Maximizing the Benefits from Your Gift Annuity Program

Maximizing the Benefits from Your Gift Annuity Program

Article posted in Charitable Gift Annuity on 2 June 2004| 3 comments
audience: National Publication | last updated: 18 May 2011
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Summary

One of the most significant differences between a charitable gift annuity and a charitable remainder trust is the obligation to make gift annuity payments is a general obligation of the issuing charity whereas the obligation to make payments from a CRT is limited to the trust itself. For this reason, organizations issuing charitable gift annuities set aside, either voluntarily or subject to state law, a portion of the amount transferred in exchange for the gift annuity in a reserve fund for the purpose of satisfying the annuity payments. The problem is that in recent years, the low interest rate environment has caused some reserves to decline to worrisome levels. In this paper, nationally recognized planned giving authority Frank Minton analyzes the various kinds of risks associated with gift annuities, shows how charities can minimize risk and maximize the benefits of their gift annuity programs, and shares some less traditional ideas for attracting more dollars for gift annuities.

by Frank Minton

  Gift annuities are more popular than ever, and charities are nervous.

 Gift annuities are particularly appealing when interest rates are low and stock markets are volatile.  Fewer charitable remainder trusts have been established during the past three years, but the number of gift annuities has increased.  Financial institutions that administer gift annuities on behalf of charities report that in 2002 70 percent or more of their life income gifts were gift annuities.  Their popularity has caught the attention of the public media, and there have been numerous articles about them in financial and trade publications.  This publicity, in turn, has prompted many charities to start gift annuity programs so that they will have a piece of the action.

 From mid-2000 to mid-2003 gift annuity reserve funds were hammered, and boards of charities began to worry about future liabilities.  Some charities have had to transfer general funds into their gift annuity reserve accounts to meet state minimum reserve requirements.  It is very possible that a number of gift annuities which were established in 1999 and 2000 before the onset of the bear market will run out of money before they terminate.  In an Internet survey conducted by the American Council on Gift Annuities (ACGA) in the spring of 2003, 25 percent of respondents said that their charity's gift annuity reserve fund had decreased significantly during the past three years, and 50 percent said it had decreased slightly.  Almost half of the respondents (45 percent) acknowledged that their institution had become more concerned about the risks associated with gift annuities.

 Thanks to some highly-publicized instances of default on gift annuity payments, donors, too, have become more conscious about the safety of gift annuities.  Nor have these defaults gone unnoticed by state insurance officials, some of whom are making noises about increasing regulation to protect consumers -- just after charities have made remarkable progress in easing regulations in many states.

 If charities take steps to manage risk, a gift annuity program can still be highly beneficial.  Aside from the significant amount of dollars that will remain for the charity from a well-managed program, gift annuities have corollary benefits.  Donors who contribute for gift annuities develop a relationship with the charity.  This often leads to additional contributions for gift annuities, and it also may result in increased current giving and to inclusion of the charity in the donor's estate plan.

 The purpose of this paper is to show how charities can minimize risk and maximize the benefits of their gift annuity programs.  The paper initially analyzes the various kinds of risks associated with gift annuities.  Then it shows how these risks can be reduced or controlled.  Finally, in the concluding section, it offers a few, less traditional ideas for attracting more dollars for gift annuities.

Risks Associated with Gift Annuities

A.        Risks to the Annuitant

            1.            Default risk

Gift annuity payments are a general, unsecured liability of the charity that issues the annuity.  In the event that the charity becomes insolvent and any segregated reserve funds are exhausted, the annuitant would no longer receive payments.  Recent defaults by charities and the failure of respected companies have caused many individuals to be more concerned about the safety of their gift annuities.

            2.            Inflation risk

The advantage of a gift annuity is that payments never decrease, whatever the performance of financial markets.  The disadvantage is that payments never increase and that, consequently, the purchasing power of the payments diminishes over time.  Suppose, for example, that a donor, age 65, contributes $100,000 for a gift annuity and receives $6,000 per year for life.  At an average inflation rate of 2.5 percent, that $6,000 will be worth only $3,662 in today's dollars after 20 years.

The mean and median age of a gift annuity donor is 77.  By that age, the security of fixed payments begins to outweigh the lack of inflation protection.  That is why the primary market for gift annuities will always be the charity's oldest donors.

B.        Risks to the Charity

                1.            Rate risk

The maximum gift annuity rates suggested by the ACGA are designed to provide an average residuum (amount remaining for the charity when the beneficiary(ies) has(have) died) of 50 percent of the original contribution.  If a charity exceeds those rates, it will not realize a 50-percent residuum unless the total return on its reserves is higher than the ACGA assumes, the longevity of its annuitants is shorter than the ACGA projects, and/or its administrative expenses are lower than those typically charged by outside administrators. (See Appendix A for a description of assumptions underlying ACGA rates effective July 1, 2004.)

If a charity issues a gift annuity to a donor, age 70, who is also the annuitant, pays the 6.5-percent rate suggested by the ACGA, and earns a constant net total return, the number of years to exhaust the contribution are as follows:

                        Total Net Return                              Years to Exhaust Contribution

                                    4%                                                       24.0

                                    5%                                                       29.5

                                    6%                                                       43.1

                                    7%                                                       ¥

The net return assumption underlying the ACGA rates is five percent, and the number of years required to exhaust the contribution, if the charity realizes that return, is well beyond life expectancy.

