Category: Structured settlements

The Cost of Managing the Expenditures of a Plaintiff with Reduced Mental Capacity

Posted on By economica

by Christopher J. Bruce

When referring to plaintiffs with normal mental capacity, the term “management fee” usually refers to expenses that plaintiffs incur for advice concerning investment decisions. Decisions concerning how their awards are to be spent – on medical care, accommodation, transportation, etc. – can generally be left to the plaintiffs themselves.

Plaintiffs who have suffered an impairment in their mental capacity – usually children injured at birth or adults injured in catastrophic accidents – however, may require assistance with many, if not most, of the decisions concerning expenditure of their awards. In this article, I propose to include the cost of this assistance in the term “management fee” and to investigate what the determinants of this fee will be in the case of plaintiffs with reduced mental capacity.

In the first section of this article, I enumerate the various types of assistance that will be required by these plaintiffs. I call this the “hierarchy of needs,” as the responsibility for this assistance involves a pyramid, or hierarchy, of decision-makers. In the second section, I investigate the costs of this assistance.

A Hierarchy of Needs

The management of the plaintiff’s award requires four types of agents:

Financial manager: Once the court award has been paid to the plaintiff, that amount will have to be invested. This will require either that a trust company invest the award in a portfolio of conservative financial assets, or that a structured settlement be purchased from an insurance company. In either case, a fee may be charged for the management of the plaintiff’s finances. (These are the fees that were discussed in the first article in this edition of the Expert Witness, “The Cost of Managing the Plaintiff’s Investments.”)

Guardian – The role of the guardian is to determine how the invested funds are to be spent: to ensure that the plaintiff is provided food, clothing, shelter, transportation, health care, and emotional care. Generally, it is not intended that the guardian will provide these services directly but will, instead, be responsible for hiring an agent called a case manager (see below), and for providing that individual with directions concerning the types and levels of services that are required. The guardian, for example, might decide that the plaintiff should be moved from his or her own home to a nursing home, but leave the decision about the selection of a specific nursing home to the case manager.

Often, the guardianship function will be performed by a committee which might, for example, include family members, legal representatives, social workers, and a life care planner/cost of care expert. The latter are experts who assist the guardian with the development and implementation of a plan for the care of the plaintiff.

Rehabilitation case manager – The guardian will often consider it necessary to contract with an agent to implement the plan that was developed in coordination with the life care planner. This individual is usually called a rehabilitation case manager, or simply case manager. He or she takes direction from the guardian and reports to the trustee (see below).

These individuals are responsible for:

  • the physical safety and emotional and social well-being of the individual in the community – for example, contracting with rehabilitation specialists, physical therapists, educational consultants, and speech and language consultants;
  • contracting with care personnel, such as rehabilitation assistants, home support workers, and nursing staff as warranted by the nature and extent of the injuries sustained and the impact of the impairments on functional ability; and
  • purchasing and maintaining goods and services, including medically-required equipment, such as wheelchairs and modifications to automobiles.
  • They are also responsible for monitoring all of the service-providers that have been hired, to ensure that their functions are being carried out as specified, and for replacing any employees who have resigned or been laid-off.

[As the case manager’s role is primarily to arrange for the purchase of goods and services, he or she may hire a subsidiary set of agents who make the actual purchases. Hence, there may be an additional layer of agents in the hierarchy: purchasing agents.]

Trustee: The trustee performs a “gatekeeping” role, ensuring that the bills incurred on behalf of the plaintiff are paid, that relevant income taxes are remitted, and that expenditures are not mismanaged (or misappropriated). Although one person (for example, a close relative) could act as both guardian and trustee, it is generally recommended that these two functions be separated, in order to provide independent checks on spending patterns.

Management fees

Payment may have to be made to each of the four categories of agents described above. I consider each of them separately here.

Financial Manager: As brain injured plaintiffs and children cannot make their own financial decisions, a third party will have to be employed to invest plaintiffs’ awards. Two options are available: a trust company may act as an investment manager, or an insurance company may provide a structured settlement.

If a trust company has been employed, it will provide its services for a fee that normally varies from about 1.0 percent to 2.0 percent of the value of the investment. Thus, for example, if the trust company is able to obtain a rate of return of 4.0 percent on the investment, from which it deducts a fee of 1.0 percent, the net rate of return will be 3.0 percent. Technically, the financial manager’s fee could be included as one of the costs of caring for the plaintiff. However, the data we recommend the courts use when calculating discount rates – the return on balanced portfolio funds (discussed in the first article in this edition of the Expert Witness,) – and the discount rates that are mandated by many provinces, are already net of investment companies’ management fees. Thus, in practice, no additional allowance will be required.

Similarly, insurance companies’ prices for structured settlements incorporate their costs of management. Hence, if the plaintiff’s award has been paid as a structured settlement, it may not be necessary to provide a separate allowance for the insurer’s management fee.

Note, however, that although it is generally not necessary to include a fee for the financial manager, it may be necessary to include a fee for the trustee (see below).]

Guardian/life care planner: There are three potential sources of guardians: the relatives of the plaintiff, a public agency (often referred to as the Public Trustee’s Office), or a private agent.

Relatives: When brain damage arises from negligence at birth, the parents of the injured child will often act as guardians; and when injury occurs later in life, guardians may be selected from spouses, parents, siblings, adult children, or other relatives. To the extent that these individuals are willing to work for free, it might be argued that no claim for their services can be made against the defendant. However, two counterarguments can be made.

First, for the same reason that relatives are often able to claim for the costs of providing household services or nursing care to the plaintiff, they may also be able to claim compensation for the time and effort required to act as guardians. Second, some allowance must be made for the possibility that the relative guardian will die before the plaintiff and, therefore, that a third party will be needed.

When either of these arguments is accepted, the cost of guardianship can be calculated as the cost that would have been charged by a public or private guardian. (For these, see below.)

Public Agency: Depending on the jurisdiction, Public Guardians may not charge fees for their services, or may charge a below-market fee. It should be noted, however, that all of the experts we have consulted have recommended that, if plaintiffs have large awards, they should not rely on the office of the Public Guardian, as the latter generally deals with relatively small sums.

