SUMMARY: Investing in structured settlements
As interest rates remain low, investors – especially retirees – are struggling to find returns wherever they can. Unfortunately, the need to generate the return required to finance financial goals is the mother of invention for a wide range of legitimate and fraudulent investment strategies.
An up-to-date offer of increasing popularity is the investment in structured annuity contracts, which often claim to offer “no risk” returns in the range of 4% to 7%. In general, the chance for “high yield” (at least compared to today’s interest rates) and “no risk” is a red flag warning. But the reality is that with structured bond investors, higher returns can be less of a risk; The attractive yield compared to other low-risk fixed-income investments is not due to increased risk but to very poor liquidity. This means that such investment offers may be a way to achieve higher returns, not through a risk premium, but through a liquidity premium.
However, the disadvantage of structured annuity insurance is that investments can be so illiquid and cash flows are so infrequent that at best they should only be considered for a very small portion of a client’s portfolio!
Invest in a structured settlement pension
The inspiration for today’s blog post was a series of requests I got from other planners last month whose clients are being asked to invest in structured annuities, but understandably are wary of the alleged “high fixed low return” risk After all, most returns that are too good to be true for their risk are actually too good to be true, and carry a higher risk than what is obvious at first, because of the unique nature However, the way in which structured resolution pensions work, the reality is that higher returns are not a high-risk premium but a low, low-risk liquidity premium.
To understand why it may be helpful to check exactly what a structured settlement is. A structured settlement arises most often when a plaintiff wins litigation – for example, for medical misconduct – and the compensation is paid as a set of payments over a period. This often happens in line with certain key aging – for example, structured billing for an injured child could be such that the majority of payments are made after the child’s 21st birthday, while structured billing is for an injured 45-year-old annual payments for the next 20 years and then a lump sum at the age of 65 years. Every situation is unique.
However, in order to avoid the financial risks that result from the plaintiff waiting for the defense counsel to make payments over the years or decades, the defense counsel (or the professional liability insurance of the defense counsel) often buys a pension from a quality insurance company Payments to the claimant so that the defendant can settle his / her end of the settlement with a single lump sum payment.
Where does structured annuity investment come into play? The opportunity arises when the plaintiff who receives the structured pension payments finds a need or need for more liquidity. Or as the infamous J.G. Wentworth (a firm that buys structured accounts) said, “If you have a structured settlement but now need money, call J. G. Wentworth, 877-CASH-NOW”! Therefore, the person receiving payments will contact the company to investigate the sale of structured settlement proceeds.
In practice, most companies that buy structured financial statements do not consider them in their investment portfolios. They then sell the structured settlement annuities to an investor, invest a small amount, or charge a premium as commission and seek another structured annuity to buy and repeat the process. This ultimately means the company must find both a continuous stream of people who sell structured annuities (not surprisingly, easier to find in these tough economic times) and investors who are willing to buy the seller’s unique annuity stream.
Typical terms for structured settlement pensions – costs and cash flow returns
What does that look like from an investor perspective? Since each structured settlement has been arranged for the particular circumstances of the winner, no two structured settlement annotation options are the same. You could offer $ 2,000 / month for the next 18 years; another could provide a lump sum payment of $ 200,000 in 10 years and another $ 100,000 5 years later with no interim payments; another could provide for a set of $ 1,000 / month payments for 10 years, then a $ 100,000 lump sum at the end of 10 years.
How does the return of such irregular payments work? From the investor’s point of view, this is comparable to the purchase of an original issue discount bond, which is due at face value. For example, if the structured settlement provides $ 200,000 in 10 years and another $ 100,000 payment in 5 years thereafter, the amount of capital required for the investor could be $ 170,884; If you calculate (it’s a standard IRR / NPV calculation for every financial calculator or spreadsheet), “invest” $ 170,884 today for $ 200,000 received in 10 years and receive another $ 100,000 in 15 years equivalent to a 5% internal rate of return. However, it is important to realize that you will not receive any ongoing 5% / year payments (unless that is what the annuity offers); Your 5% return is solely due to the fact that so much money for the future value the investor receives from the pension payments is equal to the principal amount the investor has paid today to receive them. The return is therefore legitimate, but not comparable to the current cash flows from a 5% coupon bond.