Suppose the charity, in order to gain a competitive advantage, decides to offer a gift annuity rate of 7.5 percent, which was the rate for a 70-year-old annuitant in 1998 and 1999.  Then, the number of years to exhaust the contribution for each assumed net return is considerably smaller.

                        Total Net Return                              Years to Exhaust Contribution

                                    4%                                                       19.1

                                    5%                                                       22.1

                                    6%                                                       27.0

                                    7%                                                       39.0

The charity is already at risk on some of the annuities issued when it paid higher rates, particularly on annuities issued just in advance of the recent bear market.  To exceed the ACGA's suggested maximum rate on new annuities will add to that risk.  

            2.            Mortality risk

In 2001 the ACGA conducted a mortality study based on approximately 30,000 gift annuities issued by 26 organizations that have been issuing gift annuities for a long time.  The study confirmed what had long been suspected, namely that annuitants of gift annuities live longer than annuitants of commercial annuities.  The actuaries who analyzed this data concluded that the female life expectancies reflected in the Annuity 2000 Tables with a 1.5 year age set back would approximate the actual average life expectancies of gift annuitants.

The assumptions about average life expectancies are probably pretty accurate for all gift annuities issued in the United States, but they may not be accurate for the annuities of a particular charity.  The smaller the pool of gift annuities, the greater the probability of variation from the mortality assumptions.

A person who specializes in gift annuity risk management is Bryan K. Clontz, President of Charitable Solutions, LLC in Atlanta.  He and Donald F. Behan, an actuary now on the faculty of Georgia State University, will be publishing an article about controlling the risks of gift annuities in a forthcoming issue of the Journal of Gift Planning.  In that article, the authors use the law of large numbers to explain why the mortality experience of a particular charity's gift annuity pool may vary considerably from the mortality experience of all gift annuities in the aggregate.  This is their explanation:

"The law of large numbers states that the average of a large number of random variables tends toward the mean as the number of variables grows large.  This can be illustrated by the results of flipping a coin.  If a coin is flipped ten times, there is only a 65% probability that the proportion of heads will be in the range from 0.4 to 0.6, but if the coin is flipped 1,000 times, there is a 65% probability that the result will be in the range from 0.485 to 0.515.  Thus, the average of a large sample will tend to be close to the mean almost all of the time.  While the average of a small sample is expected to be near the mean, it would not be so unusual to get a result that is far from the mean."

Sixty percent of the annuitants of one charity might exceed the longevity assumptions on which the ACGA rates are based, while sixty percent of the annuitants of another charity might die earlier than the assumed life expectancies.  Because any given charity is exposed to this mortality risk, it is necessary to build in some protection.

One way to do that is to offer rates such that the probable exhaustion of a contribution would not occur until well beyond life expectancy.  In the case of the 70-year-old annuitant, cited above, the contribution would be exhausted after 29.5 years if the charity realizes a constant net total return of five percent on gift annuity reserves (which is the assumption underlying the ACGA rates).  The ACGA life expectancy for an annuitant is about 22 years.  Thus, the annuitant could exceed life expectancy by 34 percent before the charity lost money.  Such a variation from projected average life expectancy is possible, though not very probable, even for the charity with a relatively small pool of gift annuities.

Suppose the charity exceeds the ACGA suggested maximum by one percent and also realizes a total net return of five percent.  Then the charity would lose money if average life expectancy is exceeded only slightly.  The schedule of rates adopted by a charity should take into consideration the fact that the longevity of annuitants could well exceed even the conservative projections of the ACGA.

            3.            Investment risk

The investment risk of gift annuity reserves, like the risk of all institutional and personal funds, diminishes with diversification of assets.  The appropriate asset allocation at any given time depends on a judgment about market conditions and risk tolerance.

The portfolio used by the ACGA in determining the assumed total return on gift annuity reserves has consisted of 35 percent equities, 60 percent ten-year Treasury notes, and five percent cash.  The blended return on this portfolio, using the historical total return on equities and the current yields on the Treasury notes and cash, is what a charity is presumed to earn on its gift annuity reserves. Effective July 1, 2004, the equity portion will be increased from 35 percent to 40 percent, and ten-year Treasury Notes will be decreased to 55 percent.  This adjustment was made because there are now relatively few states that impose investment restrictions on gift annuity reserves.

Most charities, unless they are constrained by investment restrictions of states like California, invest a higher percentage in equities.  Some invest gift annuity reserves in the same manner as they do endowed funds, possibly allocating as much as 60 to 70 percent to equities.  Such charities had great returns through much of the 1990s but sustained sharp losses in the period 2000-2002.  Indeed, some charities that chafed under the California equity limitations fared better than charities that were able to invest more heavily in equities.  Effective July 1, 2004, the equity portion will be increased from 35 percent to 40 percent, and ten-year Treasury Notes will be decreased to 55 percent. This adjustment was made because there are now relatively few states that impose investment restrictions on gift annuity reserves. 

In contrast to charities, which on average invest about half of their gift annuity reserves in equities, insurance companies invest most annuity reserves in bonds and mortgages.  They also try to purchase fixed income securities that match liability cash flows.  That is why commercial annuity rates fluctuate daily and are based on what investments can be purchased at a given time.

The residuum a charity realizes from a gift annuity depends not only on the average total return while the annuity is in force but also on the timing of the returns.  The gift annuities that are in the most trouble today are those completed just before the onset of the bear market.  The reserves of many of these annuities were invested heavily in equities at the worst possible time.  Some of the reserve funds have lost 30-50 percent of their value.  There is a strong probability that a number of these annuities will run dry prior to the death of the annuitants.

