As we continue with the series of posts and discussions on what I believe should be an increased awareness and approriate use of variable annuity contracts in personal injury settlements, I thought it would be instructive to take some actual annuity projections based on a common scenario, and show how the numbers stack up in each case.
Case Study of a 24 year old male, injured in a boating accident, resulting in permanent partial disability and back pain.
In this particular scenario I'm using something we see often in settlements. A young male, who had engaged in either high risk or physically demanding work or play, being injured, and ending up with some level of long term partial or total disability. As is often the case these involve modest policy limits, no litigation against private interests, and by the time medical liens are paid back, legal fees paid, and debt paid off, you are typically left with approximately $150,000 to structure in the typical situation.
Using that net figure of $150,000 we can make some general assumptions in designing a structured annuity for the client.
The first assumption is he is currently unmarried but is planning to get married and pursue some work or career now that his case is resolved and his injury is stabilized. His needs will follow two specific patterns in most cases. He will either have a job, and not need the $150,000 to generate current income at this time, or he needs current income that supplements his job. Therefore, his common concern is typically to put the money away for future income needs, or to have a method of providing supplemental income now, while still creating a long term retirement supplement later. Obviously there are all kinds of other issues present in real cases but lets just keep the assumption basic and simple as we develop our comparison and learn how these annuities compare.
In the first scenario which is the simplest to illustrate, our young man has a steady job, has some permanent partial disability and is concerned he won't be able to work to age 65 given the potential that his back will continue to deteriorate over time. Therefore an early retirement option is very attractive to him, essentially allowing him to retire at about age 55, and if fortune shines on him and he is healthy, he can continue to work past 55 when that day comes. In the standard structured annuity that is used to fund this sort of solution I selected Hartford Financial Services structured settlement annuity product, with the rate code effective on the date of this post, March 7th, 2007.
The annuity for this young man, assuming his entire $150,000 net amount is allocated to a future life time income to commence at age 55, (3-15-2038 start date) would pay him $4,247.08 monthly for life, with a 20 year period certain. This would again cost $150,000, would guarantee payment during the period certain of $1,019,299 and would project to pay over his normal life expectancy $1,397,289. This equates to an internal rate of return of 5.31%, which is entirely income tax free, net of any commissions or management charges and represents a very competitive guaranteed yield to the client over that time frame. $150,000 is converted into over $1,000,000 of tax free money, and meets his objective of having an early retirement program start at age 55.
Lets now take the variable annuity approach and again invest the same $150,000 into a variable annuity contract with the same exact goals and objectives as stated above. In this illustration I have used the SunAmerica/AIG Season's product as the basis of my comparison, as they provide through a variety of riders and options for a guaranteed 6% accumulation on the annuity account, while also providing a broad selection of either managed funds or indexed funds for the cash/investment account. As we proceed always keep in mind the very important difference between the annuity and cash accounts, as that distinction is crucial to the understanding of this product.
Assuming we put the $150,000 into the account on the same day, and we accumulate it again to the pay out day we listed on the structured settlement annuity, at a 6% guaranteed return, the annuity account will have no less then $913,215 in it on that date. Keep in mind that the variable annuity accumulates tax deferred and that the 6% yield is net of any investment or insurance charges to the cash/investment account. Under the provisions in the variable annuity contract, the client may then annuitize at a 6% annual guaranteed return for life, regardless of how long they live and what the actual investment performance was or is in the cash/investment account. Therefore, we can again assume that given the contractual guarantee, that we can now use our base cash amount of $913,215 as the foundation of our monthly income for life for this young man, which equates to $54,793 annually, or approximately $4566 monthly for life. Again, this is the guaranteed amount, and as simple math shows it is $319 monthly more then the structure, or $3828 per year. The approximate pre-tax difference to the client just in the income over the 20 year payout is $76,560. Real money but not a huge differential.
Lets continue to look at these numbers and the income tax impact on the variable annuity. If our young man at 55 takes early retirement, and this annuity is the primary source of income, he will fall into at 15% federal tax bracket assuming he is married, filing jointly and his adjusted gross income is between $15,100 to $61,300 under current law. Now I know in many states he will also face an income tax, but in many locations where people retire, their is no state income tax or it tends to be quite low. Lets just keep in mind he MIGHT have a state income tax, but then again he might not. Our one certainty in this illustration is federal taxes.
Assuming our young man now has 15% of each check taken out in taxes, a safe general assumption, his true net monthly income under this scenario would be about $4000 per month, roughly $566 less then his free cash flow amount, and about $250 monthly, or $3000 annually less then his structured annuity. I arrived at this using a 16% exclusion ratio and then calculating his 15% tax on the $3836 monthly that is reported as taxable ordinary income.
