or another individual characteristic. The plaintiff may sue for both emotional and punitive damages.

Unlike most structured settlements, discrimination settlements are taxable although the tax will be deferred until payment streams or lump sums are paid. The claimant can also enjoy the peace of mind that their settlement funds are invested in annuities held by major life insurance companies.

Unlike standard investments, there are no account management fees to worry about and the funds are managed by a team of professionals.

Structured settlements have been used to manage payments to the victims of sexual abuse. In one example, from California, the families of three girls molested by their teacher were awarded a combined total of $8.25m. Each family spread out their $2.75m award using structured settlements.

Since awards due to emotional damage are not exempt from taxation, lawyers will often try to obtain evidence that their clients experienced physical pain and injury during their assault. This includes bruises and bleeding. Although providing such details is clearly a harrowing process for victims, proving physical injury will increase the value of the settlement as neither the award or the accumulated interest will be subject to tax when the payments are made.

If a person is exonerated after being sent to prison, or there is a retrial and they are found innocent, they can sue the agencies responsible for wrongful imprisonment. This includes being pardoned, given clemency or amnesty, or having the original decision reversed or voided.

A structured settlement can help give the claimant some income stability as they rebuild their lives. They can support their children and spouse and regain some of the provider status lost to them while inside. They may even be able to take advantage of missed opportunities such as training or education without worrying about the financial implications.

Wrongful imprisonment is another situation where the proceeds of a court case will be taxable.