Protecting the Settlement Recovery: Planning Options for Settlement Recipients and their Attorneys
Protecting the Settlement Recovery: Planning Options for Settlement Recipients and their Attorneys
Protecting the Settlement Recovery: Planning Options for Settlement Recipients and their Attorneys
Greg B. Maxwell, Esq., CFP®, and Joseph W. Tombs, Esq., CFP®
Note: This article was originally published in the Utah Trial Journal in the Spring / Summer 2010 issue.
Most personal injury settlement recipients want to be responsible with their settlement funds. When asked, “What is the most important thing you’d like to accomplish with this settlement money?” the answer is almost always sensible and responsible. It may be to pay back loans, replace lost future income, fund future medical expenses, upgrade living conditions, or ensure that their family’s medical and future educational needs are paid.
Given the opportunity, most personal injury victims will create a plan to use their funds to better their lives. Unfortunately, some are often not given that opportunity and consequently often squander their tort recoveries.i Personal injury attorneys have a unique opportunity and a professional obligation to recognize and address this issue.ii Attorneys often feel an understandable desire to focus on their next case once a particular case settles, but many of the financial decisions arising at the end of a case often affect the client for years into the future and are generally too much for the client to handle alone. Additionally, missing the opportunity to help with the financial, lien resolution, and government entitlement (Medicaid, SSI) issues arising in personal injury settlements can result in malpractice claimsiii, complaints to bar associations, and unsatisfied clients. However, if a few simple steps are taken shortly before and after settlement to help educate clients regarding these aspects of a personal injury recovery, clients will be equipped to make informed decisions and protect themselves from predators and unwise financial decisions that lead to unnecessary dissipation.
For most settlement recipients, dissipation is the greatest risk to their future financial security. Dissipation in this context means that the net settlement recovery does not last as long as it should. Client’s settlement recoveries are often lost to a combination of impulsive spending, poor investment choices, and well-intentioned gifts and loans to family and friends.
The effect of dissipation risk can be mitigated, but not without effort. Many personal injury victims need constraints placed on their access to settlement funds to avoid dissipation – at least until they are ready to manage the funds themselves.
Protecting Clients from Predators
The world is a dangerous place for an injury victim with a settlement. Some of the most common predators come masked as family and friends. The injury victim is immediately asked for loans, seduced into speculative business ventures and commission-loaded investments, and lured into casinos, shopping malls and car lots. Money earmarked for replacing future income or paying future medical costs all too often gets wasted in these ways.
Allocating the Settlement – Practical Options for Injured Clients
Proper allocation of the settlement proceeds is critical for clients. There are various ways to allocate the client’s settlement recovery that will protect it from both premature dissipation and from the above mentioned predators. A client’s recovery may take several forms including cash, managed investment accounts, structured future payments, settlement trusts, or some blend of each. Each of these options has distinct advantages and disadvantages, and since no case and client are the same, no single settlement solution is right in all circumstances. Each case requires planning to fit the needs, goals and special circumstances of each client.
The four “buckets” in the diagram below represent the financial vehicles available to injury victims upon settling a personal injury case.
As you move from left to right the client’s access to the money increases. However, the risk that the client will dissipate the money prematurely also increases as you move from left to right. This liquidity vs. security dilemma is a problem many attorneys face when trying to decide how a client’s net settlement should be allocated. Moreover, in many cases, attorneys must also keep in mind that the settlement allocation chosen will need to pass muster with a judge – and judges tend to be extremely conservative, especially in cases involving minors.
Cash: Cash is the most widely used settlement option for most clients for obvious reasons – cash spends. Cash is extremely liquid and it ideal for meeting an immediate need or goal of the client. It is often used to pay down debt, purchase new cars or homes, and meet the immediate needs many injury victims face upon settling a personal injury case. The biggest advantage of cash is also its greatest disadvantage – liquidity. Cash in the hands of many injured clients will most likely be dissipated quickly because it can be spent on a client’s whim, often leaving him without future income or money to pay ongoing medical expenses.
Managed Investment Accounts: A managed investment account is only slightly less liquid than cash and only slightly more secure. Therefore, the dissipation risk is essentially the same. The client can request the funds at any time – it only takes a phone call to the investment advisor to turn the account into cash. However, an investment advisor may be a helpful educator and may be able to curtail some potentially poor decisions.
Settlement Trusts: Settlement trusts allow clients some flexibility and liquidity while also providing a level of dissipation protection. Settlement trusts can be drafted to allow for payments to be made for education expenses, medical expenses and provide the client with monthly income. They can also allow for some percentage of the trust corpus to be used for discretionary spending – thus giving the client some freedom without allowing them to dissipate the entire principal amount. These settlement trusts allow the beneficiary to gain financial discipline and establish a budget, while still allowing for some flexibility and future contingencies to be paid.
