Lawyers, accountants, and companies that purchase structured settlements determine their worth by calculating their present value. This value is a factor when computing the amount you will receive after selling your structured settlement.
What is Present Value?
Present value refers to the current worth of money that won't be received until some specified time in the future. Having a dollar today is worth more than getting a dollar a year from now for two reasons. First, if you invest that dollar, it will earn interest, so the total value one year later will be greater than a dollar. Second, inflation slowly erodes the purchasing power of the dollar. If prices rise, you won't be able to buy as much stuff with your dollar a year from now as you can today.
In other words, if you have a dollar now, it has a present value of $1. You can spend it all today and get $1 worth of stuff. Or you can invest it now and have $1 plus interest.
The present value of a structured settlement is the value of future payments in today's dollars. If you agree to receive $1 every year for ten years, the present value of that agreement is actually less than $10. This is because if you invested that $1 every year, it wouldn't earn nearly as much interest as $10 invested all at once.
So long as the inflation rate remains lower than prevailing interest rates, the present value of future payments will always be less than the sum of all future payments. This is because the pool of money used to fund the structured payments will increase as it earns interest.
However, if the inflation rate is higher than prevailing interest rates, the present value of a structured settlement will be greater than the sum of all future payments. This is because it takes a larger pool of money to fund a structured settlement when the dollars the payee receives are continually losing value due to inflation.
How is Present Value Computed?
There are two fluctuating variables that are used by economists to calculate the present value of future payments. One of these is the interest rate that money could earn today. Economists usually use the lowest-risk interest rate available, such as the rate on a federally insured savings account of a US treasury note. The other variable to consider is the inflation rate. Inflation erodes the purchasing power over time. There are calculators that compute present value available online here, here, and here. These calculators, however, don't take inflation into account. No one knows for certain what inflation rates will be in coming years, but trained economists can make educated predictions. These calculators should therefore only be used to get an approximate present value. When precise figures are needed, the services of an economist are usually required to make the valuation.
Why is Present Value Important in Considering Whether to Sell a Structured Settlement?
In order to determine whether you are getting a fair price for your structure--indeed, in order to determine how much your structure is worth in the first place--you must compute its present value. The difference between what a structured settlement purchaser offers you and the present value of your settlement represents the true cost of the deal you are being offered.
Suppose you have a structured settlement which pays you $10,000 per year for 25 years. After five years, you decide to sell it. There are now 20 years of future payments owed to you. Assuming a 1% interest rate and NOT taking inflation into account, the present value of those payments would be $180,455. Experts recommend paying no more than 7% of the present value of your structured settlement to a structured settlement purchaser. Seven percent of $180,455 is $12,631. Deducting that figure from the present value yields $167,824.
This means that if you follow the expert advice and decline to pay more than 7% of the present value of your structure, you should get at least $167,824 from the company purchasing the settlement. If the offer is less, you should definitely consider looking to a different company. Again, these figures will be different once inflation is taken into account.
This is complicated!
As you can see, calculating how much your structured settlement is worth is not a simple task. Various assumptions about interest and inflation rates have to be made and projected over time. Assumptions about interest rates and inflation can be hidden in the legalese of the sale contract--and some may not be disclosed at all. For many people, the decision to sell a structured settlement may be the biggest financial transaction they ever undertake. Bigger, even, than purchasing a house.
For this reason, wise consumers should hire an attorney to guide them through the process. Some attorneys will want to run the company's proposal by an economist, who will work as a consultant for you and may charge hundreds of dollars in fees. But money spent on legal counsel and expert financial analysis is money well spent when a large sum of money is at stake.