My name is Mike Green. I am outside counsel to several factoring companies. I blogged last year about my perspective on the court approval process for structured settlement transfers. With this article, I’d like to dig deeper into the financial/best interest analysis. This is an area which confuses many individuals and judges not familiar with the process:
Each state which has a structured settlement transfer statute requires that a Disclosure Statement be issued. While the required disclosures vary slightly from state to state, most Disclosure Statements must indicate some or all of the following:
- total amount of payments to be transferred over time;
- gross amount payable to the transferor;
- net amount payable to the transferor;
- present value of payments to be transferred;
- quotient; and
- effective interest rate.
The first three items should be relatively easy to understand. However, let me try to define the last three terms in plain English. It may not be easy.
Present value seems like a simple concept but it can be difficult to understand. We all know that $100.00 is worth more in 2008 than it is in 2018 because you could put it in a savings account and it would earn interest over the next ten years. Likewise, we all know that $100.00 in 2018 is worth less than $100.00 now for the reverse reason – you do not need to put $100.00 in your savings account in 2008 to have a yield of $100.00 in 2018.
Viewing it another way, we also know that, due to inflation, $100.00 will buy less in 2018 than it will in 2008 – that is why we put money in banks and not under the mattress – to keep up with inflation.. The value of a dollar in the future is less than the value of a dollar now.
Anyway, depending upon your interest rate (I’ll come back to that concept), you might only need to invest $80.00 in 2008 to yield $100.00 in 2018. The greater the interest rate, the more you’ll make on your 2008 $100.00 investment by 2018. Likewise, the greater the interest rate, the less you’ll need to invest in 2008 to yield your $100.00 in 2018.
Now let’s get back to calculating the present value of structured settlement payment rights. Structured settlements are funded by annuity payments. Sometimes, when people die, annuities will pass through an individual’s estate. The IRS taxes those assets.
In order to place a present value on an annuity’s payments, a discount rate must be applied to account for the decreased value of those future dollars. The higher the rate, the lower the present value. The lower the rate, the higher the present value.
Since the IRS wants the annuity to be valued at a larger number so as to increase tax revenue, it traditionally uses an artificially low discount rate to determine the discounted present value of the payments to be transferred. .
Most structured settlement transfer acts require that the present value of future periodic payments appear on the Disclosure Statement and that the present value be calculated by using the existing IRS rate to value annuities. However, the statutes’ utilization of this rate is arbitrary; the IRS rate does not reflect a fluid market rate or cost of funds for a factoring company to purchase the periodic payments.
Quotient. This figure is calculated by taking the amount which the transferor would receive (the net payment) and dividing it by the discounted present value according to the IRS rate.
Effective Interest Rate. While structured settlement transfers are sales, not loans, they are analogous to loans and it is most helpful to visualize and evaluate them this way. Like loans, the structured settlement transferor gets a lump sum of money at the date of closing. However, instead of paying the loan back over time with his or her own money, in a structured settlement transfer, the transferor is essentially “paying back” the factoring company with the future annuity payments which accrue over time.
Effective interest rate is the best and cleanest way to begin the evaluation of whether a transfer is in an individual’s best interests. A recent real world example from an approved transfer may help illustrate why the analysis of the interest rate is the best “apples to apples” analysis and why it is better to use than simply relying upon looking at the aggregate amount of payments transferred, discounted present value or quotient to determine whether a transfer is in an individual’s best interest.
Let’s call the transferor Smith.
Pursuant to wrongful death action, Ms. Smith became entitled to receive nearly $2,300.00 per month for thirty years. She sought to sell 170 monthly payments of $500.00 out of her larger $2,300.00 monthly payments from November 2008 through and including December 2022 in exchange for a gross and net sum of $42,814.00.
The total amount of payments to be transferred was $85,000.00.
Based on the IRS discount rate at the time of the transaction (4.2%), the Disclosure Statement indicated that the present value of the $85,000.00 to be transferred over the next 14 years was $64,204.53.
The quotient (net payment divided by present value) was 66.68%.
The effective interest rate was 11.25%.
