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Secondary Market Annuities: So Misunderstood, So Attractive

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calculator-1044172_640-300x200Ask an average investor what a secondary market annuity (SMA) is and you’re likely to get as many answers as people you query. The unusual, lucrative, reliable instrument is perhaps the most misunderstood of all alternative investments out there.

What’s in a name?

There’s a lot of confusion about SMAs because they are closely related to another financial contract known as a structured settlement (aka “structured settlement annuity”). Here is the clarification: Structured settlement annuities are arrangements between two parties in a legal case. The typical case arises when an individual sues a corporation for damages and wins. Quite often, the agreement that results is a series of payments over a longish time period, maybe 10 or 20 years.

Insurance companies buy up these contracts from the individuals who hold them, offering them a lower overall amount than the legal agreement calls for. Why would someone sell a tax-free tort settlement contract for pennies on the dollar? They do so because the insurance company offers them an immediate payment of a lump sum.  

The original contract between the corporation who lost the case and the individual payee is called a structured settlement. After the insurance company buys it and offers it for sale to you or me, it is now a secondary market annuity, complete with a healthy rate of return and backing of a major institution.

Not all SMAs originate with lawsuits. Some of the original annuity contracts are lottery winnings that pay x amount every month or year to the winner. Impatient lottery winners sometimes prefer a quick payoff in cash rather than a long-term payout. Unlike typical annuity contracts, however, SMAs carry significantly higher interest rates because those impatient lottery and lawsuit winners are willing to sell their contracts for deep discounts.

What are the advantages of owning an SMA?

In addition to higher interest rates (see above), SMAs carry a very low risk of default (even lower than high-grade municipal bonds in most cases). Most buyers of SMAs are looking for reliable long-term payments that are higher than market rates.

Investors who want rates higher than bank CDs are prime candidates for SMAs. You can even put an SMA into your retirement account if you have a self-directed IRA. Most SMAs cost an investor an initial outlay of between $50,000 and $600,000, with a typical payout period ranging from 4 to 20 years.

Who can invest in SSAs?

SMAs are appropriate for sophisticated investors who have significant amounts of money to place into a single instrument.

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Risks and disadvantages

  • Generally speaking, risk is very low for SMAs because the payee is a usually a major insurance company or sometimes a state lottery commission. These kinds of institutions rarely default. SMAs are considered serious financial obligations, legally speaking, and if the paying entity defaults they can be held in contempt of court.
  • One drawback of SMAs is that the new owner cannot re-transfer the interest to someone else. In other words, once you buy an SMA from an insurance company, it’s yours, and you can’t sell it like a share of stock or an ounce of gold. This non-liquid nature of SMAs is considered their biggest drawback. They are viewed by financial professionals as a “the buck stops here” investment, so to speak.
  • If you want the money earlier than the payout period allows, or if you desire a lump sum payment, you’re out of luck. Owners of SMAs are locked into the payout period and the ownership of an SMA (but there is a way around this disadvantage through the use of a “payment servicing company.” The payment servicing company (PSC) is named in court documents as the recipient of the annuity money, which must be forwarded to you. This arrangement lets the “average investor” resell the SMA at a later date. The PSC merely shops for a new investor and reassigns the income stream to someone else.
  • SMAs are often difficult for sellers to place because they need to go through a lengthy “red tape” stage that involves state regulations and court approval. This is a seller’s problem for the most part, and the buyer merely has to pay the purchase price and wait for the document dance to wend its way through several layers of official approval.
  • Speaking of paperwork and red tape, if you buy an SMA, you’ll get a hefty ream of documents at transaction time. Called the “closing book” by SMA sellers, the document dump includes a lengthy list of “benefits for the buyer from the seller,” which proves that the seller has legal rights in the income stream. There is also a “due diligence register,” which offers proof that there are no other claims on the income stream.
  • Finally, buyers of SMAs will receive a stamped and sealed court order documenting the transfer of the income stream. This is about as far as a transaction gets from a “gentlemen’s agreement” or a handshake. Awash in legal paperwork and documents, the new owner of the SMA can rest assured that all the official niceties have been covered.

Taxation

There is a lot of misinformation floating around about SMAs and their tax status. The original contract between the plaintiff and defendant is a tax-free payout (most legal tort settlements are not taxed, but there are exceptions). However, when secondary investors purchase an SMA from an insurance company, a lottery commission, or a factoring agency of any kind, the income stream is typically treated as ordinary income to the recipient. How the payouts are handled depends solely on the situation of the recipient, whether the SMA is part of an IRA and a thousand other details.

One of the key things to keep in mind, as an investor in an SMA, is that a good portion of the payout can be considered “return of principal,” which is going to have a profound effect on how a recipient reports and pays tax on the income stream from an SMA. Tax treatment of SMAs is a complicated topic to be discussed with an attorney or CPA before investing.

Note: This article is not to be taken as tax advice. The opinions and ideas expressed here are intended to aid investors in understanding the general nature of SMAs only, and are not to be used or relied upon as financial or tax advice. Anyone who intends to purchase an SMA should research the topic thoroughly and consult a financial professional, attorney or CPA before entering into any kind of contract.

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