For example, suppose that $100,000 was contributed for a gift annuity paying $8,000 per year and that the value of reserves backing that annuity has dropped to $60,000.  The charity is now effectively paying an annuity rate of 13.33 percent.  If the future, constant total net return is six percent, that annuity will crash in ten years.

By contrast, annuities completed in the early to mid-1990s are more likely to have ample reserves because of the performance of the stock market during the first few years of existence of those annuities.  Two annuities of the same size with identical average returns could result in different residua depending on the timing of the returns.  An annuity with early gains followed by losses produces a larger residuum than a gift annuity with early losses followed by gains.

            4.            Asset risk

Unless a gift annuity is funded with cash, there is an asset risk.  The risk is minimal with publicly-traded securities because they generally don't lose much of their value during the short interval between their receipt and sale.  However, in some instances bad news about a stock might cause it to drop precipitously in value before the charity can sell it.  If a charity promised to pay a seven-percent annuity rate based on the date-of-gift value, and the net proceeds from a sale were 80 percent of that value, the charity would effectively be paying an annuity rate of 8.75 percent.

The asset risk is greater when a charity accepts real estate, collectibles, closely held stock, or some other illiquid asset for a gift annuity.  The charity will have to advance its own funds for an indeterminate period of time, it will realize net sales proceeds of an uncertain amount, and it may have to pay expenses associated with owning and maintaining the asset, as well as commissions and other selling costs equal to ten percent or more of the proceeds.  Unless steps are taken to mitigate the risk, such as offering a lower gift annuity rate, the charity could wind up losing money because the net proceeds are too small to sustain the annuity payments.

            5.            Legal risk

Most states have laws regulating charitable gift annuities to varying degrees.  At the present time:

·         Twelve states require a segregated reserve fund, annual reporting, and/or a detailed application for a permit to issue gift annuities.  (Three other states that exempt gift annuities from most regulations require a reserve fund.)

·         Sixteen states exempt gift annuities from regulations but require a notification to the states of an intention to issue gift annuities.  All but one of these states require certain disclosure language in the gift annuity agreement.

·         Seventeen states exempt gift annuities from regulation and do not require notification to the state.  Six of these states require disclosure language in the gift annuity agreement.

·         Five states and the District of Columbia either do not address gift annuities or have determined that they are not subject to insurance regulation.

(See Appendix B (PDF) for a summary of state regulations.)

A charity that operates a national gift annuity program and complies with state regulations will incur costs for the initial applications and filings, will have to invest time preparing annual reports or hire someone to do this, and may have to modify its investment strategy to comply with state requirements.  If a charity does not comply with state regulations, it exposes itself to the following risks:

·         State authorities, upon learning that the charity is out of compliance, could issue a cease and desist order, fine the charity, and/or order it to offer all annuitants an opportunity to rescind their gift annuity agreements.

·         A disgruntled donor or heir could file a lawsuit against the charity charging, among other things, that it issued gift annuities illegally, failed to include the required disclosure language, and did not submit the necessary filings.

6.            Policy risk

The most important policies regarding gift annuities concern the minimum age of annuitants, the minimum contribution for a gift annuity, and the types of assets acceptable for a gift annuity.  All of them affect the risk assumed by a charity.

When an annuitant is relatively young, there is exposure to a longer period of uncertainty about changes in mortality and the financial markets.  Also, the present value of the residuum eventually realized by the charity may be quite small as the following chart demonstrates.

Contribution of $100,000

Quarterly Payments

Female Annuitant

Age of Annuitant

Annuity Rate as of 7/1/2004

Residuum for Charity (1)

Present Value of Residuum (2)

60

5.7

52,084

14,005

65

6.0

58,763

19,585

70

6.5

55,483

22,708

75

7.1

56,269

27,925

80

8.0

57,179

33,693

85

9.5

56,931

38,778

90

11.3

59,740

45,502

(1)    Based on a constant total net return of five percent, the annuitant's living to average life expectancy per the Annuity 2000 Tables.  (The ACGA rates assume a somewhat longer life expectancy.  Thus, the projected residuum would be smaller.  In fact, for ages 60-85, the ACGA projected residuum is approximately 50 percent.)

(2)    The discount rate used in calculating the present value of the residuum is five percent, the same as the assumed total net return on reserves.

Although, in general, a charity benefits more when annuitants are older, it is subject to a greater longevity risk with older annuitants.  It makes large payments to these annuitants, so a greater portion of each payment has to come from principal.  Should the annuitant live twice as long as his or her life expectancy, which is entirely possible for people in their 90s, principal will be depleted much more rapidly.  This risk is somewhat mitigated by the fact that the ACGA gift annuity rates at older ages are lower than would follow from the stated assumptions.

In the case of a very small gift annuity, the risk is that the present value of the residuum may be less than the cumulative expenses incurred by the charity in administering it.  If, in the above chart, the contribution amount were $5,000 instead of $100,000, the present value of the residuum when the annuitant is age 65 would be a mere $979.  Accepting a small contribution for a gift annuity may open the door for future gifts, so a gift annuity must be evaluated in context rather than in isolation.  Even so, very small gift annuities could become money losers for a charity.

