8. Introduction to Charitable Gift Annuities, Part 3 of 3

8. Introduction to Charitable Gift Annuities, Part 3 of 3

Article posted in General on 20 January 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 20 January 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.


Links to previous sections of book are found at the end of each section.

We have discussed the risks for the donor in purchasing a Charitable Gift Annuity (consisting largely of the risk that the charity would go bankrupt or the annuitant would die too quickly).  However, given the nature of the obligation to make lifetime payments, there are also substantial risks for charities that issue Charitable Gift Annuities.
A primary risk for the charity is that the annuitant may live much longer than projected.  The charity is obligated to continue making payments for the life of the annuitant, regardless of how long the annuitant lives.  A Charitable Gift Annuity that would have provided a substantial gift if the annuitant had lived to his life expectancy may instead generate a net loss for the charity if the annuitant lives far longer
The primary protection for this type of risk is to have a large pool of annuitants with similar sized annuities.  Although some will live many years beyond their life expectancy, others will die sooner than their life expectancy and, on average, the lifetime payments should approximate life expectancies.  The risk that one annuitant will outlive his life expectancy by 10 years is significant, but the risk that a pool of 10,000 annuitants will outlive their life expectancies by, on average, 10 years is very low.

Many charities do not have the protection against longevity risk that comes from having a large pool of annuitants with similar sized annuities.  This can occur either because the charity has a small pool of annuitants, or because the charity’s pool contains a few very large annuities.  A large pool of small annuities will not offset the risk of a few very large annuities.  Suppose, for example, a charity has 1,000 annuities paying $1,000 per year and one annuity paying $1 million per year.  The risk that the annuitant receiving $1 million per year will live longer than anticipated will not be offset by the early deaths of other annuitants because of the differential in the annuity sizes.

Longevity risk can also be influenced by the age of the donors when purchasing gift annuities.  This is an area where the relative risk may be counterintuitive.  Using standard payout rates, starting an annuity for an 80-year-old donor is actually riskier than starting one for a 40-year-old donor.  This may seem odd, because of the expectation that the 80-year-old person will certainly not, on average, live as long as the 40-year-old.  However, the annual payments to the 80-year-old are much larger than those for the 40-year-old.  Keeping this in mind, why would the annuity for the older annuitant be riskier?
To understand why starting an annuity for the older annuitant is riskier (i.e., subject to greater variation), it helps to ask the question, “What is the chance the charity could make twice as many payments as initially projected?”  The payout for an 80-year-old female is based upon a life expectancy of about nine years.  If the 80-year-old female lived to the age of 98, the charity would make twice as many payments as projected.  The potential for an 80-year-old to live to the age of 98 is quite significant.  The payout for a 40-year-old female is based upon a life expectancy of 42 years.  In order for the charity to make twice as many payments as projected, this annuitant would have to live to be 124 years old, which is essentially impossible.  Thus, in comparison, the charity is far more likely to make twice as many payments as projected to the older annuitant, reflecting the greater risk (variance) with this annuity.
A charity can increase the risk that gift annuity obligations will ultimately siphon money from regular operating income by immediately using the projected gift portion of the Charitable Gift Annuity.  This is inherently risky because the annuitants in the charity’s pool will live longer than expected approximately half of the time, meaning that the charity has a 50% chance of having to make annuity payments from operating income in the future.  This 50-50 chance is increased dramatically if the longevity tables used by the charity to calculate its payment obligations are inappropriate.  For tax calculation purposes, the IRS requires the use of its tables based upon standard longevity expectations.  However, these tables do not reflect the longevity expectations of people who buy annuities.  First, people who are sick or know that they are approaching death do not buy annuities.  By eliminating these people who are near death, the pool of individuals who purchase annuities will, on average, live longer than others of the same age.  Second, people who are poor do not purchase annuities.  Those who are poor do not, on average, live as long as those who are wealthy.  Once again, this eliminates a group of individuals with relatively shorter life expectancies from the pool of individuals who purchase annuities.  Finally, individuals who make charitable gifts tend to live longer than individuals who do not.  Once again, the life expectancy of the pool of those who purchase Charitable Gift Annuities is much longer than the life expectancy of the population in general.  Thus, a charity that removed the “gift portion” of a Charitable Gift Annuity as calculated by the IRS, should not expect to be able to cover the annuity payments from the remaining amount.  (For a discussion of appropriate estimations of Charitable Gift Annuity life expectancies see Clontz, B.  The Methuselah effect: Longevity’s impact on planned giving.  The National Conference on Philanthropic Planning, 2010.)
A charity can choose to issue a gift annuity in exchange for any type of valuable property.  However, the gift annuity is a risky proposition for the charity if the charity accepts difficult-to-value or difficult-to-sell property in exchange for the annuity.  In the case of a simple gift of such property, the charity may get more or less than the appraised value, but the charity still gets some value.  However, if the charity exchanges the property for a gift annuity, and later sells the property for less that its originally appraised value, then the charity may have given an annuity worth more than the gift.  In other words, the charity can easily lose money on such transactions.  Even if the charity is ultimately able to sell the property for its appraised value, if this sale takes some time, the charity will have to make annuity payments from its general operating income in the interim.  For these reasons, few charities will accept difficult-to-value or difficult-to-sell property in exchange for a gift annuity.
Another practice that increases the likelihood that a charity will ultimately have to make annuity payments from current income is allowing Charitable Gift Annuities to benefit a specific department or project within the charity.  There is usually no problem with this practice if the charity holds the initial funds in the restricted account until the annuitant dies, but there can be.  The question this raises is “Where do the funds come from for those annuities where the annuitant lives so long that the entire initial contribution is exhausted?”  Will the targeted department or project have to make these payments from its operating income?  If the payments come from the general annuity pool, then the general pool receives only the penalty from longer lives (which are not paid for by the funds from the restricted purpose), but none of the advantage from shorter lives (which benefits the specific restricted purpose as required by accepting the donor’s restrictions).  Ultimately, this creates a net transfer from general unrestricted funds to the specific department or project funds over and above the donor’s restriction.  Although accepting such restricted purpose Charitable Gift Annuities may still be a wise fundraising strategy, the charity must recognize the potential for this secondary drain on funds available for unrestricted, general purposes.

