Structured Settlement Investments are a financial innovation in the investment arena. They promise a unique form of investment opportunity to the investors but before analyzing how they fare before other investment alternatives, it is important to briefly understand what Structured Settlement means and how such investments originated.
Understanding Structured Settlement
Structured Settlement is the special form of compensation amount payable for any form of damage done to a party (like injury by medical negligence) by another party against whom the victim files a lawsuit. It consists of one part of the amount paid to the claimant initially and the other part of the larger amount which is paid out to that party through installments instead of paying the whole compensation as a lump sum. According to the NSSTA (National Structured Settlement Trade Association), in order to make this form of compensatory mechanism more widespread, the Congress (United States) in 1982 laid down specific tax rules called the Periodic Payment Settlement Tax Act and the Section 104 (a) (2) of Internal Revenue Code stated that the whole amount of structured settlement would be tax-free to the claimant.
Structured Settlement Investments
The defendant party has the option of buying an annuity from a good insurance company by paying a large lump-sum amount so that in future henceforth the insurance company takes up the responsibility of making annual payments to the claimant while defendant party becomes free from the responsibility.
On the claimant’s part, the party may not want to wait for the defendant to pay annual installments for the next decade or two, due to some urgent need of liquidity or immediate expenses to be met. In such a case, the claimant party may sell off the whole or a part of its structured settlement to a broker who purchases the settlement annuities for a large lump-sum amount by surrendering the right to receive further compensation installments to the buying party at a discounted rate. The agent/broker sells off this annuity to the investors who wish to buy such a policy of discounted structured settlements put up for sale. This form of investment is made possible because claimants do not wish to wait for the settlement amount to come to them in installments and desire to exchange it for lump-sum cash. This is the basic concept of the structured settlement investment. It is a financial innovation popular in US, UK and Europe.
Now apart from these settlement investments there are other investment alternatives too that people usually invest in such as the bank trust, certificate of deposit, equity mutual fund, municipal bonds, US Treasury securities etc. Each offers its own distinct advantages so discussed below is the comparison between structured settlements as an investment option and the other forms of investment alternatives that financial market has to offer.
Structured Settlements vs. Other Investment Alternatives
The investment alternatives are discussed on some important constructive that help an investor make a wise choice before putting his money into any scheme. They are as follows:
Insurance Products Supporting the Payments – As discussed before, in case of structured settlements an annuity issued by a credible life insurance company backs the payments so that there is no risk of default. An equivalent riskless investment could only be US Treasury Bonds which are government securities that offer lesser return but higher guarantee of payment and almost zero risk of default. The other investment avenues do carry a back end support but none of them is as secure as these two.
Guaranteed Stream of Income – An investor can avoid the risk of poor financial choices by investing in structured settlement wherein pre-determined periodic payments and a continuous flow of income. Another investment avenue that offers guaranteed income is US Treasury Bonds. While the other options like the mutual funds or Certificate of Deposits do not offer this guarantee. For example certificate of deposits pay a fixed interest but also impose a huge penalty if the amount invested in them is withdrawn pre-maturely.
Any guarantee provided with the investment – For structured settlements, annuity issue guarantees the payments on time. For treasuries and Certificate of deposit, Federal Deposit Insurance Corporation (FDIC) insures up to $100,000. For US treasury bonds the US Government is the guarantor and is by far most credible of all. While for the equity or mutual funds there are no guarantee at all. These fluctuate largely with the investment climate.
Tax liability on payments – The Internal Revenue Service Code Section 104(a)(2) assures that the settlement payments received by the claimant from the contract are tax-free and even the interest rate received on this amount are free of all taxes. In municipal bonds, generally interest is kept out of the tax band while US treasuries are liable to pay only Federal taxes and no other state taxes. Other options like certificate of deposit are fully taxable.
Effect of external changes and market fluctuations – There isn’t any effect of volatility in the stock market health or of fluctuations in interest rates on structured settlement amount. Same is the case with US Treasuries which pay the guaranteed sum on maturity irrespective of market conditions. While for the other options like Certificate of Deposit, municipal bonds, mutual funds and equities, all are very much affected by the market conditions.
Flexibility of making changes later – The structured settlements cannot be altered once the agreement has been entered into. The terms of payments stay put no matter what. Same is the case with the certificate of deposit which imposes a penalty for withdrawing the money before date of maturity. But municipal bonds and mutual funds are flexible in this sense. They award the investor based on good market conditions so for mutual funds the investor may move hos money to some other avenue by paying a charge for it and in municipal bonds, if the investors sell of their investment before maturity they have chances of earning a capital gain or incurring a capital loss, much different from the amount of the bond.
Costs and fees involved – Structured settlements and certificate of deposits involve no extra charges or commission of any sort if the investor holds the investment till maturity. On the other hand for equity mutual fund there may be sales charges and redemption charges apart from the management fee and other expenses. Similarly if US Treasuries are bought from secondary, market some charges may be levied accordingly. Bank trusts also charge bank management fee of 1-1.25% of the value of the asset annually.
Built-in Inflation Factor – Structured settlement offers the additional option of Cost Of Living Adjustment (COLA) to pay the money as long with an in-built inflation factor to guard the investor against rising prices with absolutely no additional costs or charges. Certificate of deposit doesn’t offer any such facility because it’s considered to be a low-risk and low-yield investment. Equity mutual fund is designed for a long run growth so they help guard against inflation in that sense. While municipal bonds and US Treasuries do not provide any guard against inflation.
Each of the investment option has its own set of advantages and disadvantages. Thus an investor must keep all these points under consideration before deciding upon the best investment avenue to suit his investment needs.