With reference to non-cash assets, some charities try to minimize risk by structuring the transaction so that the annuity payments begin when the property sells and are based on the proceeds realized.  In so doing, they could cause the donor to be regarded as having sold the asset and contributed the cash proceeds, in which case the donor would be taxed on all of the capital gain in the assets.

Minimizing the Risk in Gift Annuities

A.            Minimizing Risk to the Annuitant

            1.            Offer gift annuities only if the charity is financially sound.

Donors entrust their money to charities in expectation that they, or other named annuitants, will receive life payments.  In some instances they depend on these payments for living expenses.  When a charity issues a gift annuity it has a moral, as well as financial, obligation to fulfill the commitments in the gift annuity agreement.  Thus, only charities that are prepared and able to make long-term commitments should start a gift annuity program.

2.         As required by the Philanthropy Protection Act of 1995, provide information about the charity's financial condition and governance structure.

Such information enables a donor to judge whether an annuity offered by the organization is likely to be safe.  Some donors who supposed that surely a charity was trustworthy, and never subjected it to scrutiny, are now the victims of default.

3.         Disclose all relevant information about the proposed gift annuity so that the donor can make an informed decision.

Prior to making a decision, a donor deserves to see financial information that shows the amount of payments, how they will be taxed, the charitable deduction, and any gift tax implications, along with a clear statement that the gift is irrevocable.

B.            Minimizing Risk to the Charity

            1.            Do not exceed the rates recommended by the ACGA.

Exceeding the ACGA rates puts a charity at greater risk of losing money and definitely reduces the residuum.  When the Charitable Midterm Federal Rate (CMFR) is low, higher rates may also cause the present value of the annuity to exceed 90 percent of the contribution, in which case the obligation to make annuity payments will be treated as acquisition indebtedness, possibly creating unrelated business taxable income for the charity.  (A charitable gift annuity will not be considered commercial insurance and will be tax exempt to the charity provided it meets the conditions of IRC Sec. 514(c)(5), one of which is that the present value of the annuity is less than 90 percent of the value of the property transferred.)

The current ACGA rates, and probably still lower rates, would appeal to donors because the interest rates on CDs and other fixed-income investments remain quite low in spite of some recent increases.  Last year they reached 40-year lows. From the spring of 2002 to the spring of 2003, commercial fixed-annuity rates decreased approximately 10 percent, and the ACGA rates declined by about the same percentage.  If a charity persists in following one of the previous, higher gift annuity rate schedules, it is presuming to be less affected by current market conditions than insurance companies expect to be.

The differential between gift annuity and commercial rates has remained fairly constant through recent adjustments in gift annuity rates.  A convergence of commercial and gift annuity rates would be an indicator that gift annuity rates are too high.  That is why the review of gift annuity rates conducted periodically by the ACGA includes monitoring commercial rates. The ACGA recently decided to continue the gift annuity rates that became effective on July 1, 2003 until June 30, 2005, unless unforeseen circumstances should necessitate an interim adjustment.  Though the ACGA followed its own methodology in reaching this conclusion, it was reassured by the fact that commercial rates have remained relatively constant for the past twelve months. 

Adding the benefit of the charitable deduction to gift annuity payments narrows, but does not close, the gap between gift annuities and commercial annuities.  That is why gift annuities should always be marketed as a means of making a gift and not simply as an investment.  As revealed by the following data from a 2003 ACGA Internet survey, the vast majority of charities do not exceed the ACGA rates.  By staying within those rates they encourage donors to make decisions based on the charity they want to support rather than on which charity pays the highest available rate, and they minimize their risk.

Practices of Charities Regarding the ACGA Gift Annuity Rates

Always follow the ACGA rates 68%
Usually follow the ACGA rates, but in some instances offer lower rates 15%
Usually follow the ACGA rates, but in some instance offer higher rates 6%
Usually follow the ACGA rates, but in some instance offer either higher or lower rates 8%
Regularly offer rates lower than the ACGA rates 2%
Regularly offer rates higher than the ACGA rates 1%

It is noteworthy that 85 percent of charities never exceed the ACGA rates, and that a mere one percent of charities regularly exceed those rates.  Since the ACGA rates are recommended maximum rates, charities that pay lower rates are acting within the ACGA recommendations.

Note about capping rates:  A major problem with capping rates is that it penalizes older donors.  All insurance companies and most charities pay higher rates to older annuitants because those individuals will receive payments over fewer years.  For example, according to the Annuity 2000 Mortality Tables, the life expectancy of a male age 81 is 9.17 years, while the life expectancy of a male age 90 is only 5.32 years. To pay the same rate to both is to discriminate against the older annuitant.  It would be more fair to reduce all rates than to cap rates at a certain age.

                2.            Invest gift annuity reserves prudently.

Charities that are registered to offer gift annuities in Florida, Arkansas, Wisconsin, and California will be prohibited from investing required reserves in certain types of assets, and they will be subject to limitations on other types of assets.  The prohibitions and limitations apply only to required reserves, not to surplus reserves.  Still, charities operating in these states will necessarily have to invest reserves more conservatively than charities operating in other states.  Some states impose only a prudent investor standard.  While that does not give a charity carte blanche to invest gift annuity reserves in anything it wishes, it does give the charity considerable discretion. (Note:  Next year Arkansas is expected to adopt a prudent investor standard for gift annuity reserves.)

A charity that offers gift annuities in all states must, at a minimum, establish two segregated reserve funds -- one for California annuities (California mandates a separate trust fund to hold reserves for California annuitants) and one for the annuities of all other states.  It may elect to create additional segregated reserve funds to hold the reserves for Wisconsin, Arkansas, and Florida lest the investment restrictions of those particular states apply to all annuities wherever the donors reside.

