Financial planners, financial advisers, other Investment representatives, plaintiff attorneys or even plaintiffs themselves occasionally raise questions about the rate of return on structured settlement annuities compared to other investment alternatives. It is important to keep in mind that these structured settlement payments, pursuant to IRC Sec 104(a)(1) or 104(a)(2), are totally free of any Federal, State or City income taxation. On the other hand the investment return on the settlement proceeds received in cash and outside of a structured settlement will generally be taxable as to income, capital gains, or both.
The income generated by investment of a large cash lump sum settlement would likely subject the plaintiff to higher tax brackets. Therefore, considering federal and state taxes and your tax bracket, you would need to earn 20% to 40% greater rates each and every year throughout a lifetime (or the term of the structured settlement if not a lifetime or life contingent annuity) to equal the same rate of return as the structured settlement on a net after-tax basis. The number that you need to earn on a taxable basis to equal the internal rate of return on the structured settlement payments is sometimes referred to as the
"taxable equivalent yield" or "taxable equivalent internal rate of return". Click on the blue link to access a handy table that will help you compare.
If the plaintiff has health considerations, significant future medicals, but uncertain mortality, "rated age" structured settlement annuities with a deferred start date could function as a "backstop," and could produce a taxable equivalent internal rate of return that exceeds 9%, guaranteed for a lifetime.The average return for large capitalization stocks from 1926-2004 has been 10.4%* a year and between 1990-2004 it was only marginally better at 10.9%*, with much more risk and volatility. Liquidity can be provided by pairing the structured settlement with a settlement preservation trust, settlement conservation trust, or a special needs trust if there is a need to protect public benefits. The use of a "structured annuity backstop" is a strategy that facilitates a greater cash component and greater liquidity.
At a minimum, a plaintiff should consider the portion of his or her portfolio, or settlement proceeds, that would normally be invested in conservative products -- such as U. S. Treasuries, Municipal Bonds, Corporate Bonds, etc. (typically one-third to one half of the settlement) -- in a "structure" as this will improve the rate of return on these monies due to the tax-free status. If a trust officer, stockbroker, money manager, or financial planner advises they can exceed the total amount of payments on a net after-tax basis, see if they will issue a letter guaranteeing their statement. They probably can't!
Structured settlement payments are contractually guaranteed through customized (bespoke) structured annuities that we place with a multi-billion dollar life insurance company (or companies). If you have any doubts and think you can do better with your investments while minimizing risk, consider
"Monte Carlo simulation" as an effective means to illustrate (to attorneys or plaintiffs) the volatility of investment returns with certain hypothetical investment mixes (on settlement proceeds) against the amount and timing of the plaintiff's absolute needs. It may be helpful to you.
As an alternative, variable payout structured settlement annuities** permit a claimant, with suitable risk tolerance, to participate in the financial markets (i.e. bear investment risk) with no taxes on dividends or capital gains. Thus there is now a method to round out your structured settlement program on an income tax-free basis.
Please also keep in mind there are no ongoing external fees, commissions, trust advisory fees, wrap account fees, reporting requirements or additional expenses in connection with these structured settlement payments.
*Source: Ibbotson Associates, Chicago 2005. Ibbotson data is unmanaged, reflects the reinvestment of dividends and capital gains, bears no management fees or operating expenses and is not available for direct investment.
**May only be sold by prospectus, by structured settlement brokers who are also affiliated with a broker-dealer with the required securities registrations and licensed to sell variable annuities in the appropriate states. Current underwriting rules permit a maximum of 50% (of dollars being structured) to be allocated to this type of vehicle