Trusts are not a silver bullet for all clients, however. Trust principal is not guaranteed because the funds are placed in an investment portfolio that fluctuates and can lose value. Corporate trustees often have hefty trustee fees and management expenses that will decrease the net return of the trust portfolio. Additionally, most trust departments at major banks have little experience dealing with the unique needs of injury victims.
Structured Settlement Annuities: Structured settlement annuities provide injured clients with guaranteed, tax-exempt future payments. The payment structure is extremely flexible and can be designed to fund future goals (i.e. college or retirement) or can be used to provide lifelong income. Seriously injured clients seeking a lifetime payment can also benefit from a “rated age,” which serves to increase the payout per premium dollar. For many clients, structured settlement annuities provide much needed dissipation protection, guaranteed income and financial stability.
However, they, too, are not without their drawbacks.
Annuity payments are guaranteed by the annuity companies that offer them, and thus are only as solid as the company backing them. Most annuity companies in the structured settlement market are rated A+ or better with AM Best and, while the risk of annuity company insolvency is small, it nonetheless exists. Also, while these annuities are flexible in design, they hard to change once established, which can increase the risk that a client will feel a need to later factor his/her future payments.
Practice Tip – Structured settlement annuities can pay directly to trusts, allowing settlement money to grow tax-free inside the annuity while taking advantage of the liquidity of a trust. Structuring into a trust also makes it impossible for the client to factor the future payments because the trust, not the injured client, is the payee of the annuity.
Is Offering a Structured Settlement Annuity Enough?
Some attorneys try to meet their professional obligation for securing competent financial advice to clients by simply offering them a chance to use a structured settlement. A structured settlement is an ideal tool in some situations and protects the settlement funds from premature dissipation, but it is not enough. Recent lawsuits against plaintiff attorneys reveal that not only must they inform their client of the option to structure their recoveryiv but they cannot rely on the defense to control the structured settlement process.v An attorney’s legal duty is arguably met by retaining a structured settlement broker and documenting that the client was informed of a structured settlement option, but this falls short of meeting the attorney’s professional duties.vi Allocating the settlement may involve the use of a structured settlement in certain cases, but real settlement planning involves a more comprehensive approach.
For clients who choose to structure a portion of their settlement, perhaps the most dangerous predators are the annuity factoring companies. These companies advertise incessantly in an effort to tempt structured settlement recipients with the allure of “cash now.” In some unique circumstances, a factoring transaction may actually be needed. However, many injury victims who desperately need the guaranteed future payments succumb to the endless solicitation and are left destitute.
Section 5891 was recently added to the Internal Revenue Code in an effort to protect structured settlement recipients from these companies. The legislation requires a judge to approve proposed factoring transactions after considering the best interests of the annuity payee.vii The penalty for unapproved factoring transactions is a 40% tax imposed on the factoring company.viii This legislation is a very positive development, but it does not solve the underlying problem. If an annuity payee is intent on factoring future payments, a way can usually be found to do it. Judges too often have crowded dockets and are willing to capitulate to an earnest seller and an even more anxious buyer.
In order to know the right mix of cash, future payments, and trusts for each client, it is imperative your client is educated about the pros and cons of each option before settlement, and that your client’s unique situation and circumstances are understood. Pre-settlement planning allows the client to consider their post-settlement needs and goals before the stresses and pressures of mediation. In addition, a pre-settlement financial plan allows the client to have input in and “sign-off” on the form the settlement ultimately takes. Proper pre-settlement planning can greatly reduce the risk that clients will prematurely dissipate their settlement recovery because liquidity issues, future cash needs and contingency plans have been discussed and pre-planned.
Pre-Settlement Financial Education
Early in the settlement process, before mediation or arbitration, the client needs to be educated – ideally by an independent settlement planner or attorneyix – about the following topics:
The tax implications of receiving a settlement;
The impact a settlement may have on current or future eligibility for government entitlements (Medicaid, Medicare, SSI, etc);
The vehicles available to meet the client’s future needs and goals (structured settlement annuities, settlement trusts, special needs trusts, managed accounts, etc);
Guardianship issues and other control issues; and
A frank discussion of dissipation-related issues.
This pre-settlement meeting separates the planning from the stress of mediation, resulting in better decisions. It is in everyone’s best interest if the client has only one decision to make at mediation – should the case be settled for the amount offered? However, clients are ill-equipped to make this decision without the answer to the primary question on their mind, “After this is all over, how many of my basic goals will this cover?”