The illiquidity risk premium of investing in structured settlements
Why are the returns as high as they are? It is not because of the risk; As noted above, pension payments are typically funded by high-rated insurance companies, which are believed to have virtually no risk of outright annuity default (after all, the originally structured payee relied on these payments), and the Court would not have approved it if the pension provider was not healthy!). And the payments are guaranteed and committed to the dates that are assigned; In contrast to the lifelong annualization that planners are more familiar with, payments from structured settlements are not life-independent (that is, payments continue even if the initial annuity dies). Instead, returns are due to illiquidity.
After all, how many people out there want to buy an arbitrarily structured settlement of $ 200,000 in 10 years and another $ 100,000 to arrive five years later with no intermediate cash flows? The answer is not many. However, in many cases, the recipient of the structured settlement needs liquidity for some reason and cannot wait long. The result: The structured settlement receiver will be ready to give up a healthy discount rate to get this lump sum now.
So, where does that suit the financial planning client? The internal yield of many structured settlement payments is quite attractive in today’s market. Rates of 4% + are quite common (although this is not a big margin compared to the return of comparable long-term bonds). But most customers are unlikely to find a structured settlement that actually delivers cashflows that match just when the customer needs them, and there are just so many to choose from at any given time (for example, here’s an example of a bullpen of one provider) – which at best means that this should only be done with a small part of the portfolio that does not create a liquidity problem for the client investor. Otherwise, the client could become a seller and be forced to go through the same discounting process – bearing in mind that the structured settlement broker also needs a cutback, so if the “cost” for a 5% return is $ 170,884, the previous example, the seller will get something less than this amount. This means that a buyer who becomes a seller is likely to suffer his loss as he essentially absorbs both sides of a broad bid-ask spread. That is, this is only for “long-term money”! And of course, the broker’s necessary due diligence, which arranges the structured settlement and confirms the rating of the underlying insurance company, is essential as always.
It is also worth noting that structured annuity investing is not just something to be asked of the customer. Some of the structured settlement brokers involved are now also directly accessing financial advisors (to gain access to more investment dollars), and in some cases, the advisors may actually be compensated and paid into commissions to help organize such investments ( not unlike the way registered agents are paid for many forms of annuity investments). However, this requires the broker/dealer to review and approve the quote (so that the registered agent has no difficulty in selling). And in practice, it seems that brokers/dealers themselves are mixed in these offerings. At least one company I know does not want to allow their representatives to make structured annuity insurance, not because they are uncertain or risky, but because the broker / dealer fears that if more investor dollars flow into that room, structured settlement annuities will encourage companies more aggressively and possibly even predatory in trying to convince structured settlement recipients to use their guaranteed payments in return for fast and easy cash payments now (as typically structured settlement annuity recipients are not likely to do “the math” on) the internal interest rate is used to discount their payments!). On the other hand, the reason for the high returns on structured bond investments lies in the fact that so few investors are involved that the market is very illiquid and inefficient; Theoretically, if multiple companies were competing for payments from a structured settlement receiver, there would be more competition, resulting in a higher price, delivering more money to the seller and offering lower (more “competitive”) returns to the investor.
In the end, structured annuity investments can only go so far. There are only so many structured annuity insurers that receive payments, even though this “industry” has expanded in recent years to also buy the annuity payments from lottery winners, and even wants some annuity payments from individuals who have just purchased a commercial product now liquidate it. However, there are limitations to the capacity with which this particular investment strategy can grow. For the time being, however, returns would suggest that the seller’s demand is beyond the buyer’s interest, creating an opportunity for the client investor who can tolerate illiquidity and otherwise perform due diligence.
So what do you think? Have your customers been approached about structured pension adjustment procedures? Did you advise them to invest or not? Have you considered contributing to the brokers offering such investments?