Most often associated with life insurance and disability payments, structured settlements and annuities are monthly or yearly payments aimed at providing individuals with a steady income over a period of time, often decades.
Companies known as “factoring firms” try to purchase the rights to these payments from recipients in exchange for a lump sum of cash, which the companies say could be more useful for someone experiencing financial hardship. The buying and selling of these financial products has become a multibillion-dollar industry.
If you’re receiving a structured settlement or annuity, the thought of cashing it in may be tempting, but this type of transaction carries risks. In fact, most states require courts to approve these sales to make sure that selling a settlement is truly in the recipient’s best interest.
Here’s a look at important factors to consider before pulling the trigger on this type of deal.
Discipline and budgeting
The experts agree: Taking a lump sum of cash instead of getting regular payments over 20 or 30 years can be risky. An individual may end up squandering that money in a few years, whereas regular payments “force a discipline that the lump sum takes away,” says Jim Ludwick, a financial advisor in Odenton, Maryland.
What’s more, collecting regular payments can reduce some of the stress associated with retirement planning.
“A major benefit of taking annuity payments is simplicity,” says Peter Ashby, a financial advisor in Roseville, California. “You receive a set amount of money every month for a set period of time. This makes retirement planning or budgeting much easier, as you know exactly how much money you will have to spend each month.”
Keep in mind that the cash you receive from a factoring firm may be less than you would get from the settlement or annuity you’re giving up. So although you may get a lot of money on the spot, you could lose out on quite a bit as well.
“A company will buy your payment stream at a discount,” says Larry McClanahan, a financial advisor in Portland, Oregon. “The discount depends on the buying company, interest rates and other factors, but the range can easily be between 8% and 20%. You could end up leaving a lot of money on the table.”
Tax and investment implications
If the lump sum in question is substantial enough, it may push the recipient into a higher tax bracket. Money from structured settlement and annuity payments, on the other hand, typically isn’t taxed.
Moreover, once you receive a potentially large sum, the onus will be on you to figure out how to invest it so it produces a steady income stream. Continuing to receive annuity payments from a life insurance policy, for example, relieves you of that responsibility.
“The insurance company takes on the risk of trying to generate enough money to make your monthly payment,” Ashby says. “This takes some of the pressure off of the individual who would have to invest on their own or pay a professional to try and generate the same type of return.”
There are situations in which a sale might make sense. Structured settlements lack liquidity, McClanahan says, meaning that their overall value can’t easily be converted to cash in an emergency. If, for example, you suddenly have to pay for an expensive medical procedure, a lump sum from selling a settlement or an annuity could be a lifesaver. The key is being honest with yourself, and making sure that an urgent expense is truly vital.
“In my experience, what someone claims is an emergency isn’t always that in reality, and they end up blowing the money,” Ludwick says.
You may also want to check whether you can borrow against future payments, and if so, how much. Or, consider borrowing against a life insurance policy, which may offer low rates and flexible repayment schedules. These alternatives tend to carry fewer risks than flat-out sales of settlements and annuities.
The bottom line
Before selling a settlement or annuity in times of financial difficulty, be sure to exhaust all other options first. There are plenty of other ways to raise money to cover unexpected costs.
Consider applying for a loan from your bank or credit union. Or, try borrowing from a peer-to-peer lender. Whatever your need is, these alternatives will probably be better than selling a settlement or an annuity that you’ll almost definitely need to lean on at some point in the future.
Image via iStock.