A Secondary Market Annuity May Be Right for You – But Be Careful

Think you might want to buy a secondary market annuity – a guaranteed stream of payments you ultimately buy from someone else, usually at a discounted price of 10-15 percent? It might make sense if you’re seeking a higher rate of return in today’s ultra-low interest rate environment.

But buyer beware – these are complicated instruments, flush with legal requirements and pitfalls. Make sure all the rules are followed, or the deal may just unravel. Worse yet, you can wind up paying a penalty of 40 percent federal excise tax on the principal.

Most of the time, you’re best off hiring a lawyer to walk you through the process. Make sure he or she is a well-regarded specialist in so-called factoring transactions, the process used by factoring companies – i.e., specialized finance companies — to broker the sale of payment streams between annuity owners and prospective buyers. The annuity owners get a lump sum payment; the buyers get the annuity at a discount.

Some Background

Some background is in order. You’re probably aware that when someone wins a state lottery, they don’t get the entire amount all at once. They can take a much smaller lump sum, or they can elect to receive the entire amount as an annuity – a promise of a series of payments over time.

Similarly, when people win a legal settlement, such as a personal injury lawsuit, they often settle not for a lump sum but for a promise of regular future payments – again, an annuity. The payment of these annuities are direct obligations of insurance companies and are safe and dependable.

In purchasing a secondary market annuity from the original owner – a so-called structured settlement — the stream of income is assigned to you. Secondary market annuities typically offer a rate of return well above the norm because the original owner wants a lump sum payment, not a series of payments, and so sells the annuity at a discount. The insurance company is obligated to make these payments regardless if it is the original owner or the new owner.

The development of structured settlements was a relatively smooth affair. But the development of a secondary market for structured settlements, which ushered in factoring companies, was not. Many annuity sellers who dealt with factoring companies were forced to swallow unusually sharp discounts. This, among other things, sparked so much controversy that 38 states enacted statutes that invalidate transfers of payment rights under structured settlements unless they get court approval in advance.

Then the Internal Revenue Service reinforced the state statutes, cracking down on improper structured settlements even more by imposing a 40 percent federal excise tax if a transfer of structured settlement payment rights does not receive required court approval.

Where Does This Leave Potential Buyers Today?

Fast-forwarding to today, where does this leave potential buyers of secondary market annuities? They typically have a robust inventory to sort through in a given year, typically valued at $600 million to $1 billion-plus, and buyers have more protection than ever. Nonetheless, it is still a case of caveat emptor.

A would-be secondary market annuity buyer must make sure the proper procedures are followed, and that the secondary market annuity is thoroughly vetted. Otherwise, he can still wind up with a bad deal and a very fat penalty. Most of the time, you have to hire a specialized attorney, and you have to make sure he or she is good at what they do.

Here are two specific tips:

• One way or another, make sure the payments of the structured settlement exist and are unencumbered.
• If you deal with a factoring company that has an outside attorney to oversee the purchasing process, make sure he is an honest broker, not merely doing the bidding of the factoring company. Check that is he not incentivized to approve the deal. Regardless of whether he approves or disapproves of the transfer of funds, he needs to be compensated.

Andrew Murdoch, president of Somerset Wealth Strategies, a wealth management company that sells secondary market annuities, summarizes the whole situation succinctly. “These transaction can go wrong,” he says. “Having an independent attorney review them is good protection. The extra money offered by secondary market annuities might not be worth it if these transactions are not properly vetted.”

KEY SECONDARY MARKET ANNUITY TERMS:

• Secondary market annuity: This is an annuity owned by someone else that you can purchase at a discount and have the stream of income re-assigned to you. The insurance company that originated the annuity continues to guarantee payments.
• Structured settlement: The process of buying a secondary market annuity.
• Factoring company: A specialized finance company that brokers the sale of payment streams between annuity owners and prospective buyers. The annuity owners get a lump sum payment; the buyers get the annuity at a discount.
• Standard annuity: Unlike a secondary market annuity, this is purchased directly from an insurance company. There are many types of annuities sold by many insurance companies, but they don’t offer terms as attractive as a secondary market annuity because they are sold at full price.

By Steve Kaufman