Private Guardian or life care planner: If it is felt that the Public Guardian is not appropriate, it may be necessary to hire a private guardian. A number of knowledgeable individuals have suggested to me that a life care planner might fill this role. As the function of this individual is to develop a plan for the care of the plaintiff and to ensure that that plan is implemented as intended, it may require only a limited number of hours – perhaps five to ten per month – at approximately $200 per hour. Thus, an annual allowance of approximately $20,000 would not be unreasonable.

A guardian committee may also include a lawyer. If we assume five hours per month at $300 per hour, the annual fee would be $18,000.

Rehabilitation case manager: The costs of hiring rehabilitation case managers vary significantly depending on the severity of the injury to the plaintiff. A U.S.-based life care consulting firm, Caragonne and Associates, has developed an “assessment protocol” for calculating the number of hours of case management that will be required for seriously injured clients. The protocol identifies five dimensions of care, and scores each dimension on the degree of involvement required from the case manager: from low, through moderate, to high. The five dimensions are:

  1. Level of client’s independence: This dimension measures the extent to which the client needs advice and encouragement. It ranges from high independence, in which the client requires only “periodic encouragement” from the case manager, to low independence/high need, in which frequent intervention is required to assist and orient the client.
  2. Number of providers of needed services: This dimension ranges from low intervention, in which the client has obtained the resources needed, to high intervention, in which the case manager will have to contact multiple agencies and providers to arrange for the goods and services needed by the client.
  3. Frequency of appraisal: The more often can the client’s status be expected to change, the greater will be the need for reappraisals by the case manager.
  4. Coordination of providers: Once a life care plan has been put into place, the case manager will have to coordinate the implementation of that plan. The greater is the number of providers that have to be coordinated, and the more frequent is the number of interventions, the greater will be the number of hours worked by the case manager.
  5. Travel: The further the case manager has to travel in order to meet with the client and his or her providers, the greater will be the number of hours required.

Caragonne and Associates estimate that if the client’s needs are rated as “high” on four or more of these dimensions, case management will require eight to twelve hours per month. If the client’s needs are rated as “moderate” on most of the dimensions, case management will require five to seven hours per month. Even a “low” rating on most dimensions will require one to four hours per month.

As many brain-injured clients and child plaintiffs will require a high level of services on most of the Caragonne dimensions, it can be expected that case management will require eight to twelve hours per month. Assuming ten hours per month, at $100 per hour, a case manager would cost approximately $12,000 per year.

Trustee: When trust companies act both as financial managers of the plaintiff’s award and as trustees of the plaintiff’s expenditures, they may offer a rate that is lower than the sum of the financial management fee and the trustee’s fee. As practices will vary among companies, it is important that counsel receive clear quotations for the sum of the two services.

If the Public Trustee acts as trustee, it may charge for its services. In Alberta, for example, that fee equals three-eighths of a percent of the total size of the investment – that is, $3,750 per year for each $1million.

When a structured settlement has been purchased from an insurance company, the insurer will not act as trustee. Hence, an additional fee for that service will often have to be calculated. RBC, for example, will act as trustee of a structured settlement for a charge of 5% of the annual annuity payment, subject to a minimum annual fee of $7,500. Tax preparation services would be in addition, at hourly rates, likely under $1,000/yr.

Summary

It has been our observation at Economica that when the courts use the term “management fee” they are usually referring to the fee for a financial manager, to supervise the investment of the plaintiff’s award. What I have argued in this article is that, when the plaintiff is a child or has been brain injured, there are at least three other classes of agents who will be responsible for managing the expenditure of the award, and who may also have to be compensated. In those cases, therefore, the “management fee” may extend well beyond the value normally considered by the courts.

Most importantly, allowance may have to be made for compensation of the guardian, the life care planner, and the case manager; and, when the award has been invested in a structured settlement, allowance may have to be made for trustee fees. As these fees could well exceed $50,000 per year, they could add over $1million to the size of the award to a young person. Hence, it is crucial that these sources of cost be considered seriously.

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Christopher Bruce  is the President of Economica; he has a PhD in economics from  the University of Cambridge

The Cost of Managing the Plaintiff’s Investments

Posted on By economica

by Christopher J. Bruce

As most individuals are unaccustomed to managing large sums of money, it may be appropriate for plaintiffs to employ advisors to assist them with the investment of their awards. In these cases, it has often been argued that the cost of hiring such advisors should be added to the value of the award. This cost is referred to as a management fee or financial management fee.

The fees that are charged by financial advisors are almost universally quoted as a percentage of the total value of the amount that has been invested. For example, the fee charged by a bank or trust company for managing an investment of $1 million might be 2.0 percent of that investment, or $20,000 per year. This percentage normally declines as the size of the investment increases. For example, on an investment of $3 million, it might be 2.0 percent on the first $2 million and then 1.5 percent on the next $1 million.

The effect of the management fee is to reduce the net value of the rate of interest, or discount rate, obtainable by the plaintiff. For example, assume that a trust company is able to obtain a rate of return of 5.0 percent (after accounting for inflation) on an investment of $1 million, and that the management fee is 2.0 percent. The income earned in each year will be 5.0 percent of $1 million, or $50,000. But from that will be deducted a 2.0 percent management fee, or $20,000. Thus, the net return on the investment will be $30,000 ($50,000 – $20,000), which represents a 3.0 percent net rate of return on the investment.

When calculating the value of the plaintiff’s award, the financial management fee could be taken into account either by adding the dollar cost of the financial advisor to each year’s losses, or by discounting the future losses by the net rate of return on investments. The former approach requires the calculation of the management fee for each year in the future, whereas the latter requires only that the rate of return on investments be replaced by the net rate of return (3.0 percent is used in the example above instead of 5.0 percent). Thus, as both approaches produce the same estimate of the award, economists generally prefer to use the simpler approach: the net rate of return.