To this point we have been discussing primarily the risk that a donor will live longer than expected.  However, the charity may also have investment risk.  When issuing a Charitable Gift Annuity, the charity takes a large sum of money upfront, and uses it to pay annual payments for a long period of time.  This involves investing the upfront sum of money. 

As the charity increases the risk for its investments, it increases the risk that those investments will perform poorly, ultimately requiring the charity to make annuity payments out of current operating income.  To reduce investment risk to a minimum, a charity could invest in only secure fixed income investments of appropriate duration to closely match the payment obligations.  Of course, as risk diminishes so too does the expected return and consequently the expected amount remaining at the death of the annuitant.  Some charities invested their gift annuity pools heavily or entirely in equities during good times, and subsequently pulled out of equities following a market crash, resulting in gift annuity pools with net liabilities to the organization.

It is important to note that investment duration also plays a role in investment risk for annuity payments.  For example, charities that issued gift annuities during a high interest rate environment, and then “conservatively” invested in secure short-term fixed income investments, were later faced with making these high annuity payments when interest rates for short-term fixed income investments had fallen dramatically.  If instead the charity had invested in secure fixed income investments that matched the duration of the expected annuity payments, then subsequent changes in interest rates would not have caused problems.  Essentially, the charity would have locked in the high interest rate investments at the same time the charity made the high interest rate commitment.

            These sources of risk do not suggest that charities should avoid issuing gift annuities, because these risks are all manageable.  An investment portfolio can be constructed to match the annuity payment obligations subject to the charity’s risk/reward preferences.
Of course, the “perfect match” for the annuity payment obligation is a commercial annuity.  In this case, the charity simply purchases an annuity on the annuitant’s life from an insurance company.  Assuming the stability of the insurance company, the charity transfers all market risk, interest rate risk, and annuitant longevity risk.  The charity simply becomes a conduit through which the insurance company annuity payments are made.  Because the Charitable Gift Annuity includes a gift portion, there is enough money to purchase the commercial annuity and have funds remaining for charitable purposes.  Additionally, by purchasing these commercial annuities the charity may immediately use the remaining funds.  (This is true in all jurisdictions.  Even those States with gift annuity reserve requirements recognize that there are no reserves needed where a commercial annuity substitute has been purchased.) The downside to this transaction is that the price of a commercial annuity includes not only the cost of making the payments, but also a profit for the issuing company.  Thus, in theory, the charity could retain this profit margin by managing its own gift annuity pool.  However, in practice, this may be difficult because managing a pool appropriately requires both expertise and a sufficiently large number of annuitants to reduce unexpected longevity risk.  Even a charity that does not reinsure all of its gift annuities may appropriately consider reinsuring only its very large annuities.  This is because a large pool of small annuities will not be sufficient to offset the longevity risk for a small number of very large annuities.  In this case, the only way for a charity to manage the risk that an annuitant with a very large annuity will live much longer than expected is to purchase a commercial annuity for that obligation, because there are simply not enough other large annuities in the charity’s pool to offset the risk.
Financial advisors can become involved with Charitable Gift Annuities in a number of ways.  As mentioned above, managing a gift annuity pool requires expertise to match the obligations with the investments and the charity’s risk/reward preferences.  This is precisely the kind of expertise that financial advisors may bring to a charity.  Additionally, financial advisors can be helpful to a charity in managing its risk not only through appropriate investments, but also through the purchase of matching commercial annuities, either selectively for very large gift annuities, or universally for all gift annuities.  Financial advisors can also be helpful to their clients who are considering gift annuities by examining the financial stability of the issuing nonprofit organization.  Financial advisors may also be able to benefit the nonprofit organization (while simultaneously building a client base) by providing information to a nonprofit’s donors about planned giving products such as Charitable Gift Annuities in cooperation with the charity.
A major benefit of Charitable Gift Annuities is that they are generally exempt from securities regulations.  This is what permits nonprofit organizations to sell gift annuities in a largely unregulated environment.  However, there are cases where the sale of a Charitable Gift Annuity will lose its exemption from securities regulation.  This is a major issue because if the exemption is lost then the sale of these securities can result in criminal penalties (and, in fact, has resulted in jail time in previous cases).  The sale of Charitable Gift Annuities will not be exempt from securities regulation where the annuities are marketed primarily as investments, rather than as a means to benefit the charity.  An example of marketing a Charitable Gift Annuity as an investment is to compare the “yields” or “returns” with bank certificates of deposit, or other traditional investments.  (As discussed previously an annuity payment rate is not a yield or a return, and thus, such comparisons are, prima facie, inappropriate.) The sale of Charitable Gift Annuities will also lose exempt from securities regulations if sales commissions are paid.
Charitable Gift Annuities are a handy and frequently used gift planning vehicle.  Although simple in form and easy to complete, gift annuities do offer some flexibility in their structure.  The simplicity in creating these agreements conceals a substantial complexity in understanding and managing the underlying risks.  This complexity expands substantially when considering the full tax implications of Charitable Gift Annuities.  As such, these tax implications are discussed in their own separate chapter.

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