So, at this point many structured settlement brokers would declare the structured annuity the winner on the guaranteed net cash flow analysis, while the variable annuity would win on the gross monthly income comparison, which using these calculation would be correct assumptions. However, this is where the real world and the value of these products starts to intrude upon the old reliable structured annuity, in that the variable annuity contract has several features and provisions which elevate it beyond the structure. They are as follows:
1. The cash/investment account is fully liquid and continues to grow during the payout phase. Quite simply, our young man likely has at least $1 million dollars in cash value in his annuity contract, and as I'll demonstrate in a minute, quite possibly twice that amount. The structure is guaranteed periodic payments that pay out $1,000,000, the variable annuity is a $1,000,000 cash account that also pays out $1,000,000. Therefore, just using our simple math this young man is easily $1,000,000 ahead using the variable annuity, at least on paper, compared to his electing to use the structure.
2. The variable annuity has a guaranteed increasing death benefit of 6% annually that is paid income tax free to the young man's estate at death. As all of us know in the settlement business, the death of an annuitant often triggers a financially traumatic event. The life income either stops and his heirs are left with nothing if the period certain has expired, or there is a need for immediate cash that creates a desire to factor the remaining payments. Using the variable annuity approach we instead are looking at a steadily growing guaranteed death benefit that is paid income tax free to his estate with no need to factor or cash in a contract. Other then using the cash flow of the structured annuity to purchase life insurance on our young man, there is no way the settlement annuity can match this result.
3. The variable annuity illustration I used was for the guaranteed return. The variable annuity by staying fully invested in the equity market over the decades will possibly surpass the guaranteed yield. Using a historical gross equity yield of 11.4% over the last 40 years, and then reducing it to a net yield of 8.4% to account for fee's, expenses and marginal investment performance, the numbers we illustrate for our young man are substantially different. The account would now have $1,828,096 in it at age 55. The monthly gross cash flow would be guaranteed at $9,140 monthly, or $109,685 per year, and even after taxes computed at 25% percent marginal rates, after exclusion ratios, would net a monthly figure to our young man of $7,042, or $84,507 annually. This is almost $3000 monthly more then the structured annuity, or $720,000 more over the 20 year payout. It gets even more striking when you now consider our subject is sitting on a pile of $1,828,096, in addition to his monthly income, and that his pile could continue to grow over the 20 years as well.
4. The variable annuity has a provision that INCREASES income during the payout phase, if the account exceeds the guarantees. Using an five year step up basis, the investment/cash account could increase by the proportion that the investment account exceeds the guarantee account during the pay out phased. In other words, unlike the structured annuity that stays level in our illustration for life, the variable annuity every 5 years could see an increase in the basis by which his guaranteed money is calculated, thus allowing him to stay fully invested in the market and maintain pace with equity markets and inflation through these potential set up's in value.
5. The client owns the annuity contract and is able to start his income when he desires, in whatever amount he deems appropriate or to access the cash account in either whole or part if emergencies arise. Again, as I've stated before, lets all get over the myth that people can't get cash out of their structured settlement and that we provide spend thrift protection. Anyone can factor their contract, obtain cash and pretty much blow up their annuity at any time, and usually at significant cost to them. Yes it takes time, yes it takes a court order, but anyone who reads Matt Bracy's blog at The Factoring Channel will quickly realize that if there is a determined annuitant, they will find a way to get their cash. With the variable annuity we still incentivize people to use the annuity for life time income through the use of guarantees, death benefit provisions, some potential income tax penalties, and loss of superior investment performance, etc. However, if they do want their cash they can get it, usually with in 72 hours and typically with little or no surrender charge on the more competitively priced annuity contracts. You can't show me numbers where factoring is a financially stronger deal then someone taking money out of a VA contract. Also, lets keep in mind the client could start his income either later then, or earlier then, age 55 depending on his needs and desires, increase greatly his financial freedom and reducing the incentive to factor.
6. The client, given that the variable annuity is a securities product, by regulation must have a registered representative or investment advisor monitoring his account and providing annual reviews and updates. Why is this a benefit? It's because the settlement industry is designed to be a "set it up and forget the client" sale, as the settlement broker or agent is paid on the front end, and has zero financial incentive or regulatory mandate to keep in touch with the client beyond the policyholder service provided by the life markets that underwrite the structure. Injury victim's and annuitants need and deserve on going advice and assistance in their financial affairs so that they don't foolishly factor away annuity benefits, or otherwise ruin their financial futures.
Ok, this was long and it's a lot of reading, but tomorrow I'll be illustrating another case involving a 32 year old widow who needs income now, as well as the future and how a blended solution of a variable annuity and structure is her best possible option.