Assume that it has been agreed that plaintiffs should place their awards in a particular type of investment portfolio, and that the projected rate of return on that portfolio is, say, 4.5 percent. If the financial management fee is 1.75 percent, the appropriate discount rate would be 4.5 percent minus 1.75 percent, or 2.75 percent.

This is the basis of the argument that is often made in court: that a (financial) management fee must be deducted from the discount rate to obtain a “true” net discount rate.

Although this argument sounds reasonable, it is not – for the simple reason that in most cases in which financial experts testify concerning the value of “the discount rate”, it is a net discount rate to which they are referring. That is, they are referring to a rate from which the management fee has already been deducted. Thus, it is not necessary to deduct a further management fee from the recommended discount rate – the latter already includes a management fee.

What I wish to show in the following two sections is that whether it is necessary to deduct the management fee will depend upon the way the discount rate has been determined.

In the first of these sections, I will consider four situations in which the court has used testimony from expert witnesses to select the discount rate. In the second section, I will consider those cases in which the discount rate has been mandated by government regulation.

Court Selected Discount Rate

The courts have been clear that plaintiffs are expected to invest their awards in financial assets that do not expose them to unreasonable risk. For example, in its seminal decision in Lewis v. Todd (1980 CarswellOnt 617), the Supreme Court of Canada approved of the expert’s use of “high grade investments [of] long duration.” [para. 17] Financial experts have generally held that this implies that the plaintiff’s award should be invested in a balanced portfolio of conservative financial assets – for example in a mix of government bonds, highgrade corporate bonds, and “blue chip” stocks.

In this section, I will consider four approaches that plaintiffs could take to the investment of their awards; and investigate whether it would be appropriate to deduct a management fee in each of them. These approaches assume that the plaintiff will either:

  • Purchase mutual funds that spread their investments across balanced portfolios of financial assets.
  • Employ a financial advisor to assist them with decisions concerning their investments.
  • Use their own expertise to invest in financial markets.
  • Purchase a structured settlement.

Under the first three of these approaches, I assume that the plaintiff, and his or her advisors, will attempt to balance two goals: maximize the rate of return on investments, and minimize the risks associated with the purchase of financial assets. This balance is achieved by investing in a balanced portfolio of assets spread across a range of potential instruments. (Under the fourth, structured settlement approach, the plaintiff leaves the choice of investments to the provider of the structured settlement.)

Balanced portfolio funds: One method of achieving a balanced portfolio is to purchase a type of mutual fund called a balanced portfolio fund. Each of these funds – which are offered by all of Canada’s banks, by many investment houses, and by insurance companies – invests in a balanced blend of asset classes. These funds offer numerous advantages to the plaintiff. They reduce risk by spreading their investments across different types of assets, in different industries, and different countries. They offer clearly identified choices concerning the degree of risk that the plaintiff is willing to accept, often ranging from “very conservative“ to “aggressive growth-oriented”, and the selection of the assets to be incorporated in each fund is made by experts who are supported by teams of researchers.

Furthermore, balanced portfolio funds offer the attractive feature that the rates of return that they have earned are publicly available. Thus, not only can the plaintiff-investor determine easily what any fund’s performance has been; but the rates of return on those funds can be used by the courts as objective measures of the returns that are available to plaintiffs when they invest in conservative, balanced portfolios.

The interest rates that are reported publicly, on balanced portfolio funds, are net of management fees. For example, if a fund earns 4.5 percent on its investments, and the fund’s operators charge a fee of 2.0 percent, the published rate will be 2.5 percent. It is information concerning these published rates – that is, rates that are net of the fund operators’ rates – that Economica uses when discounting plaintiffs’ future losses. [See Selecting the Discount Rate, Expert Witness, Vol. 21, Spring 2017.] As these rates are net of the operators’ fees, there is no need to add a “management fee.”

Financial advisor: Instead of purchasing a mutual fund “off the shelf,” the plaintiff could employ a financial advisor to purchase a balanced portfolio of investments, specific to the preferences of the plaintiff. Generally, these advisors charge a fee that equals approximately 1.0 to 2.0 percent of the value of the assets that they are managing. Is there an argument for adding the cost of this advice to the plaintiff’s award, as a management fee? I will argue that the answer is “no.”

To see why, consider the following example: assume that a financial advisor who charges a management fee of 2.0 percent is able to obtain a rate of return of 5.0 percent. The net rate of return received by the advisor’s clients will be 3.0 percent. [For example, $100,000 invested at 5.0 percent will generate a return of $5,000 per year and, with a management fee of 2.0 percent, will cost $2,000 per year. Thus, there is a net gain of $3,000, which is 3.0 percent of the invested amount.]

In this case, the appropriate discount rate will be the net rate of interest obtained by the advisor, or 3.0 percent. For example, to determine how much would have to be invested today to replace a $103,000 loss a year from now, one would divide $103,000 by 1.03 (= 1 + the interest rate), to get $100,000. When future losses are discounted by this rate, the costs of the advisor’s services have been accounted for in the calculation – the $3,000 gain after one year equals the return on the investment, $5,000, minus the advisor’s fee, $2,000.

Thus, if the discount rate that is used by the court to calculate the value of the plaintiff’s award equals the net investment return obtainable by the financial advisor, no additional allowance needs to be made for a management fee.

Although the rates of return obtainable by financial advisors are not publicly available, a reliable objective measure of that rate is the rate of return on balanced portfolio funds. As
independent financial advisors generally rely on the same research that is available to the operators of mutual funds (they usually work for the same financial institutions), they can be expected invest in portfolios of financial assets that are similar to those that are contained in balanced portfolio funds. They can, therefore, be expected to generate similar rates of return net of management fees.

If that is true, then the estimate of the return available to independent advisors includes an allowance for the management fee, and no additional management fee need be awarded.

Self investment: In those cases in which plaintiffs are expected to use their own skills to invest their awards, there will be no (or only minor) management fees and, hence, no call for such fees.

Structured settlement: The cost of any structured settlement includes the cost to the issuer of managing that settlement. Hence, again, there would be no need for an additional management fee.

Summary: I can find no situation in which it would be necessary to award a management fee to a plaintiff who is mentally competent.

