Market-based structured settlement programs have re-emerged recently and are growing in popularity. From MetLife’s variable annuity offering in the 1990’s to the recent introduction of an investment portfolio approach, market interest drives the creation of alternative options for settlement dollars.
What exactly is a market-based structured settlement? It is an agreement of the settling parties for periodic payments which are funded by an investment portfolio rather than an annuity contract. This results in future payments determined by investment performance, rather than a schedule of fixed benefits. Similar to an annuity-funded structured settlement, the payment schedule (start date, duration, frequency, etc.) is determined at the time of settlement and cannot be changed. The amount of each payment is fixed as a proportion of portfolio value, as opposed to being a fixed dollar sum.
Structured settlements have long been synonymous with guaranteed annuity-funded periodic payments. So how can a program that provides variable payments and is not funded by an annuity be a true “structured settlement?”
Internal Revenue Code Section 130 provides the framework for modern structured settlements and it defines what constitutes a “qualified” assignment for tax purposes. However, not all settling cases fall within the express terms of Section 130; primary examples include non-physical injury cases and pre-1997 workers compensation claims. Cases may also fall outside of Section 130 based on which type of funding asset is utilized. Since market-based programs involve the purchase of investments which may include but not be limited to US Treasuries, these programs utilize the “non-qualified” assignment mechanism. As with all tax-sensitive transactions, prudence dictates not straying far from established formats, and for structured settlement arrangements which fall outside of the realm of qualified assignments, Section 130 is still instructive.
Section 130(c)(2)(A) requires that payments be “fixed and determinable as to amount and time of payout”. This seems pretty clear. However, further research reveals that the Internal Revenue Service refined its definition of “fixed and determinable” in a series of private letter rulings. PLR 199943002 (addressing variable annuity payments) and 201435006 (addressing fixed annuity payments with an index-linked adjustment rider) offer the following definitions:
- Fixed: obligations set forth in the terms of the settlement agreement; and
- Determinable: payments that can be calculated based on an objective formula.
Does a purely market-based payout plan conform to this definition? Yes, provided the payout schedule is fixed at the time of settlement, and the payout parameters (e.g. start date, duration and frequency) are included in the settlement agreement. Furthermore, the agreement of the parties must include the formula by which each payment is calculated, thereby making the payments determinable.
Non-Annuity Funding Vehicle
As mentioned above, market-based programs utilize non- qualified assignments and are therefore not limited to annuities and US Treasuries. Under a market-based program:
- A trust company or administrator purchases and holds a portfolio of securities – typically a diversified portfolio of equity and fixed income securities.
- Payments are calculated based on an objective formula- tied to the value of the investment portfolio at the time of distribution.
- Assets are liquidated and the administrator distributes funds to the payee based on the periodic payment schedule.
While market-based programs will undoubtedly appeal to different payees, the mechanics of their deferral are surprisingly similar. The use of an alternative (non-annuity/Treasury) funding vehicle necessitates the use of a non-qualified assignment. However, market-based programs still follow the familiar framework of existing programs.
The above discussion is focused on the mechanics of deferral as a technical exercise. It is important to note, however, that market-based programs are not appropriate for all situations. For payees who need guaranteed or lifetime income, there is usually no substitute for the traditional fixed settlement annuity. On the other hand, for the client who has discretionary dollars or who wants to blend fixed and market-based programs as a hedge against inflation, market-based programs offer new value and planning options.
To learn more about both qualified and non-qualified settlement options available to you and your clients, please contact your AVITAS Team today.