An investment strategy for gift annuity reserves, in addition to taking applicable state regulations into consideration, may include the following risk-control techniques:

·         An asset allocation that strikes the proper balance between risk and potential return.

Although charities will reach different conclusions about what constitutes an appropriate asset allocation at any given time, it is probably prudent to invest gift annuity reserves more conservatively than the charity's endowment.  Typically, charities distribute a percentage of the value of endowment assets based on a rolling average value, so distributions decrease when market values decline.  However, the payments from gift annuities remain at the same level when the market value of reserves declines.  Thus, gift annuity reserves invested heavily in equities are affected more severely in a prolonged bear market.  Having a significant portion of reserves in fixed income investments with laddered maturities may protect the charity during those periods.  A large charity that has accumulated significant surplus reserves could afford to invest more aggressively than a charity with marginally adequate reserves.

·         Diversification within each asset class.

This, of course, is sound advice for any fund.

·         Selection of investments based on expected cash flow needs.

If a gift annuity reserve fund has insufficient liquidity, it may be necessary to sell securities at the most inopportune time in order to make the required annuity payments.  To avoid having to do this, a charity can project future cash flow needs based on annuities in force; then it can build a portfolio such that interest payments and maturities of various fixed-income instruments will generate enough income to meet those cash flow needs.

3.                  Have gift annuities issued by an affiliated organization.

Many national organizations with local affiliates have established national gift annuity programs.  The local affiliates can direct their donors to establish a gift annuity through the national office.  Normally, a substantial portion of the residuum will be transferred from the national office to the affiliate.  The United Way of America, the Red Cross, The Nature Conservancy, the American Cancer Society, and the American Heart Association are a few of the national organizations that offer this opportunity to local affiliates, whether or not those affiliates are separately incorporated.

A charity that has no connection with a national organization may be able to use the services of a local community foundation for the issuance of gift annuities.  The community foundation may require that all or a portion of the residuum remain in an endowed fund at the foundation, but distributions from the endowment can be made to the charity that referred the donor.

Charities that are relatively new or have quite limited financial resources probably should not issue gift annuities.  To do so puts both them and the annuitants at financial risk.  By aligning themselves with a larger organization that already issues gift annuities, they can eliminate financial risk to themselves, protect their donors, and still receive benefits.

            4.            Consider reinsuring some or all gift annuities.

One way to transfer most of the financial risk of gift annuities is to reinsure them.  The charity would use a portion of the contributed assets to purchase an annuity from an insurance company that will pay the amount promised to the annuitant(s).

Reinsurance does not release the charity from ultimate liability.  In the event that the insurance company goes bankrupt and defaults on the payments, the charity has a contractual obligation to continue them.  If the charity purchases annuities only from highly-rated insurance companies, the risk of this happening is minimal.  Even if the company does default, the state guarantee association would provide the annuity owner protection up to a certain point. 

It should be noted that in particular states such as California and New York, "reinsurance" means reinsuring the risk in case of default, not purchasing commercial annuities.  For instance, in California a charity does not have to maintain reserves for a particular annuity if, pursuant to permission by the Department of Insurance, it enters into a reinsurance contract with an insurance company according to which, in exchange for a premium payment, the insurance company agrees to make the payments if the charity is unable to do so. Some insurance companies have developed contracts whereby a charity simultaneously reinsures the risk and purchases an annuity that pays the stipulated amount. 

Whether the charity derives a greater financial benefit from reinsuring or self-insuring depends on the longevity of the annuitants and the net total returns realized by the charity.  Generally, self-insurance is favored if a charity would be able to earn a return in the range of six percent or higher on reserves while reinsurance will be more beneficial if the returns are relatively low.

With reinsurance, a portion of the contribution is available for immediate use.  This is also true of self-insured gift annuities, but charities that self-insure are more likely to keep the entire contribution in reserve until the termination of the annuity.  Aside from possibly resulting in less money for the charity, reinsurance of gift annuities could be off-putting to donors.  They may be disappointed and confused when they learn that the charity retains only a fraction of the contribution.

On the other hand, they may be reassured upon learning that their payments come from a highly-rated insurance company instead of a struggling charity.  If a charity lacks the financial strength to guarantee payments, it should definitely consider reinsuring its gift annuities.  Even if it is financially sound, it may still wish to reinsure gift annuities selectively.  For example, it may reduce risk by reinsuring large annuities or annuities for annuitants in the age range where the charity is at greater risk.

            5.            Adopt sensible policies regarding gift annuities.

Participants in the 2003 ACGA survey were asked what actions, if any, their institutions had taken because of concern about financial risk.  The majority had taken no action, but those that had reported the following:

Stopped issuing gift annuities 5%
Reduced gift annuity rates beyond the recent ACGA reductions 15%
Raised the minimum age of gift annuitants 68%
Started reinsuring gift annuities 14%

Interestingly, the most common action was to raise the minimum age of annuitants.  The most common minimum age for immediate gift annuities, according to the same survey, was 55 (28 percent of charities).  The next most common minimum ages were 60 (18 percent) and 65 (14 percent).  Over a fourth of the charities had no minimum.