Mandated Discount Rate

An argument might be made for the award of management fees in those cases in which the discount rate mandated by the government exceeds the rate predicted by the experts before the court.

Assume, for example, that the mandated rate was 3.0 percent and that the best evidence before the court was that the net rate of return available on a balanced portfolio of funds was 2.0 percent. It could be argued that the difference between the two rates had arisen because the mandated rate reflected the rate of return available before deduction of management fees. In that case, it might be appropriate to award a management fee of 1.0 percent, to bring the net discount rate to 2.0 percent.

It must be pointed out, however, that the rates currently mandated in British Columbia, Ontario, and Saskatchewan are significantly lower than the net rates available on balanced portfolio funds. Hence, although there is a case for awarding management fees in some cases, the conditions for those cases do not exist at this time.

Conclusion

In virtually every situation in which financial experts testify concerning the value of the discount rate, the rate of return that they refer to is net of the cost of investment. Hence, it is not necessary to deduct a financial management fee. And, although such a deduction might be necessary in cases in which a mandated discount rate had been used, the rates that have been mandated in Canada in recent years are so low that it must be concluded that they are also net of management fees.

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Christopher Bruce  is the President of Economica; he has a PhD in economics from  the University of Cambridge

Implied Rates of Return on Structured Settlements

Posted on By economica

by Derek Aldridge & Christopher Bruce

The purpose of a lump sum award in a personal injury or fatal accident case is to provide a fund that, when invested, will generate a stream of benefits equal to the plaintiff’s future stream of losses. One method of generating such a stream would be to purchase a life annuity. This, for example, is what is anticipated by Section 19.1 of the Judicature Act (RSA 2000) when it provides that:

(2)  On application by any party to a proceeding, the Court may order that damages awarded be paid in whole or in part by periodic payments…

This type of periodic payment has come to be known as a structured settlement annuity. Such annuities are sold by insurance companies. When calculating the price it is going to charge for an annuity, the insurer determines how much it would have to invest, at current interest rates, in order to generate a stream of income at least equal to the required periodic payments. For example, if it had promised to pay $10,000 per year indefinitely , and the rate of interest that it thought it could earn was 10 percent, it would charge at least $100,000 – as $100,000, invested at 10 percent per year, would generate a stream of income of $10,000 per year.

Conversely, therefore, if we observe the lump sum that an insurance company charges for an annuity that promises a specified stream of payments, we can calculate the rate of interest that the insurance company expects to obtain on the investment of that sum. For example, if it was observed that the company had charged $100,000 for a periodic payment of $10,000 per year (indefinitely)¹, we would be able to calculate that the rate of return it expected to obtain on investment of that $100,000 was at least 10 percent.

We have used this principle to calculate the rate of return that insurers expect to obtain on a series of standard structured settlements. By contrasting these rates of return with the rates that Economica has been using, we can check whether Economica’s rates are consistent with those that sophisticated investors – insurance companies – expect to earn on low-risk investments.

With the assistance of Heber Smith, of Smith Structured Settlements (www.structuredsettlements.ca), in August 2011 we obtained quotes on an annuity that provided payments of $1,000 per month to a male plaintiff. These quotes were for

  • three different ages of plaintiffs: 20, 35, and 50;
  • two different termination dates: the plaintiff’s age 60 and his age of death; and
  • two different assumptions concerning inflation indexation: one in which the insurer increased the annual payment each year by the rate of consumer price inflation and one in which the payment was increased each year by a fixed 2 percent.

We report the quotes that we obtained for twelve different scenarios in columns 6 and 8 of the table below. As an example of how to read this table, the $127,064 figure in column 6 of the first row in the table, indicates that we were quoted a price of $127,064 to purchase an annuity that paid $1,000 per month, increasing at the rate of consumer price inflation, from the plaintiff’s age 50 to his age 60. Similarly, it is seen from column 8 of the first row that that annuity would have cost $121,255 if the payments had been adjusted by 2 percent per year instead of by the prevailing rate of inflation. (If we assume that insurers believe that inflation will be 2 percent on average, the difference be $5,809 difference between columns 6 and 8 in the first row is a “premium” the insurer charges to compensate it for taking the risk that inflation might prove to be higher than 2 percent.)

The comparable figures in columns 6 and 8 of the third row of the table report the cost of an annuity that extends to the end of the plaintiff’s life, instead of to age 60 (as in the first row). The figures in the third row would be relevant if an annuity was being purchased to pay for costs of care, instead of for loss of earnings (first row). The remaining rows in the table report the costs of annuities paying $12,000 per year to a 20-year old and a 35-year old.

Given the quotes reported in columns 6 and 8, we were able to calculate the real rate of interest (interest rate net of a two percent expected rate of inflation) the insurance company was expecting to receive from investment of each annuity. These rates are reported in columns 7 and 9, with the figures in column 7 referring to the quotes in column 6 and the figures in column 9 referring to the quotes in column 8. As an example, the figure of -0.95% in column 9 of the first row indicates that the insurance company anticipated that it would receive a nominal interest rate of approximately 1.05% (i.e. 1.05% nominal interest – 2.00% inflation = -0.95% real rate of interest, or discount rate).

Of the twelve discount rates reported in the table, only one – the 2.10 percent rate of return in column 9 of the second row – exceeds the lowest rate used by Economica, as reported in Table 2 of the first article in this newsletter – 1.80 percent on investments of less than four years; and most of the remaining discount rates are significantly lower than the rates that we recommend.

The result is that the present discounted values quoted by insurance companies for the purchase of structured settlements are considerably higher than the comparable values that would have been calculated by Economica. The latter values are reported in column 4 of the table. It is seen in column 4 of row four, for example, that whereas Economica would have calculated that a plaintiff would need $277,538 to replace $12,000 per year from age 20 to age 60; the quote we received for a structured settlement was $506,890 – 82.6 percent more.

The differentials are even greater if we use the discount rate that some other expert economists have recommended – 3.50 percent. In the fourth row of column 5, for example, we report that the present value of $12,000 from age 20 to age 60 would be $252,895 if 3.50 percent is used – less than half of the $506,890 that we were quoted for a structured settlement.

