Structured Settlement proposals are often the opening gambit in settling personal injury, wrongful death or chronic injury Workers’ Compensation matters. They are presented by Structured Settlement brokers who are most often selected by the liability carriers. The brokers maintain their status by successfully settling cases at the lowest cost to those carriers. The structures of deferred periodic and/or lump sum payments may reflect the broker’s understanding of the Plaintiffs’ needs, and will be below the funding limitations established by the liability carriers. The payment vehicle is either an annuity or a trust, and the broker or provider is paid a percentage fee from the amount paid into the structure, usually, on a gross basis.

While not offering a tax or legal opinion, the Internal Revenue Code establishes that settlements in wrongful death, personal injury and chronic injury Workers’ Compensation matters, excluding punitive damages, are recovery of losses and not taxable. Periodic payments are likewise treated as nontaxable recovery of losses over time, if the payment vehicles are either annuities or Treasury obligations, and if certain arcane rules are met. These rules seem to be designed to separate periodic payments from payments received from the investment of the proceeds of a settlement. A failure to adhere to the rules would presumably result in making taxable a part of the payments considered interest, but not the original value of the settlement. It can be assumed that the beneficiary could then offset the income with expenses (e.g. medical expenses and a portion of the broker’s fee).

As mentioned above, annuities and Treasury obligations are the specifically mentioned vehicles for periodic payments. In addition, Structured Settlement vehicles for certain classes of beneficiaries may be prescribed by statute or require Court approval.

The time value of money is easily understood in concept and difficult to understand in application. The first part is

What will a dollar invested today at 5% simple be worth in a year?

The $1.05 is the future value of the dollar invested today.

What is the value today of a payment of $1.05 to be made in a year?

                          The present value of that payment discounted at 5% is a dollar.

The discount rate is merely the inverse of the interest rate. Sometimes, it is called the Internal Rate of Return (IRR). That, technically, is the rate at which future payments are equal to the original investment.

The current value of a Structured Settlement is a function of

1. The amount and timing of payments, including any Cost of Living Adjustments (COLA). A payment of a $1.05 in a year has a current value of $1. Under the same terms, a payment of $1.05 in two years has a value $0.952. Small adjustments in timing can have a significant impact.

2. The timing of the placement of funds. The longer the funds are held by the annuity or trust before distribution, the more they earn. For this reason and because fees are charged on the amounts deposited, lump sum distributions in the first year of deposit or periodic payments beginning less than 45 days after deposit should be avoided. It is better to take initial needs in cash.

3. The nature of the payment. Payments are either guaranteed or contingent. The guaranteed (certain) payments will be made to the individual or his/her estate. Contingent payments will be made if the individual is alive at the time the payment is due. The value of guaranteed payments is determined by application of discount rates; the value of contingent payments is determined by the application of life expectancy and discount rates.

The life expectancy of the beneficiary is determined by certain tables, if normal, or by adjustment of age to match actual life expectancy. The impact of life expectancy on the value can be adjusted by application of a mortality factor, and the decision whether life expectancy is applied as of the last birthday or nearest birthday.

4. The broker or provider fee. The general practice is to include the fee in the value of the Structured Settlement. The fee rate is applied on a gross basis, or as a percentage of the structure including the fee. The fee, ranging from 4 to 10%, is paid up front from the structure, A fee of 6% applied on a gross basis equates to 6.38% of the net annuity or trust value.

5. The discount rate employed in determining the present value of the Structured Settlement. The discount rate employed by an annuity company is somewhat a reflection of that company’s investment portfolio and the risks contained therein

If the discount rates were readily available and applied on a simple monthly or annual basis, the process would be easy to understand. But the actual rates are not always known, and they are applied from the day of deposit to expected date of payment. Also annuity companies apply blended discount rates, particularly for long term structures, and interpolate differently to arrive at the rates for particular payment schemes occurring in particular years.

There is seldom a right valuation for a Structured Settlement. Guaranteed payments can be calculated with a high level of precision, even when the onset of payments is deferred. The number of hidden variables, and life expectancy and how it is applied, create uncertainty. Fortunately, beyond the discount rate, the various assumptions and choices, if conventionally applied, should yield a quote or proposal that varies by no more than one percent from independent evaluation using the same discount rates.

There are five different types of payments used in structured settlements. They are