As noted above, the present value of the residuum is generally larger when annuitants are older, though the mortality risk is higher in the case of the oldest annuitants.  On balance, a charity likely can increase the cost effectiveness of its gift annuity program by raising the minimum age of annuitants, so charities have a good reason to take this action.  A charity wanting to assure the cost effectiveness of its program probably should set 60 or older as the minimum age for an annuitant of an immediate gift annuity and for the minimum payment starting age for an annuitant of a deferred gift annuity.

For an annuity to be cost effective, it should also be of a certain size.  Some charities, particularly religious organization, accept contributions as small as $1,000 for a gift annuity.  It's hard to imagine how such a minute gift annuity can be profitable for a charity since it takes about as much time to administer a $1,000 gift annuity as a $100,000 gift annuity.  The most common minimums are $5,000 (40 percent of charities) and $10,000 (39 percent of charities).  While charities must be guided by the affluence of their constituencies, they should try to move the minimum to at least $5,000 and preferably to $10,000.

Although charities are loath to establish a maximum contribution level, some are hesitant to accept a very large contribution for a gift annuity (e.g., one which would constitute 40 to 50 percent of gift annuity assets) because the investment and mortality risks would be magnified.  Rather than declining the gift, the charity should first determine whether reinsurance of all or part of the obligation is possible.

The risks associated with accepting illiquid assets for a gift annuity can be controlled by either flatly prohibiting acceptance of them (not recommended except in New York) or by stating the conditions under which they are acceptable.  For instance, a charity might require that the assets be marketable, and it might offer a lower-than-normal annuity rate.  The rate a charity can safely offer could be determined by the following formula:

            R = S -- PT x N, where

                       V

R is the gift annuity rate to be offered,

S is the net sales proceeds,

P is the annual annuity payment,

T is the time, expressed in years and fraction of years, between the date of the gift and the sale of the property, and

V is the appraised value of the property.

            6.            Develop a strategy for dealing with problem gift annuities.

            One of the following scenarios will apply to a charity's pool of gift annuities.

·         All of the annuities will be for the unrestricted purposes of the charity.

·         Some of the annuities will be for designated purposes and others will be unrestricted.

·         All of the annuities will be for designated purposes.

If all gift annuities are unrestricted, the charity need not set up a fund accounting system to track the performance of each annuity.  Even if it does, it will be more concerned with the performance of the pool as a whole than with that of a particular annuity.

If all or some annuities are for designated purposes, the charity must necessarily do fund accounting in order to determine the residuum to be transferred for the stated purpose when the annuity terminates.  The residuum would be the original contribution, increased by the annuity's pro rata share of earnings, and decreased by annuity payments plus the annuity's pro rata share of expenses.

Even in a financially-sound gift annuity program, a particular annuity may run dry.  In other words, the residuum (balance in the account) will reach zero before the death of the sole or surviving annuitant.  The payments, obviously, must continue for the life of the annuitant(s), and they must come from another source.  Assuming some gift annuities are unrestricted and have surplus reserves, some of those assets could be used to continue payments on the failed gift annuity.  The more difficult challenge is to find money to continue the payments, if all of the charity's gift annuities are restricted.

Obviously, a charity could transfer some of its general funds to continue payments, but this will not be a popular solution when the administration has precious little discretionary money at its disposal.  As a more palatable alternative, could the charity cover the payments with a small assessment against the reserves of all of the other, restricted annuities?  Or would the charity be in breach of its fiduciary duty for having diverted restricted money for a different purpose?  What if the charity regularly assesses all annuities an administrative fee in addition to the fee it pays a financial institution to manage its gift annuity program, and it uses some of this money to make the payments?

Rather than waiting for a gift annuity to run dry and then scrambling for a solution, a charity should, in consultation with its counsel, develop a strategy for continuing payments.  It must also forewarn donors that there will be no money left for the intended charitable purpose, while reassuring them that their annuity payments will continue.  Possibly some of the truly philanthropic ones will make an outright gift.

7.         Adopt a prudent policy regarding expenditure of gift annuity funds for charitable purposes.

According to the 1999 survey on gift annuities conducted by the ACGA, 83 percent of charities place the entire contribution for a gift annuity in the reserve fund and, upon termination of the annuity, use the residuum for charitable purposes.  Only 17 percent spend some portion of the contribution immediately.

The latter is permissible so long as the charity maintains sufficient reserves to back outstanding annuities and meet state reserve requirements.  However, it increases the risk that, during an economic downturn, a charity may have to move some of its general funds into the reserve fund.  Some financially-strapped charities spent a significant portion of each contribution when it was received, intending to replace these "borrowed" funds when circumstances improved.  They have been unable to replenish the reserves, and now they are inadequate to fulfill future obligations  This is a ticking time bomb.

To avoid ever finding itself in such a situation, a charity should adopt one of these spending policies:

·         It if tracks individual annuities (i.e., does fund accounting), spend nothing until the annuity terminates, and then use the residuum for charitable purpose -- the policy of 83 percent of charities.

·         If its annuities are unrestricted and it does not track them individually, periodically make a distribution from the reserve fund for charitable use, being careful at all times to maintain reserves of at least 125 percent of the present, or actuarial value of annuity obligations.

·         If it chooses to spend some of the contribution immediately, then transfer to the reserve fund at least 125 percent of the present, or actuarial value, of that annuity obligation and spend only the balance.  This is preferable to a policy of spending "x" percent of contributions and investing the balance because, when interest rates are low, the balance may be barely adequate to meet reserve requirements, let alone provide a cushion.  Spending "x" percent probably would not be a problem if the percent is small.  It should be remembered that the projected 50 percent residuum is based on the assumption that 100 percent of the contribution is invested in the reserve fund.  If a portion is expended, the residuum will be less.