To conclude: in every case, the present values that we would estimate using our discount rate assumptions are considerably lower than the actual cost that a plaintiff would incur if he were to buy an annuity to fund his future losses. This is very strong evidence in support of the claims that we have made over the last several years that our discount rate approach is a conservative one. Based on the costs to purchase structured settlement annuities, and the plaintiff’s ability to demand that his/her loss be funded using this “periodic payment” approach (given Section 19.1 of the Judicature Act), it follows that any reasonable change to our discount rate approach would be to use lower rates, not higher (as some other experts have argued).

Acknowledgment

As noted above, Heber Smith, of Smith Structured Settlements generously provided us with quotes on various annuities which we used in the creation of this article. On previous cases, we have worked together with Mr. Smith when the plaintiff’s lawyer chose to argue that damages should be satisfied by periodic payments (in accordance with Section 19.1 of the Judicature Amendments Act), rather than a conventional present value. An advantage of having future losses assessed in this manner is that it removes the subjective nature of opinions concerning the discount rate. Instead of relying on opinion concerning the rate of return that a plaintiff will earn on his or her investments, we can determine precisely how much it will cost the plaintiff to purchase annuities to fund the future losses.

Smith Structured Settlements serves the personal injury community as an annuity brokerage specializing in the preparation of fee-based Section 19.1 damages reports. Should you wish to investigate such an option they may be reached at www.structuredsettlements.ca.

 

 

Footnote:

  1. Of course, structured settlements never continue indefinitely. We use this example because of its mathematical simplicity. [back to text of article]

Timing, Turning Bad into Good

Posted on By economica

by Heber G. Smith

This article was originally published in the autumn 1998 issue of the Expert Witness.

In the past, my financial advisors were quick to remind me how splendidly they were handling my finances. More recently, however, they are somewhat sheepish discussing the more than modest shrinkage in my meager retirement assets, referring to such world events such as the Asian Crisis and the Russian meltdown as possible causes.

Upon closer scrutiny, I discovered what may have been long apparent to investors more skilled than I — that portfolio performance isn’t always a function of management but of timing. During a bull market, most equity positions increase in value but during bear markets, the converse is usually true. To make matters worse, an investor who is dependent on a market-based portfolio for needed income, will find that the concept of dollar cost averaging works against him/her when withdrawing regular fixed dollar sums from equity portfolios during a bear market. The timing of such sells to satisfy fixed income requirements dictates that, on average, more assets are sold low than are sold high. In order, therefore, to enable a personal injury client to reap the income required for the settlement duration, we suggest that an action settled during the early stages of a bull market is best. Consider the following chart (below left), which illustrates regular withdrawals of $1,200 per month adjusted for a 25% tax rate when $250,000 is invested in the TSE 300 in the fall of 1992. The result is an increasing portfolio value.

Figure 1

Figure 2

* An assumption of stock market cyclicity of 6 years was used so that the same TSE 300 data repeated every 6 years leaving the starting time as the differentiating variable.

Conversely, a different picture appears if the same $1,200 per month adjusted for tax is withdrawn from the same sized portfolio beginning in the spring of 1998 (above right). Under this scenario, the personal injury claimant has the added anxiety of wondering whether his funds may dissipate before their specified time. Unfortunately for the claimant, a personal injury settlement date is not dependent and timed for receipt according to stock market investment cycles.

Hope in the ability to time markets need not be as critical a factor. By using a combination of a structured settlement and dollar cost average purchases in the TSE 300, one can reduce risk and, during volatile markets, virtually assure an increase in settlement withdrawal periods.

Consider providing for a claimant’s income requirements via a structured settlement for the first 16 years and the purchase of a second annuity to support the dollar cost average purchases in the TSE 300 over the same period. The following graph depicts the value of the investment fund at the end of the 16 years when purchased in the spring of 1998 in comparison to the value of the investment fund purchased by using an annuity and dollar cost averaging over the same period.

Figure 3

So what makes it all work? It is the combination of financial planning tools; diversification and risk reduction that go a long way to turn what could be bad timing into good (or at least better timing). But the biggest factor is the imputed contribution made to the settlement by Revenue Canada Taxation in the way of tax forgiveness on the interest element of the annuity contract supporting the settlement. In combination, the above enables a claimant to grow the investment fund prior to withdrawals thereby increasing the number of payment periods and reducing anxiety due to dissipating funds.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

Not All “Bears” Are Bordering Extinction

Posted on By economica

by Heber G. Smith

This article was originally published in the summer 1998 issue of the Expert Witness.

Plaintiff counsel’s job respecting a personal injury action is securing an acceptable offer. All of his/her energies are expended to that end with the result that little attention is given to after-settlement considerations. Now that the claimant has the cash, how does he/she convert the cash into income to provide for lost future income or the cost of future care?

Impressive gains in the market have headlined all financial publications in recent years. Consider recent mutual fund advertisements citing returns of 20.8% in one year and 21.2% in two years. What sensible personal injury or wrongful death award would not be enticed by the siren of such gargantuan returns?

In contrast, today’s interest and annuity rates seem inordinately low and may drive investors that should seek safety to the equity markets. However, consider the risks and costs with embarking on such a strategy.

One risk that needs to be considered is the nature of equity markets. In many respects we may have become lulled into a false sense of security with the extraordinary increases over the past few years. Recent market volatility and uncertainty are causing many investors to rethink their positions. As a result there has been a movement toward higher quality equities and a resurgent interest in bonds. Another uncertainty that today’s investor faces is trying to determine the length of this increased volatility and uncertainty. Is today’s uncertainty merely a pause, or does it foreshadow a greater correction? Historically, the usual market uptrends have been sporadically dotted with significant downturns that have taken many years to recover to pre-correction levels. Under these conditions, recipients of lump sum awards fully vested in equity markets could become severely disadvantaged especially if the downturn was to last for an appreciable amount of time. In the current issue of Investment Executive, Carlyle Dunbar is quoted as saying: “though they [investors] won’t sell if the market drops, most aren’t expecting a drop of 20% or 25%. The reality has been that most investors – especially newcomers go into shock when a bear market develops.”

