Late-night television viewers are no doubt familiar with commercials for a financial company where someone leans out a window and screams “It’s My Money, And I Need It Now!” The announcer then helpfully advises the viewer that if the viewer is owed a future payment stream from an annuity or insurance company, the financial company will be happy to buy some or all of their future payments in exchange for giving the viewer a lump sum payment today.
What those commercials don’t say, however, is that these are incredibly bad transactions for the viewer, who typically gets only pennies on the dollar for the payments they’re selling.
While many people might not realize who the target viewer is, these companies are looking for people who have been seriously injured in motor vehicle and other accidents and who have settled their claims by using a “structured settlement.” A “structured settlement” is a financial transaction where instead of getting a single lump sum payment, the injured person is issued an annuity. An annuity is a financial contract in which an insurance company promises to make a stream of payments to someone over many years, typically decades. One of the features of an annuity is that once the settlement is done, the payment dates and amounts are unchangeable; most annuity issuers will not even consider changing payment dates or amounts.
Structured settlements have numerous advantages, one of which is enabling the person to accumulate interest tax-free. Another advantage is that by having the future payments fixed, the injured person can engage in intelligent financial planning since they know when and how much they’ll be paid in the future. These fixed payment dates and amounts also tend to prevent an injured person from spending the money faster than they get it, which is generally beneficial to the recipient.
As a plaintiff’s attorney who has participated in many cases which involved the use of structured settlements, I can tell you that I have never met a client who understood what a structured settlement was before I introduce the concept to them. Almost all of these people are unfamiliar with the financial concepts involved in a structured settlement, including discounting future payment streams to present value using a discount rate. They simply lack the financial knowledge necessary to analyze these transactions and determine whether or not they’re reasonable.
Sometimes, however, the injured person changes their mind and decides that even though they agreed upon the payment timetable when they settled the case, they want to get the hands on the rest of their money sooner. But the insurance company that issued the annuity typically ties that money up in long-term investments as soon as the ink is dry on the settlement papers, so they’re unwilling to renegotiate the payment timetable.
Unfortunately, unscrupulous companies over the last 20 or so years have realized that there are many financially unsophisticated injury victims who own these annuities, with no understanding of what they’re actually worth today. So these companies spend huge amounts of money on advertising to make everyone aware that they’re willing to buy those future payment streams, all without telling these people that they’re only going to get pennies on the dollar for what they’re selling.
For example, if I owned an annuity today that promise to pay me $1,000 on January 1 of every year for the next 10 years, it’s very simple to calculate how much that income stream is worth today. To do that, you look at current interest rates and, among other factors, the financial strength of the company promising to make those payments to me. After all, promises made by a very secure insurance company are much stronger and more valuable and trustworthy than promises made by an insurance company that’s teetering on the edge of bankruptcy.
Some people may think that such an annuity is worth $10,000 (10 years times $1000 per year). But that’s actually incorrect, because that doesn’t take into account the time value of money. This annuity is actually worth less than $10,000, because of the interest we could earn on that amount during the 10 years it takes to pay it out.
Let’s assume that we use a 5% discount rate (which is similar to an interest rate). Under that assumption, that annuity is worth $7,721.73 today. That means that if you can invest $7,721.73 at an annual interest rate of 5%, you can withdraw $1,000 every January 1 for the next 10 years, and that when you make that 10th withdrawal, you will have a zero balance in that account. That means that the interest you are earning is just enough make those payments, and no more.
If interest rates are lower, it will mean that less interest will be earned over that time period, and more money would need to be deposited at the beginning to reach that balance. For instance, if we use a 2% discount rate instead of a 5% discount rate, that annuity is actually worth $8,982.59, over $1200 more. So with annuities, lower interest rates ( like we have today), mean that annuities are actually worth more, not less.
These “structured settlement funding” companies are extremely sophisticated, and understand very clearly the strength of the insurance company that issued the annuity, and exactly what they would be purchasing from the seller in this transaction.
So what they typically do in these situations is offer absurdly low purchase prices to the recipient. I’ve seen numerous cases where a structured settlement funding company offers an annuity owner less than 15% of what the annuity is worth. To use the example of the “$10,000 annuity” described above, they’re not offering 15% of the $10,000, which would be $1,500. instead, they’re offering less than 15% of the discounted value of the annuity. So for the example cited above, with a 5% discount rate, they would only be offering 15% of the $7721.73.
