Secondary market annuities: Understand them before your clients doArticle added by Nathaniel Pulsifer on January 9, 2014
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Secondary market annuities are a little-known corner of the financial landscape. However, a recent LIMRA study found that 61 percent of annuity consumers conduct online research. This means buyers nationwide are finding out about secondary market annuities online, and it's time that more advisors become familiar with the market before their clients come asking.
What is a secondary market annuity?
The term "secondary market annuity" (SMA) refers to existing, in force period certain payment streams. We use the term "secondary market" to differentiate these existing payment streams from "primary market" newly issued period certain annuities.
While there are payments in the SMA market that originate in lottery prizes and individually owned annuities, it’s important to clarify that most SMA transactions stem from structured settlement compensation for legal claims like personal injury or medical malpractice. It’s also important to note that these secondary market transactions have nothing to do with viaticals or life settlements. Life settlements make bets on actuarial tables, but the secondary market annuities discussed here are period certain guaranteed receivables.
So, what are structured settlement annuities?
The majority of secondary market annuities are guaranteed payment streams backed by period certain annuities from major carriers that currently pay compensation for damages, injuries, or legal claims.
When an injured party elects to take their award as a “structured settlement” over time, U.S. tax code IRC 130 allows the plaintiff to receive their compensation tax free. By opting for a structured settlement over time rather than a lump sum, the plaintiff can
receive both the award and the earnings of that award tax free.
Defendants typically use a qualified settlement fund or other vehicle to shift compensation for the injured party to a major carrier in
a tax qualified manner, and generally purchase a life with period certain annuity to fund the specific payments due under the settlement. The qualified fund or an affiliated entity of the defendant is the annuity owner, and the plaintiff is the payee.
Structured settlements are a useful tool in the legal system that help provide for minors, help injured people support themselves if they are not able to work, and help reduce reliance on public support systems.
However, times change and often, payees under a settlement have a need for cash. As the payees are not the owners of the annuity, their payments are not commutable directly with the carriers into cash. Sellers of payments turn to factoring companies to purchase some or all of their future payments for cash today, and must accept a discount rate for those future payments.
Why the high yield?
When sellers sell at a discount, a secondary market annuity is created that offers the new recipient a higher-than-market rate of return. Buyers of SMAs can receive yields 1 percent to 4 percent higher than comparable primary market, period certain annuities of similar credit quality.
How are the payments transferred to new payees?
Following a 2002 IRS ruling in IRC 5891, where the procedures for a court ordered transfer of payment rights was clarified, 48 states have now adopted relatively uniform transfer guidelines. This opened the market for structured settlement payees to turn some or all of their future payments into current cash in a court ordered process.
Following this legislative clarity, the market grew significantly. The 800 pound gorilla is, of course, JG Wentworth, which purchases hundreds of millions of dollars per year of future payments, and securitizes these receivables into bond offerings several times per year. But there are dozens of other factoring companies as well, with less developed access to capital.
The financial crisis of 2008 opened a door for individual investors to purchase these future payments as lines of credit, and institutional buyers dried up for many of the small-to-mid-sized factoring companies.
The market today
Fast forward to the end of 2013:
Secondary market annuities summary:
- We have a developed market with stable flows of inventory from a diverse platform of factoring companies and attorneys in the industry.
- Modeling the business practices of the large institutions that securitize structured settlement payment rights, we also have a safe and confidential court-ordered transfer procedure that ensures individual buyers obtain clear title to these high-quality, period certain payments at a discount to the open market.
- And the best in class brokers use a secure wholesale platform that facilitates the re-transferability of these payments for their customers should they seek to do so in the future.
In future articles, I plan to detail many additional aspects of secondary market annuities and how they can be used in individual planning scenarios, but I hope this introduction sheds some light on this relatively new asset class.
Individual buyers are finding the market online, and advisors should, at the very least, know about it. Forward thinking advisors may also wish to offer SMAs to their clients. I'd be happy to answer any questions or concerns you may have in the comment section below.
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