Another consideration is the fiduciary role of financial advisors who are governed by the “prudent-man” rule. Should a lump sum recipient retain a financial advisor, it is likely that their risk position be classified as conservative. Under this classification, a recipient’s assets would be allocated across equities, fixed income and cash equivalents. The fact fixed income and cash equivalents typically return less than common equities would preclude the possibility that the recipient would achieve the type of returns advertised by many funds.

The prudent man rule dictates that, amongst other criteria, a financial advisor provides for “reasonable diversification”. Such diversification might suggest a common 50/40/10 (equity/bond/cash) portfolio investment split. Some formulas may suggest a 60/30/10 but the former may be more responsive for an investor requiring income. Consider the following example:

Equity Bond Cash
Percentage Allocation 50% 30% 10%
Assumed Return 10% 5.5% 3%
Management Fee 2% 1% 0.5%
Tax 20% 40% 40%

Weighted Average, Net After Tax Rate of Return: 4.53%

Given that the above strategy assumes a high measure of equity exposure, one may wonder why the recipient of a personal injury award or wrongful death settlement might not consider a structured settlement when the net return is approximately 5.5% (the equivalent of a pre-tax rate of return of 9.17% for a tax payer in a marginal rate of 40%). An investment strategy, incorporating a structured settlement tailored to the specific circumstances of the claimant, will result in superior returns at a lower risk.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

Structured Settlement Assignments

Posted on By economica

by Heber G. Smith

This article first appeared in the autumn 1997 issue of the Expert Witness.

Unlike their American counterparts, property and casualty insurers in Canada typically (in compliance with Revenue Canada’s Information Bulletin, IT-365R2 dated May 8, 1987) remain liable to pay the periodic payments payable under terms outlined in the settlement agreement. They, effectively, become a guarantor of the life insurance company that underwrites the annuity contract(s) issued in support of the agreement.

The ownership obligations transcend its simple performance as a back-stop to the annuity contract. The property/casualty insurer, as owner and annuitant (beneficiary), must deal with the accrual tax ramifications of the internal interest component of the annuity contract. As an insurance company, however, it has access to the right to take a reserve under Section 1400(e) of the Rules and Regulations in the Income Tax Act (Canada). Since the interest build-up in the annuity contract is approximately equal to the increasing obligations of the defendant insurer to make future payments to the claimant, the two become a virtual wash and the tax cost to the insurer virtually disappears.

What options exist for the non-insured defendant to a personal injury action? Are such entities simply denied access to the structured settlement option as a method of resolving a personal injury or wrongful death action? The problems faced by such a defendant are twofold; the first is that, because it is not an insurer, it may lack the internal expertise to assess the risk that may be involved with the continuing obligations under the terms of the settlement agreement; and secondly, without access to Section 1400(e), it would be responsible for the tax liability arising out of the annuity and unable to take a write-off for the obligations to make future payments to the claimant.

Revenue Canada now permits a defendant to “assign” it’s contingent ownership rights and obligations inherent with the annuity contract and the performance requirements contained in the settlement agreement to a qualified assignee. Under the terms of such an assignment the defendant shall agree to absolutely assign to the assignee and the assignee shall agree to absolutely assume and to substitute its performance in respect of the obligation to make the required payments to the claimant. The plaintiff must agree to consent to the absolute assignment and assumption and agree to the substitution of the performance of the defendant for that of the assignee. The plaintiff may then absolutely release the defendant in respect of the liability of the defendant for damages resulting from the injuries or wrongful death.

The result is that self insured defendants now have access to the tax-free periodic payment option to remediate a claim with respect to personal injuries or wrongful death. In addition to the traditional self insured defendants, the beneficiaries of such an arrangement include defendants of product liability actions where aggregate claims exceed available insurance limits. Foreign insurers defending actions in Canada may avail themselves of such arrangements without modification to traditional structured settlement administration wherein they assign their obligations on all such transactions. Most insurers are not prepared to change their internal systems to accommodate the small number of potential claims that they may be required to defend in Canada. Another opportunity to use structured settlements, where without assignments it would be impossible, include criminal assault or abuse situations under which a victim has a right to initiate a civil action.

Plaintiff’s counsel may wish to lean on the structured settlement broker to ascertain the financial covenant afforded by the arrangement. The financial covenant may be better or worse than it would have been were the defendant insurer to remain as owner and guarantor under the terms of settlement. A report delineating the risks versus the benefits may be beneficial. For the comfort of the claimant, counsel may wish to be provided with a precedent Revenue Canada advance tax ruling of the scheme or alternately make application to Revenue Canada for such a ruling.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

Structured Settlements: Case Suitability

Posted on By economica

by Heber G. Smith

This article first appeared in the summer 1997 issue of the Expert Witness.

It has been said that “only the very large cases” merit consideration for a structured settlement. Some suggest that the list should be expanded to include actions that involve minors and/or those otherwise incapable of managing their own resources.

In reality any injury action that has been reserved for $50,000 or more may merit consideration for a structure, but that doesn’t mean that every case in that category should be structured. Typically, files that, if structured, might generate insignificant income, may not merit consideration in the final analysis. For example, actions involving tax-creditable Cost of Future Care under which the claimant may be financially sophisticated, may also not be worth consideration; but only if the claimant is elderly. A young claimant in a high marginal tax bracket may find him/herself in the unfortunate situation whereby the tax credits reduce tax payable at the lowest rate while investment income increases tax payable at the highest rates. The spread between the two rates of tax and the long period over which the investment must compound to offset inflation may tilt the scale in favour of the structure. Such little nuances make it tricky for plaintiff’s counsel to determine exactly when to recommend that his/her client entertain a structure.

