The Annuity Solution to Fund Cost of Future Care

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.


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.