8.            Give your gift annuity program a check-up.

It is important to

·         Determine the adequacy of your gift annuity reserves,

·         Identify any problem annuities and take appropriate action,

·         Review your investment philosophy,

·         Know whether you are in compliance with state regulations, and

·         Re-visit your policies.  

The check-up will help keep your gift annuity program fiscally fit.

Suggestions for Increasing Gift Annuity Contributions

Most gift annuities are funded with cash or publicly-traded securities, and usually there will be one donor, who is also the annuitant, or a couple who donate jointly-owned or community property and are joint and survivor beneficiaries. Because these arrangements are generally well understood, they are not discussed in this paper. However, four less common applications of gift annuities are described in this final section of the paper. Attracting more gift annuity contributions through these applications, along with following the risk management strategies in the preceding section, can help maximize the benefits from a gift annuity program.

A.        Gift Annuity for Another Individual

Some individuals provide supplemental financial support for aged parents who have limited income or for siblings who are struggling financially.  Still others may want to help a friend have a better quality of life or reward a long-time employee who is retiring.  Often, such assistance is paid with after-tax dollars, which can be quite costly for the donor.  For example, a person subject to a 35-percent tax rate must earn $769 in order to provide a $500 monthly check.  It could be advantageous to transfer capital for a gift annuity and name as the annuitant the person whom the donor desires to help.  The donor receives an income tax deduction, and the tax paid by the annuitant will probably be minimal because a portion of the annuity payments will likely be tax-free for a number of years, and the taxable portion of the payments will be taxed at a low rate.

Example:  On June 1, 2004  Mr. G contributes stock having a fair market value of $100,000 and a cost basis of $40,000 for a gift annuity and names his mother as annuitant, reserving no power to revoke her interest.  His mother, whose date of birth is January 15, 1922, will receive quarterly payments based on the ACGA rate. 

Mr. G in the example will recognize $30,138 of capital gain (the portion of gain allocated to the present value of the annuity).  However, his charitable deduction of $49,770 (based on the June 2004 CMFR of 4.6%) will offset the taxable gain and reduce taxes on other income somewhat, assuming he is able to use the deduction.

Since Mr. G will already have recognized the taxable gain, no part of his mother's payments will consist of capital gain.  For the balance of her life expectancy, those payments will be partly tax-free and partly taxable as ordinary income.  The payments to her will be taxed the same as they would have been if Mr. G had contributed $100,000 cash.

Mr. G makes a gift to his mother of $50,230 (the present value of her annuity payments).  As a present-interest gift, it qualifies for the gift tax annual exclusion of $11,000.  Thus, assuming he has made no other gifts to her in the year he establishes the gift annuity, the taxable gift to his mother would be $39,230 ($50,230 -- 11,000).  He can avoid making any taxable gift by retaining in the gift annuity agreement the right, during his life or upon his death, to revoke his mother's annuity interest.  Then he will have made no completed gifts to his mother until she actually receives the annuity payments, and since each year's payments are under $11,000, they will be covered by the gift tax annual exclusion. 

B.                 Gift Annuity Funded with IRA Assets

1.            Inter Vivos gift annuity funded with IRA assets

If the CARE Act, now before Congress, should be enacted into law, individuals over a certain age would be able to transfer all or some of their IRA assets to a charity for a gift annuity.  That rollover would not be treated as a taxable distribution.  However, the payments would be entirely taxable as they would have been if they had been distributed directly from the IRA.  Meanwhile, the only way a lifetime gift of IRA funds can be made is to withdraw money from the IRA, reserve whatever will be required for tax (including the withholding), and contribute the balance for a gift annuity.  The deduction resulting from the contribution for a gift annuity will reduce the amount that has to be reserved for tax.

2.            Testamentary gift annuity funded with IRA assets

While awaiting action on the CARE Act, or even if it passes, gift planners may want to propose funding a testamentary gift annuity with all or a portion of remaining IRA assets. This gift arrangement was addressed in PLR 200230018. The most important conclusion in the ruling was that the proceeds payable to the charitable beneficiary will be income in respect of a decedent to the charity under IRC Sec. 691(a)(1)(B) and will not be income in respect of a decedent to the taxpayer's estate. Since the charity is tax-exempt, none of the IRA proceeds will be taxed at the time the annuity is funded. Though the IRS did not rule directly on the matter, it is presumed that payments would be entirely taxable as ordinary income, unless some portion of the IRA was funded with after-tax contributions. Distributions from an IRA left to an heir would likewise have been fully taxable.  A testamentary gift annuity funded with remaining IRA assets could be appealing when:

·         the donor wants to provide fixed, guaranteed payments to a surviving friend or relative and make a charitable gift, or

·         the donor wants to provide for a survivor and make a charitable gift, but the contribution would be too small for a charitable remainder trust to be practical, or

·         the donor wants to assure payments to a surviving spouse for as long as he or she lives without concern that they might cease because of market losses or ever escalating mandatory deductions.

Note: Even if legislation permitting a tax-free rollover does not pass, the growing number of Roth IRAs creates an expanding market for inter vivos gift annuities since distributions would not be taxed.