Typically, those cases most suitable for structuring include:

  • Infants;
  • Those claimants not mentally capable of managing their own resources;
  • Claimants whose future life expectancy may be in doubt;
  • Claimants who are in high income tax brackets;
  • Cases involving a Cost of Future Care claim;
  • The elderly who wish to control the distribution of their estates;
  • Claims that might entail a Tax Gross-Up or Management Fees; and
  • Excess of Policy Limits cases.

Effects of Taxation

For any Canadian taxpayer, regardless of his/her tax jurisdiction, taxation will have an onerous impact on resultant net income. With 40% taxation on incomes in excess of $30,000 it becomes incumbent on plaintiff’s counsel to introduce the structure option and the tax free nature of the resultant income to a claimant. With a structure analogous to a “matching grant” or “imputed contribution” from Revenue Canada it is no wonder that such a settlement vehicle has become instrumental as the main incentive to conclude many personal injury actions.

Design Development

Input by plaintiff’s counsel to the modeling of the payment scheme is critical to the ultimate success and conclusion of an action by means of a structure. Consideration must be given to medical, rehabilitation, custodial and health care costs, adjusted for anticipated inflation. Future education costs (for both the claimant and/or his/her family) and loss of future income estimates should also be discussed during the settlement negotiation process.

Ideally, the structured settlement specialist should attend that meeting and work with the plaintiff and his/her counsel on the same basis that a mediator caucuses during that process. When accurate estimates of the claimant’s future income and eligible tax credits are known, it is possible to accurately estimate Revenue Canada’s imputed contribution to the proposed settlement — a sum that may very well be sufficient to bridge the gap between the parties.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

Lost Years Maybe, Lost Care – Never

Posted on By economica

by Heber G. Smith

This article was originally published in the spring 1997 issue of the Expert Witness.

Whilst the debate over methodology of compensation for the “Lost Years” may rage on, there does exist a simple solution for providing care for a claimant whose injuries (or for that matter, other health ailments) may result in a diminution of life expectancy.

Compensation for the cost of future care of an individual whose life expectancy is demonstrably impaired, need obviously be less than that required for someone whose anticipation of a future lifetime is normal. But who is to say that he or she will live that long? What happens if he/she lives longer?

On the flip-side of the life insurance industry’s practice of “rating-up” or declining an unhealthy applicant for life insurance, some insurers have a practice of improving the income provided by a fixed premium for an annuity applicant deemed by the insurance underwriters to have little likelihood of living to a normal life expectancy. The results of this practice may reduce dramatically the cost of providing “guaranteed-for-life” future care. Cases involving severe injuries have lead some insurers to rate-up prospective measuring lives (the person on whose life the payments are determined) by as much as and in some cases more than 50 years. As one might imagine, the saving inherent in providing lifetime payments for a 65 year old claimant as opposed to a 15 year old can be consequential.

To further reduce the cost is the flexibility that Revenue Canada confers on the structured settlement annuity. Since the casualty insurer is the owner and beneficiary of the supportive annuity and since paragraph 1400(e) of the Income Tax Regulations governing reserving taxation of insurers permits the tax free ownership of the annuity, it is possible to purchase more than one annuity to support the periodic payment stream. This permits the structured settlement annuity broker to ferret the most favourable components of a required stream from a number of companies; i.e. select the most favourable interest rates from one or more companies and the most favourable (negative) life expectancy offering from another.

Revenue Canada now permits a new twist in it’s heretofore “irrevocable and non-commutable” requirements under IT-365R2. Upon the death of the claimant the cost of future care payments under a structured settlement need not vest indefeasibly in the claimant’s estate. Since the death of the claimant negates the need to provide for care, Revenue Canada now takes the position that the future guaranteed payments may revert to the defendant insurer and that the insurer may commute those payments. Comforted by the fact that it may recover a significant percentage of its cost of future care outlay, the insurer may be somewhat more favourably predisposed to negotiate other components of the action.

Very seldom do people die at the “right” time. The problem becomes magnified in respect to a personal injury action since the defendant may overcompensate a victim that dies too soon and a victim that lives too long may find him/herself without adequate resources to provide for care at an age when it may be most imperative to so. The annuity is truly a no-waste solution.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

Annuity Concepts (Continued)

Posted on By economica

by Heber G. Smith

This article first appeared in the summer 1996 issue of the Expert Witness.

In the previous edition of The Expert Witness our contribution discussed annuities in general as well as some features that qualify annuities as the ideal tool to deliver a specified sum to a specified party at specified times. Whilst the ultimate purpose of this series is to provide users with an effective understanding of how they can use structured settlement annuities, a thorough background in annuity options may be helpful, not only to the litigation counselor in the remediation of tortous actions but also to the estates and wills practitioner. This article will address how the use of “non-commutable” terminology can give fluid expression to the wishes of the annuity settlor.

Costs

The settlor of a trust, intent on generating periodic payments rather than lump sum cash to a beneficiary, will most certainly face some onerous costs in an attempt to achieve an expression of his/her desires. But a cost far greater than that of disbursements for legal fees, fund management and trust costs are those costs associated with the failure of the trust to perform financially to the expectations of the testator. Most practitioners are familiar with the occasional inadequacy of investment performance, especially when considered net of costs and fees, but the biggest land mine in the path of the testator’s plan is the potential for litigation and the ultimate insufficiency of the trust to achieve the settlor’s wishes.

The inclusion of a simple irrevocable clause within the terms of an annuity contract may preclude such failure.

Income versus Capital

In all too many circumstances, the beneficiary has and may exercise, the litigation alternative to a trustee declared proviso for trust income or partial trust income. A dissatisfied income beneficiary may, possibly without expense to himself/herself, attack trust capital. Even in the event that the beneficiary might be unsuccessful in such an endeavor, that endeavor may be at the expenses of the estate or trust.

A “non-commutable” annuity, however, may not and cannot be converted to cash. This proviso within an annuity may or may not be ascribed to the initial payee under such contracts. In addition, the provision may apply only to the primary beneficiary or payee or possibly to both the primary and secondary right holder but not to a subsequent right holder. Once an annuity settlor has dealt with the issue of potential income beneficiaries, he or she may elect that the subsequent right’s holder (beneficiary or payee) be entitled to commute the then present value of the annuity payments.

