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One of the most difficult questions for a settlement broker to answer is “what is the rate of return on this annuity quote?” when the payment stream is guaranteed for the life of the annuitant.
Take, for example, a payment stream costing $100,000 on a 50 year old male, who we will assume for this illustration has a life expectancy of another 32 years to age 82. Monthly payments in the example, which are to begin one month after settlement, are $656.36. If this man lives exactly another 32 years and receives 384 monthly payments, the annual rate of return is 7.044 percent.
If he lives 10 years beyond his life expectancy, to age 92, and receives 504 monthly payments of $656.36, the annual rate of return is 7.541 percent.
If he dies 10 years sooner than his life expectancy, to age 72, and receives 264 monthly payments of $656.36, the annual rate of return is only 5.543 percent.
The problem in attempting to answer the question is obvious: we don’t know how long this person may live. Thus, we don’t know the number of payments that will be made, critical to our calculation.
The life insurance company issuing the annuity is assuming what is known as mortality risk. It might price the annuity based on certain mortality factors, including an assumed life expectancy, but it has to be prepared to continue payments if the annuitant (called the measuring life) lives beyond life expectancy.
On the other hand, the annuity company pays out less and retains the difference if the annuitant dies sooner than life expectancy.
By spreading the risk among a large number of annuitants, the insurance company figures it will come out even. This is the same mortality risk principle that insurance companies use in calculating life insurance premiums, but it works just the opposite.
Life insurance companies are in the business of assuming mortality risk, and this is one of the major benefits to an individual of a life-contingent annuity. With payments guaranteed for life, the annuitant does not have to worry about running out of money as he or she might if left to managing invested assets.
The other major advantage to a tort injury victim is that all payments are exempt from income taxes, including the internal growth of the annuity, if the annuity is not owned by the annuitant. Sometimes the annuity is owned by the self-insured defendant, but most often it is owned by a third-party assignment company that has assumed the obligation for the future payments under what is called a “qualified assignment” as permitted by Section 130 of the Internal Revenue Code.
If the annuitant’s marginal (highest) tax bracket is, say, 28 percent federal and 7 percent state, a combined 35 percent, the taxable equivalent annual yield of a 7.044 tax-free structured settlement is 10.837 percent. On 7.541 percent, the annual taxable equivalent yield is 11.602 percent. Even on the 5.543 percent tax-free example, the taxable equivalent yield is 8.528 percent.
Most structured settlements that contain payments for the life of an individual are also guaranteed for a “period certain” so that heirs would receive the remaining guaranteed monthly payments if the annuitant died soon after the claim was settled.
In our same example of the 50 year old male with a 32-year life expectancy, using a $100,000 premium amount, if we guarantee payments for, say, 25 years and his life thereafter, the monthly payment is reduced to $562.90.
That obviously causes the rate of return calculations to change. But the problem in calculating a valid rate of return remains: how many payments will be made?
NOTE: The rates used in these examples were for one annuity company and were valid on the date quoted. However, rates will vary between companies are are subject to change.
Article written by Richard B. Risk, J.D. – risklawsfirm.com

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