In such a transaction, therefore, the annuity owner would be selling 10 payments of $1,000 each, and they would only be paid a total of $1,158.26. They could get almost that same amount simply by waiting one year for the first payment of $1,000. In essence, the funding company in this example is buying nine additional payments of $1,000 each for a total purchase price of about $200.
To see just how unfair this transaction really is, now let’s analyze this transaction from the side of the coin. The structured settlement funding company is putting in $1,158.26, and getting out 10 separate payments of $1,000 each, spread out over 10 years. What is the rate of return they’re getting on this money? How good of an investment is this for them?
In this example, the funding company’s profit on this transaction comes to OVER 86% PER YEAR, every year for 10 years.
To put that in perspective, as of today (January 25, 2016), the well-recognized financial website BankRate.com says that 5-year CD yields, from FDIC-insured banks, are averaging 0.84%. In the realistic example explained above, the structured settlement funding company is earning 100 times the interest a bank would pay them for their vast.
In plain English, this is outrageously unfair, and the term “scam” is a fair description of this transaction.
I’ve explained many times to potential clients how badly they are being taken advantage of in these transactions. not once have I ever explain this to someone and they think it’s fair. Unfortunately, I’ve also seen that many times in these situations, even after having had their eyes opened to how badly they are being taken advantage of, the annuity holder still doesn’t realize that in fact they do have other options to pursue.
For example, one other option is to go to a bank and get a loan, using the annuity payment stream as collateral. A bank is not going alone out money at the rate that it pays for CD investments, but the borrower would pay far less to a bank than they end up paying to a structured settlement funding company.
Many states have laws requiring the structured settlement transactions to be approved by a judge. In large part, these are meaningless, rubberstamp court appearances. I have on several occasions happened to be in court when an unrepresented person appears with the funding companies attorney seeking a judge’s approval of the transaction. I’ve seen judges clearly attempt to talk people out of doing this, by explaining in the most harsh terms the judge would come up with how badly they were being taken advantage of. (By the way, many states have laws requiring judges to approve these transactions if they find the seller understands the transaction, regardless of whether or not the judge thinks the transaction is fair. Those kinds of laws, which prevent judges from prohibiting unfair transactions, are the result of lobbying and campaign contributions by settlement funding companies.)
Unfortunately, many times the injured person still wants to go ahead with it, and in those situations it was always clear to me that the person simply didn’t understand exactly what was happening, and realize that they in fact had other options.
The Washington Post recently ran a series of articles exposing how these settlement funding companies operate, including exposing a practice of manipulating the judicial system by filing thousands of cases in favorable counties, regardless of where the parties involved in that case live. The most recent article can be seen here. That page has links to further explanations and prior articles.
The long and short of it is that the current practices of settlement funding companies can and should be outlawed. While these companies can serve valid purposes and they do provide assistance to some people in some situations, they do so by taking outrageous and unfair advantage of their customers, creating unconscionable internal rates of return for the funding companies.
While banks and loan companies making loans for car purchases, home mortgages and the like are required under federal law to give the borrower specific information setting forth in very plain English how much they’re paying an interest, those requirements do not apply to settlement funding companies. While settlement funding companies typically do disclose the relevant information to the unsophisticated buyer, they also typically do that buried in a mess of legalese, hidden in the middle of a dense 30-page document with language only a lawyer can understand. I have yet to see a funding company give the relevant financial information in a single one-page form similar to the way the law requires banks and lenders to do it.
At a minimum, to protect our citizens from this kind of predatory transaction, I urge each state to promptly enact legislation doing all of the following:
- setting a maximum internal rate of return charged by settlement funding companies;
- creating tighter venue requirements so that settlement funding companies can’t judge-shop by filing all of their approval suits before friendly judges who rubber-stamp their approvals;
- mandating the use of disclosure forms similar to the Federal “Truth In Lending” Act which lay out in a single page the important numbers for a transaction including how much the customers paying to the settlement funding company, and the internal rate of return that the settlement funding company is making on the transaction; and
- mandating that settlement funding company advertisements and commercials give useful and realistic disclaimers.