A testator, facing the uncertainties with respect to the execution of his or her wishes under the terms of a trust, may find that an annuity represents a refreshing alternative especially when one considers the fact that the annuity contract is without additional costs or fees.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

The Annuity Solution to Fund Cost of Future Care

Posted on By economica

by Heber G. Smith

This article first appeared in the spring 1996 issue of the Expert Witness.

Ask any seasoned personal injury litigation professional what the advantages of a structured settlement are and you’re certain to hear that “the periodic payments are tax-free”. While true, there is more, much more to the structured annuity that makes it the preferred settlement vehicle. In order to fully appreciate the structure concept, how ever, it is important to understand the fundamentals of an annuity.

The much maligned annuity truly is a financial performer. A very competitive annuity marketplace has led to rates of return that out-muscle the after-management-fee yield available through a well managed bond portfolio. But the true magic of an annuity is it’s capacity to provide income – when it is needed and in the amounts that are needed. From a personal injury or wrongful death settlement point of view, every payment that is required to be paid, or expected to be paid, will be paid. And at the end of the required period all of the funds will have been fully and purposefully spent; truly a no-waste solution.

Pay Too Much; Solve Too Little

While it may be actuarially correct to remunerate a plaintiff in accordance with the possibility or probability of his (or her) surviving each successive year, does it make sense practically to compensate every cost of future care claimant to the end of the life expectancy table? Furthermore, does it make sense for the claim ant to expend only a portion of the required care cost, thereby permitting the reinvestment of the fund, in order to provide for the remote possibility of his surviving to the end of the life expectancy table? For example; a twenty five year old male has about a 30% chance of not surviving beyond age 70. Actuarially speaking, our 25 year old must spend progressively less of his required cost of care and progressively more must be reinvested to provide for the eventuality that he may survive past age 100, or to the end of the mortality table. If his cost of care at age 70 is $10,000 annually his fund would provide that $7,000 be paid out of the award or settlement and $3,000 must come from another source.

The above is academically fair – at least for a large number of claimants. But what of our single claimant? In order to provide for the possibility of a longer than average life expectancy he must deprive himself of much of his required care, although, depending on when he dies he may be survived by some very happy beneficiaries. If he assumed normal life expectancy, spent fully on his cost of care and outlived the investment, funding for his care would then cease or the family and/or society would pick up the cost.

Typically those who fund the excess are defendant insurers and the beneficiaries are not the claimants, but the estates of the claimants. An annuity can, however, pay fully 100% of the required cost of care every year that he remains alive.

By understanding how an annuity works you will be better prepared to advise your clients how to negotiate a settlement. Let’s look at how an annuity works!

Annuity Terms and Concepts

Annuities Defined

An annuity is an investment vehicle that pays periodic payments consisting of interest and principal until such time as the fund becomes extinguished. In this manner it resembles a mortgage in reverse, where the annuitant assumes the role of the bank and the insurance company the borrower. The annuitant may elect to have the term of the payments set out as a specific period of time (as a specified number of years) or set to some undetermined eventuality (to the death of the annuitant), or a combination thereof.

Term Certain Annuities

The term of the annuity may be for a certain number of years (i.e., 10 years, 25 years, etc.) and the entire fund including principal and interest will be paid out coincident with the final payment. At any given time the value of the annuity may be determined using tables or a spreadsheet that calculate the then present value of the remaining payments.

Life Annuities

The term of a life annuity is the life of the annuitant (or in the case of structured settlement annuities, the measuring life). The last payment that would be made to an annuitant would be the last payment due prior to death. A life annuity provides payments that continue for life, regardless of how long the claimant remains alive. By taking advantage of the annuity issuers capacity to spread the risk of “living too long” amongst many such claimants, not every claimant need provide for the contingency that it may be he who remains alive beyond the end of his appropriate life expectancy.

One of the common criticisms of life annuities is “It’s OK while I’m alive, but on my death the insurance company keeps all of my money”. To some extent that criticism is valid. That is why most annuitants elect a life annuity with a guaranteed period.

Life Annuities with a Guaranteed Period

A guaranteed life annuity overcomes the above criticism in that it contains a provision that guarantees the payments to continue for a minimum number of years and thereafter for so long as the annuitant or measuring life remains alive. Understanding annuity concepts and life expectancy enables the annuity broker to assist the parties in selecting the most advantageous guarantee period to place on the annuity. The existence of family dependents, existing life insurance policies and other assets would have an influence on the determination of the guarantee period.

“Rated-Up” Life Annuities

To successfully lead evidence at trial that a significant diminution in life expectancy may be ascribed to a given plaintiff may be difficult. Without the most compelling evidence a caring judge might be very reluctant to rule that the unfortunate victim before him was certainly going to die at some date much earlier than normal life expectancy.

An annuity issuer on the other hand is not faced with the onerous task of ruling on the future economic well being of a plaintiff and can easily categorize a given accident victim’s injuries and ascribe a life expectancy assessment within which that individual may be grouped. Whether he lived too long or died too soon would not be of concern to the insurer since it need only be concerned with averages. As a result, annuity issuers often attribute a much more pessimistic life expectancy than do the medical experts or the courts. The outcome is simple; less years to pay = lower cost.

The fact that major annuity issuers compete fiercely with one-another further enhances the defendant’s opportunity to purchase an annuity priced on the basis of the most pessimistic assumptions.

Indexed Annuities

Some annuities provide increases each year, typically to offset inflation. These are referred to as indexed annuities. The indexing rates normally vary from 2 to 4 percent annually and it is possible to purchase annuities indexed to the actual rate of inflation. To provide increased payments in the later years the issuer holds back a portion of what otherwise would be paid to the annuitant and reinvests it.

Misunderstanding can often arise with respect to assessing the rate of return on indexed annuities. The rates of return on level annuities are relatively easy to estimate but not so easy on indexed annuities. While level annuities may generate higher incomes in the early years, inflation erodes the purchasing power of future income which make level annuities inappropriate for long term solutions.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.