Monte Carlo Analysis

Comparing Life Annuities with Alternative Investments

Period certain annuities are easy to understand and compare to investment alternatives. As our table of certain annuity returns shows, the rate of return advantage of certain annuities over similar investments ranges between 1% to 1 ½ % annually with a very dramatic compounding effect over time.

Annuities that pay for life include an additional valuable insurance feature since the life company, in agreeing to make payments for life, assumes the risk that the annuitant will live longer than the anticipated life expectancy. Therefore, the claimant does not have to worry about running out of money. Payments for life are a wonderful benefit, but are more difficult to value precisely in comparison with investment alternatives that lack the lifetime guarantee. The table on this page summarizes the results of an analysis technique called Monte Carlo Simulation ("MCS"). It uses varying assumptions for an investment portfolio, assuming a settlement is not structured. Very simply, in using MCS, we make initial assumptions regarding portfolio investment returns and the volatility (i.e., the range of differences in the yearly rates)of those returns. Then, we run a thousand or more calculations of projected returns based on a wide variety of changing assumptions drawn from past experience and assess the probability of a given outcome.

The first table contains our assumptions consisting of the investment allocation of a portfolio and the assumed future returns for those investment categories. The investment categories are straight forward: stocks, bonds and a money market fund. We use three sets of investment return assumptions:

Conservative - such as those that might be used by a fee-only financial planner for a client planning for retirement. Many financial planners and investment advisors use an 8% (or lower) figure for projected stock returns given today's low interest rates and relatively high equity price/earnings ratios.

Historical - returns for these categories based on the last 80 years. Many advisors feel these figures are too optimistic for the reasons given above.

Speculative - here we use an arbitrarily high ("irrationally exuberant") 15% return assumption for stocks just to see how it compares to an annuity.

Not shown are the volatility assumptions and co-variance figures for each investment category that are based on extended historical data. Also not shown are investment expenses of .75% annually and combined federal and state income taxes of 20%.

Using these investment assumptions, we use MCS to compare payments available from a structured settlement annuity versus the alternative investment portfolio for a 50 year-old male. For each set of assumptions, the MCS program runs a thousand projections of year by year future investment results. The figures in the second table represent the probability that the claimant would have any funds left in investment account if the same amount is disbursed from the account as provide by an annuity. For example, under the conservative portfolio column at age 78 (life expectancy for a 50 year-old male), the claimant will have funds remaining only 24% of the time. Using historical data this figure will rise to 46%, and, with the speculative data, it increases to 76%. Even using the relatively optimistic investment assumptions provided by historical returns, the claimant is unlikely to have any funds remaining at his normal life expectancy. If he lives beyond 78, which is probable, he will be destitute. If claimants understand the high risk of depleting their settlement dollars with a cash-only settlement, they would rarely choose this option.

The third table shows the percentages by which the disbursements from the investment account would have to be reduced below the annuity payments to have a 90% chance of having any remaining funds at the ages shown. What claimant would want to have 33% less to spend than provided by the annuity in order to have an acceptable chance of not depleting his resources? Even if he does reduce his disbursement by this percentage, there is still a 10% he will have no money left at age 78.

As we pointed out under the life annuity section, our analysis assumes that claimants will invest in efficiently diversified portfolios with low expenses. It also assumes that they will be fiscally disciplined and will avoid family or other pressure to dissipate their settlement funds long before their financial needs end. Unfortunately, this is usually not the case.

A life annuity offered through a structured settlement is a uniquely beneficial financial resource as this summary and its tables illustrate. We would be pleased to answer any questions and to prepare customized illustrations for claimants' individual situations.

We added the fourth column in the second and third box for anyone who might want to compare a regular fixed annuity paying for life with the structured settlement annuity. Since the income disbursed from the regular fixed annuity is taxable and the mortality assumptions less favorable, the investment portfolio compares much more favorably. However, even with these disadvantages compared to structured settlement annuities, most financial planners recommend that everyone should have a portion of their retirement income in the form of a life annuity to insure against outliving their resources.