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1 MANAGING THE POTENTIAL RISKS AND BENEFITS OF A CHARITABLE GIFT ANNUITY PROGRAM 2010 MINNESOTA PLANNED GIVING CONFERENCE Lyle Brizendine Regional Director – Institutional Philanthropic Specialist Bank of America Merrill Lynch 314-466-3196 Lynn E. Maaske Senior Vice President & Market Director, Investments—U.S. Trust Bank of America Private Wealth Management 612-656-0341

2 Charitable Gift Annuities Most popular form of life-income charitable gift. Average size of a gift annuity is slightly over $43,000. At the time immediate gift annuities are funded, the average age of the annuitants is 79. Nearly 56% of annuitants are female. Approximately 90% of annuities are immediate and 10% are deferred. Nearly 31% of gift annuity donors increase their annual giving. Source: 2009 ACGA Survey 2

3 Benefits to Donors/Annuitants 3

4 Immediate annuity provides annuitant a lifetime annuity stream at a rate that is more favorable than most other investments, particularly conservative investments. After-tax cash flow from annuity stream to annuitant is further enhanced because a significant portion of each annuity payment is tax-free. Deferred gift annuity allows donor to defer annuity payments until a future date, allowing the donor to supplement retirement income and secure a more favorable annuity rate. 4

5 Benefits to Donors/Annuitants Donor receives charitable income tax deduction based on the fair market value of the asset used to fund the charitable gift annuity, so the potential capital gains taxes associated with the disposition of low cost basis assets can be deferred over the term of the annuity stream. Donor can convert a concentrated asset position into a reliable lifetime income stream while eliminating some of the risk associated with an undiversified investment portfolio. 5

6 Benefits to Donors/Annuitants Charitable gift annuity is much easier, cost-effective, and less time consuming for a donor to establish than a charitable remainder trust. Most institutions will issue charitable gift annuities for less substantial gifts than would be necessary for a donor to justify the expense to establish a charitable remainder trust. Donor can provide a meaningful gift during his or her lifetime without compromising their retirement income security. 6

7 Risks to Donors/Annuitants 7

8 Charitable gift annuity payments are a general, unsecured liability of the charity, so, if the charity becomes insolvent and any segregated reserve funds are exhausted, the annuitant would no longer receive payments. Donor should investigate the financial strength of the charity issuing the gift annuity. Does the institution have a strong balance sheet? Does it have a substantial charitable gift annuity program? Is the institution in compliance with the state requirements for the issuance of charitable gift annuities in the state in which you reside? 8

9 Risks to Donors/Annuitants Are all gift annuity proceeds invested in a segregated pool? Has the institution provided for professional management of its gift annuity pool of investments? Does the institution otherwise diligently manage the administration of its gift annuity program? Since the rate paid to the annuitant is fixed at the time a charitable gift annuity is issued, there is the risk to the annuitant that future inflation will diminish the purchasing power of the annuity stream. 9

10 Risks to Donors/Annuitants This risk should be of special concern to younger prospective donors who have a much longer time horizon during which inflation could have a material impact on the real value of the annuity stream. 10

11 Benefits to Charities 11

12 Benefits to Charity Many prospective donors are reluctant to make significant gifts because they are concerned that they potentially will diminish their retirement income stream to an unacceptable extent, but a charitable gift annuity makes it possible for a charity to secure a significant gift while not compromising the donor’s confidence in their retirement income security. Many donors who make gifts in exchange for charitable gift annuities ultimately make additional planned gifts, often in the form of multiple charitable gift annuities. 12

13 Benefits to Charity By prudently managing the proceeds of its gift annuities, the issuing institution can increase the residuum that it ultimately realizes from a charitable gift annuity program over time beyond the 50% residuum that is targeted by the ACGA (American Council on Gift Annuities) as it maintains its rate tables based on a variety of economic, financial, and mortality assumptions that are constantly changing. As more donors establish charitable gift annuities with a particular charity, the more likely it is that additional donors will become aware of and take advantage of gift annuities or other planned giving arrangements with the institution. 13

14 Risks to Charity 14

15 Rate Risk to Charity As just indicated, the ACGA rate tables are intended to provide a charity which uses the tables a reasonable assurance that over time it will receive an average residuum of 50% of a donor’s original contribution. If a charity chooses to offer more aggressive rates, it risks achieving less, perhaps significantly less, in an average residuum from the original donor contributions. 15

16 Rate Risk to Charity Even if the charity uses the ACGA rate tables, there is the risk that it will issue gift annuities in advance of unfavorable developments in the financial markets which will compromise its ability to invest the proceeds to achieve the returns contemplated in the ACGA rate tables. Prospective donors who pressure a charity to provide rates in excess of the rates suggested in the ACGA rate tables (even shopping rates among multiple charities) are perhaps lacking in the philanthropic intent necessary to consider as a potential donor to the charity. 16

17 Mortality Risk to Charity  Studies by the ACGA have indicated that annuitants of charitable gift annuities live longer than the general population.  ACGA rate tables incorporate a two-year setback to the life expectancies reflected in the mortality tables developed by the Society of Actuaries (Annuity 2000 Mortality Tables).  The smaller the pool of annuitants that a charity has in its gift annuity program, the greater the likelihood that mortality risk could be much greater. 17