C.        Gift Annuity as a Solution for a Problem Charitable Remainder Trust.  

In PLR 200152018, the IRS permitted the trustor (who was also the income beneficiary) of a charitable remainder unitrust to transfer his income interest to the charitable remainder beneficiary in exchange for a gift annuity.  The annuity payments were to be made from the charity's general funds, the donor of the income interest was to be the sole annuitant, the annuity would be non-assignable except to the charity, and a commutation, prepayment, or refund would be prohibited by the gift annuity agreement.

Although the ruling dealt with a unitrust, a contribution of the income interest of an annuity trust for a gift annuity is conceptually the same and should be permitted. Here is an example of how a gift annuity could be the answer for an annuity trust that is in danger of crashing.

Example: A donor, now age 75, initially funded a charitable remainder annuity trust with $500,000 and elected an eight percent payout rate. Due to the relatively high payout and stock losses, the current value of trust assets is only $260,000. If the trust's annual net return is six percent, it will crash in eight years, which is prior to the end of the donor's life expectancy. Even an eight-percent annual net return extends the trust's life for only another year, which is still less than her life expectancy.

The present value of an annuity paying $40,000 per year in quarterly installments for the life of a 75-year-old beneficiary, using a 4.6 percent CMFR, is $313,270, which is more than the value of the trust assets. An appraisal of the income interest, which would be required to substantiate a charitable deduction, could not justify valuing that interest at more than the amount of trust assets. Thus, the value of the income interest is presumed to be $260,000.

If the income interest is contributed for a gift annuity paying the ACGA suggested rate, the donor will receive annual payments of $18,460 and an additional income tax charitable deduction of $111,714.

The annual payment is less than half of what she was receiving, but she can count on receiving payments for the duration of her life. Moreover, she will have preserved a gift to the charity--a gift that would likely evaporate if the annuity trust continued in existence.

Since both the income and remainder interests are now owned by the charity, the two interests merge, the trust is terminated, and the trust assets are distributed to the charity.

A gift annuity could also be the solution when a unitrust is being systematically depleted because the payout rate is too high, or when a NIMCRUT that did not flip is paying out a very modest amount of income.

D.        Gift of a Remainder Interest in a Residence for a Gift Annuity.

This gift arrangement may not belong in a paper about controlling risk because it can put a charity at high risk. The reason is that the charity must advance its own funds for an indeterminate period of time, lose the earnings it would have realized on those funds, and ultimately attain full ownership of a property that could have either appreciated or depreciated in the meantime.  

Nevertheless, when the donors are elderly, the gift annuity rates offered are conservative, and the properties are in a prime location, these arrangements can produce an excellent return on a charity's outlay. There is certainly a large market because many individuals would be willing to transfer title to their residence to a charity if they continue living in it and receive payments for life.

Gift of personal residences subject to a retained life estate are particularly appealing when the CMFR is low because the charitable deduction is quite large. Thus, in addition to living in their home and receiving payments, donors can reduce their taxes. If the donor wants a portion of the value of the residence to pass to heirs, it should be possible to give a fraction of the remainder interest in a residence to a charity in exchange for a gift annuity and to give the remaining fraction to heirs.

A Concluding Word

The fact that charities have recently become more conscious of the risk in gift annuities is a good thing, for they will be prompted to take more steps to control risk and maximize the benefits of their gift annuity programs. Then this instrument which has already been in existence for 160 years in the United States can have another great century.


APPENDIX A

Assumptions Underlying Gift Annuity Rates

The assumptions underlying the rates that will become effective on July 1, 2004 are the same as the assumptions underlying the rates that became effective on July 1, 2003.  That is why the rates are not changing in 2004.  However, there has been a modification in how the total return assumption is computed.  That change in methodology led to the same outcome.

Following is a summary of the assumptions on which both the July 1, 2003 and July 1, 2004 rates are based.

  1. The residuum realized by the charity upon termination of an annuity is 50 percent.
  2. Life expectancies are based on the Annuity 2000 Mortality Tables for female lives with a 1.5-year setback in ages. The rates also incorporate projections for increasing life expectancies.
  3. Annual expenses for investment and administration are one percent of the fair market value of gift annuity reserves.
  4. The total annual return on gift annuity reserves is six percent.*
  5. The rates for the youngest and oldest ages are somewhat lower than the rates that would follow from the first four assumptions.

* The total return is based on the following:

Asset Allocation

The rates effective on July 1, 2004 assume a portfolio consisting of

  • 40 percent equities,
  • 55 percent 10-year Treasury bonds, and
  • 5 percent cash.

Benchmarks

The following benchmarks are used to determine the average annual total return for each component of the portfolio:

  • For equities, the average annual total return for the approximately 100-year period, 1901 -- 2003 less one percent
  • For bonds, the average current yield during the first quarter of 2004, which was 4.01 percent.
  • For cash, 1.5 percent

APPENDIX B

Download State Regulatory Categories - Charitable Gift Annuities (PDF)

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CGAs

A great article that's still relevant today!

Spreading Risk

Great research and content. It lends us further evidence that charities, especially smaller ones, should consider reinsuring some, if not all, of their CGAs.

Gift Annuities vs Pooled Income Funds

The pooled income fund seems a far better route for a small charity or a charity with small givers. There is no re-insurance needed and the administrative costs can be handed off to professionals. Because of all the variable risks it seems best to set high minimums ($100K or more) and re-insure. It is rarely in a charity's best interest to be in a business it has little or no expertise in, and investments is one business that even the the most skilled professional gets burned from time to time.

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