Clients often do not know what to expect at each step of the litigation process and thus feel disempowered. They do not fully understand the time it will take to get court approval, settle liens, or wrangle with the defense over the wording of the settlement agreement. At some point in mediation, many clients get angry at the defendant and its insurers, at the system, the process, and often at their own attorneys. It can become difficult to convince angry clients to accept reasonable offers and even harder for them to be pleased with your representation or their own decisions made in that environment.
On the other hand, a client who is prepared for what to expect at mediation and who knows the costs of meeting his goals feels empowered to make an informed settlement decision. This client is more likely to follow the advice of counsel and to be more content with the settlement.
Post-Settlement Financial Education
The transition into post-settlement financial life can be difficult. Left to their own devices, settlement recipients often seek advice from sources unfamiliar with the complexities associated with the financial aspects of handling a settlement recovery and fall prey to the all-too-familiar predators. Post-settlement financial education for injury victims and their families has traditionally been glaringly absent. This missing link has led to many dissipation tragedies. Post-settlement financial education should include the following topics:
Credit repair: Litigation leaves most injured clients’ credit rating in the cellar. Simple steps can be taken to start repairing one’s credit but many injury victims don’t know how to access the information and start the process.
Budgeting: Learning the basics of creating and living on a budget teaches injury victims and their families the financial discipline necessary to help keep them from factoring their future payments or otherwise unwisely dissipating their recovery.
Insurance review: Auto, home, umbrella, life, health, disability insurance policies need to be reviewed. For many injury victims, the settlement recovery is the first time they have had financial assets worth protecting. Proper insurance can help protect against premature loss.
Estate planning: The injury giving rise to the litigation may cause a need to review the estate plans of the members of the injury victim’s family. Parents of disabled children may need to revise their wills to avoid disqualifying their children from government entitlements. Of course, widows will need to revise their wills. If the settlement is especially large, there may need to be some careful estate tax planning. A commutation rider may need to be added to a structured settlement, etc.
Tax planning: Personal injury settlements are generally exempt from income tax. However, claims for punitive damages, bad faith or employment-related claims may be fully taxable. In addition, the income from the investment of the settlement proceeds will be taxable. The burden of these taxes may be minimized with careful planning.
Investments: Plaintiffs with settlement money to invest need to be counseled regarding the basics of investments. They need to be familiar with the effects of fees, expenses, sales loads, taxes, risk, etc. and directed to providers that won’t take advantage of them.
Plaintiff attorneys hold the key
A client’s transition from litigation and final settlement to post-settlement life is not an easy one. Every client’s financial knowledge and education is different. Each client needs specific attention to help him/her bridge the gap from pre-injury life to post-settlement normalcy. Making sure that a client receives proper financial education and assistance before and after the settlement greatly depends on the willingness of their attorneys to make the financial aspects of settlement as much a part of their case process as winning the recovery. Some attorneys may feel comfortable providing their clients this type of financial education themselves while others prefer to bring in an independent settlement planning specialistx. In either case, plaintiff attorneys hold the key to helping their clients create and implement a settlement plan that will increase their client’s quality of life and long-term financial security.
i Cordell, D.M. and J.W. Tombs, Planning Considerations for Personal Injury Settlement Recipients, Journal of Financial Planning, January, 2005, pp. 26-28.
ii ABA Model Rules of Professional Conduct, Rule 2.1 and Comments 2-5.
iiiGrillo v. Henry, 96th Dist. Ct, Tarrant Co. (Tex.) and Grillo v. Pettiette, et al., 96th Dist. Ct. Tarrant Co.
vLyons v. Medical Malpractice Insurance Association, 730 N.Y.S.2d 345, 286 A.D.2d 711 (N.Y. App. Div. 2001) and Macomber v. Travelers Property and Casualty Corporation, 260 Conn. 620, 804 A.2d 180 (Sept. 3, 2002).
vi ABA Model Rules of Professional Conduct, Rule 2.1, Comments 4 and 5.
vii I.R.C. § 5891(b)(1) (2002).
viii I.R.C. § 5891(a) (2002).
ix Most personal injury attorneys do not have Errors & Omissions liability coverage for financial and tax advice. Referring clients to independent financial and/or tax professionals helps ensure that the client is educated and the personal injury attorney is protected from potential liability regarding the financial and tax aspects of the settlement.
x Make sure that any professional you introduce has experience with injury victims and the proper credentials and education. The Certified Financial Planner (CFP®) designation and membership in the Society of Settlement Planners are good indications of competence and experience in the field. The Society of Settlement Planners is a national group of attorneys and settlement planners dedicated to protecting Plaintiff’s rights and interests in financial matters.
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