Selling or Investing in Pension and Structured Settlement Income Streams
Individuals with income streams from pensions or structured settlements are being solicited by companies who purchase the right to these income streams in exchange for a discounted lump-sum payment of the total annuity amount. Although the prospect of receiving one large lump-sum payment often seems more enticing than collecting several smaller periodic payments, the risks and limitations involved in selling one’s income stream may diminish any benefit gained from a lump-sum payment. Similarly, although the prospect of investing in such second-market annuities seems enticing because they are often promoted to be as safe as traditional investments but with greater returns, the risks and limitations involved in purchasing the right to someone else’s income stream may diminish any benefit gained from these investment vehicles. A careful examination of current law, industry trends, and one’s own circumstances is therefore necessary to determine whether “factoring” an income stream from a pension or structured settlement is worth the effort.
How Factoring Works
“Factoring” is a financial transaction in which a seller sells its right to a financial asset to a factor at an amount lower than the total value of the asset. The factor then re-sells the right to the financial asset to a third-party at an amount higher than the amount the factor paid the seller.
In the context of pensions and structured settlements, the three parties involved generally include the recipient of the income stream (the seller), the factoring company (the factor), and the investor (the third-party). The factoring process begins with the recipient selling his or her right to the income stream to the factoring company in exchange for a lump-sum payment that is less than the total annuity amount. The factoring company then sells the right to the income stream to an investor for an amount higher than the amount the factoring company paid the recipient. The investor then collects on the income stream until the pension or structured settlement is exhausted, generally turning a profit over the amount paid to the factoring company for the right to collect on the income stream.
The discounted lump-sum amount the factoring company pays the recipient accounts for any risk involved with the pension or settlement and for transaction and management services provided by the factoring company. The factoring company’s overall profit is the difference between the amount it pays the recipient for the right to the income stream and the amount it receives from the investor purchasing the right to the income stream.
Selling a Pension or Structured Settlement Income Stream
While some recipients will ultimately benefit from selling their pension or structured settlement income streams, each individual should first consider the following that may affect the value of the lump-sum payment he or she receives.
- Legal Limitations:
Federal law generally prohibits a recipient from assigning his or her pension benefits – see 29 U.S.C. § 1056(1) for private pensions; 5 U.S.C. § 8346(a) for public pensions; and 38 U.S.C. § 5301(a)(1) for military pensions. Therefore, a recipient seeking to sell his or her income stream to a factoring company must first fit within one of the exceptions provided in the Code.
Internal Revenue Code § 5891(a) generally imposes upon a recipient a 40% tax on the lump-sum payment he or she receives from selling his or her right to a structured settlement income stream. To avoid the tax, a court must first approve the assignment of the income stream from the recipient to the factoring company.
- Additional Costs:
In purchasing the right to an income stream from a recipient, a factoring company may require the recipient to purchase a life insurance policy, and the factoring company may further require that it be named the beneficiary of the policy. In this instance, should the recipient die before all pension payments are collected by the factoring company, the life insurance policy will cover the remaining balance due to the factoring company.
In selling his or her income stream from a pension to a factoring company, a recipient may incur tax liability on the income gained from the lump-sum payment he or she receives. The income gained from the lump-sum payment may also bump the recipient into a higher tax-bracket.
- Low Valuation:
The lump-sum payment received from a factoring company may be significantly lower than the total annuity amount an individual would receive from collecting on the entire income stream of the pension or structured settlement. Factoring companies use a discount rate to determine the present value of a recipient’s income stream. Often the discount rate is considerably high, thereby lowering the income stream’s present value, and consequently reducing the lump-sum payment received by the recipient.
Investing in a Pension or Structured Settlement Income Stream
Investors interested in purchasing a pension or structured settlement income stream should first carefully consider the following that may affect the return on their investment.
- Legal Liability:
As previously mentioned, federal law generally limits the assignability of pensions. An investor should therefore initially determine that the pension income stream he or she is purchasing can be assigned.
An investor should also be cognizant of the process by which he or she will receive payments from the income stream. While some agreements allow the source of the income stream, i.e. the issuer of the annuity, to directly pay the investor, others may require that the source continue to pay the recipient, who will then forward the payment to the investor. In this instance, an enforcement mechanism is helpful to ensure that the investor will receive payments from the recipient.
- Additional Costs:
A factoring company may charge an investor a high commission rate for the income stream purchased – as high as seven percent. Additionally, any gain from the income stream may carry tax liability.
- Factoring Company Reputability:
Because of the risks and limitations involved in purchasing the right to income streams, it is imperative that an investor perform his or her due diligence to evaluate any factoring company with whom they are engaged. Factoring companies may often operate in legal grey-areas, and an investor may have little recourse if an investment goes sour.
If managed properly, the benefits of factoring income streams from pensions and structured settlements can outweigh potential risks and limitations, but selling one’s income stream or investing in someone else’s income stream is a decision that first requires thoughtful evaluation, considerable planning, and assistance from outside professionals.