Judges and transferors sometimes get confused in cases like Ms. Smith’s. They ask the transferor, “Do you understand that you’re barely getting half of what you’d get if you waited?” On its face, that question is accurate; Ms. Smith was giving up $85,000.00 over the next 14 years in exchange for $42,814.00. However, in asking such a question, the judge would be ignoring the fact that $85,000.00 is not the present value of the payments which Ms. Smith was transferring; the present value of the $85,000.00 in future payments is significantly less.
That said, the discounted present value as presented in the Disclosure Statement is not necessarily accurate or the best indication of the real “value” of Ms. Smith’s structured settlement payments. The IRS rate of 4.2% is an artificial construct; Ms. Smith cannot convert her right to the $85,000.00 in future payments into cash at a discount of a mere 4.2%. If she could, she undoubtedly would do so and there would be no factoring industry.
Since an individual can’t convert his or her future payment rights at the IRS discount rate for valuing annuities, a competitive market has developed to help individuals convert structured settlement payment rights into lump sums. While I am not privy to such information, I doubt that most factoring companies are able to “borrow” money at the IRS rate of 4.2%; I would suspect that that figure is higher, thus further diminishing the actual present value of the $85,000.00 to be transferred. Further, factoring companies are businesses with overhead and seek to make profits. In sum, when you calculate costs of funds (that is, the interest rate at which the factoring company could get money) plus overhead and profit, it is likely that no factoring company could obtain a 4.2% interest rate as set forth by the IRS.
Moreover, the IRS rate of 4.2% fails to reflect the additional costs which must be incurred by the factoring company in obtaining court approval of a transfer. These costs include “inside” costs such as for taking applications and processing and “outside” costs such as hiring counsel and paying court filing fees to obtain the necessary court approval required by statute.
Accordingly, while the Disclosure Statement indicated that the present value of the $85,000.00 was $64,204.53, the calculation was hypothetical and not based on market realities. In the real world, due to the fact that the real discount rate would have been greater than 4.2%, the present value of the $85,000.00 on the open market was lower than $64,204.53.
The quotient (net payment divided by present value) is similarly unhelpful. According to the quotient, Ms. Smith was getting on 66.68% of the present value of her future payments. However, since the denominator in the calculation (the present value based upon the artificially low IRS rate) is too high, the quotient necessarily yields a percentage that is too low.
In this case, Ms. Smith’s effective interest rate was 11.25%. Yes, that rate is higher than most mortgages. However, it is significantly lower than most credit cards. Essentially, in this transaction, Ms. Smith was essentially seeking to “borrow” $42,814.00 at 11.25%.
In my experience, most transferors are seeking lump sums to pay down debt, forestall collection and/or foreclosure or to make large investments (such as a down payment on a home or to purchase a business) and they have no access or ability to otherwise borrow or obtain the large lump sum they seek at more favorable terms. By selling their interest in future payment rights, these transferors are able to obtain the large lump sums they need without incurring debt.
If memory serves, Ms. Smith planned to use her $42,814.00 lump sum to pay off a higher interest credit card and use the balance towards a down payment on a home. By paying off the higher interest credit card, she was able to increase her monthly cash flow and, as stated, she had no other access to such a large sum of money towards the down payment of a home.
The judge in Ms. Smith’s case understood the transaction and approved it.
Some final thoughts: I sometimes see judges become concerned at an interest rate which may seem high. Sometimes proposed transactions will contain an interest rate which exceeds 20%. While, in some circumstances, that interest rate is indeed unreasonably high, other times that rate may be reasonable. The judge and the transferor need to understand that, in general, the effective interest rate is based on the size of the payments to be transferred, the dates that those payments will be transferred and the perceived viability of the annuity company, considering also the factoring company’s overhead and profit. The factoring company also bears the risk of inflation. If inflation increases, it acts as a discount rate, “diminishing” the future value of the periodic payments. When an individual makes a structured settlement transfer, the inflationary risk (as well as the insurance company viability risk) passes to the factoring company.
“Smaller” transactions, i.e. proposed sales which involve one relatively small payment or periodic payments which are due many years in the future, will often have higher effective interest rates because of the factors described herein.