18 Mortality Risk to Charity If a gift annuity program includes one or more large annuities relative to the average size annuity in the program, particularly in a smaller program, the mortality risk associated with the annuitants on those larger contracts living well beyond their life expectancy is significant. A charity can mitigate this mortality risk by offering rates below those recommended by ACGA, particularly for older donors, or consider reinsuring any contracts that pose serious concerns about the implications of the annuitant living beyond his or her normal life expectancy. 18

19 Asset Risk to Charity Asset risk can only be completely avoided by having gift annuities only funded with cash. If a gift annuity is funded with publicly traded securities, there is risk that the security will drop in value between the time the gift is received and the charity liquidates the security which results in less cash to invest to achieve the rate assured the annuitant under the gift annuity contract. Procedures should be put in place to ensure that any gift of publicly traded securities is immediately liquidated. 19

20 Asset Risk to Charity Gifts of non-financial assets pose even more potential risk if they are used to fund charitable gift annuities. Gifts of residential or commercial real estate; oil, gas, or other mineral interests; farm and ranchland; and closely held stock can be very illiquid. Even though the asset may take time to liquidate, the charity still must fund the annuity stream to the annuitant. 20

21 Asset Risk to Charity There is no assurance that the charity will realize the value from the asset upon which the annuity contract was based. There may be costs associated with maintaining the asset and/or positioning it for sale which must be advanced by the charity. The charity can somewhat mitigate this risk by determining whether there are potential problems associated with accepting and holding the asset, determining the marketability of the asset, and offering a lower annuity rate. 21

22 Legal Risk to Charity Charitable gift annuities are regulated at least to some degree by virtually all states with respect to contracts that are issued to donors domiciled within their respective borders. Some states have specific reserve requirements that the issuing charity must maintain with respect to contracts issued within their borders. Some states require that the proceeds of annuities issued to its citizens be maintained in a segregated fund. 22

23 Legal Risk to Charity Many states require charities to notify the state of their intent to issue charitable gift annuities, including some which require submission of a detailed application for a permit to issue gift annuities. Many states have specific disclosure language that must be included in gift annuity agreements. A number of states require filing of an annual report by the charity of its gift annuity activities within the state. 23

24 Legal Risk to Charity If a charity is not in compliance with a state’s requirements with respect to charitable gift annuity activities, a charity may be ordered to cease issuing contracts, be subject to a fine, and even offer annuitants an opportunity to rescind their gift annuity agreements with the charity. If a charity is not fully in compliance with the relevant state’s gift annuity requirements, a donor in that state who becomes unhappy with the gift annuity arrangement could be in a stronger position to bring litigation against the charity to nullify the arrangement. 24

25 Risk of Inappropriate Program Guidelines If the minimum gift required to fund a charity gift annuity is too small, the cost of administration may significantly diminish or even eliminate any ultimate benefit to the charity. If the minimum age for an immediate annuity is too low, the risks to the charity are greater that significant changes in the financial markets and mortality expectations will diminish the residuum that ultimately will be available to the charity. A charity should have clear guidelines in place with respect to the types of assets that will accepted to fund gift annuities. 25

26 Risk of Inappropriate Program Guidelines Although based on data gathered by the ACGA most charities do not use proceeds of any gift annuity contract until the last annuitant named in the contract has died, there are some charities that will ill-advisedly spend amounts above any required reserve which could put undue pressure on the pool during economic downturns. Charities with limited resources and small gift annuity programs, where possible, should consider having contracts issued through a larger affiliated organization or a local community foundation with the residuum being distributed to the charity at the death of the final annuitant on a contract. 26

27 Investment Risk to Charity Certain states, particularly California, place specific restrictions on how gift annuity proceeds may be invested, although most states have adopted the prudent investor standard as the prescribed investment guideline for gift annuity proceeds. The ACGA rate tables are constructed to provide the issuing charity a reasonable assurance that over time it will achieve a residuum of 50% of the donor’s contribution which funded the gift annuity and the model investment portfolio the ACGA currently uses in calculating its expected return assumption is 40% equity, 55% fixed income, and 5% cash. 27

28 Investment Risk to Charity The ACGA also assumes that the annual expense associated with the investment and administration of the charity’s gift annuity reserves will be 1%. The strategic asset allocation that a charity using to invest its gift annuity investment pool should be developed in the specific context of the number and size of the contracts in the pool, the payout rates on the contracts, and the ages of the annuitants represented in the pool. 28

29 Investment Risk to Charity The charity should consider engaging a qualified investment advisor to assist in developing a formal Investment Policy Statement which establishes asset allocation guidelines based on the specific characteristics of the charity’s gift annuity pool as well as the risk tolerance of the institution’s governing board. The charity should periodically undertake asset/liability modeling of the investment pool to determine whether it is maintaining the optimal asset allocation to maximize the charity’s ultimate benefits from the program within the institution’s investment risk tolerance. 29

30 Investment Risk to Charity Although many charities are reluctant to consider reinsuring individual annuity contracts because they feel it will likely diminish the institution’s ultimate benefits from the contract, in certain cases, particularly where a contract is large relative to the total annuity investment pool or where the annuitant is quite elderly, it may be prudent to consider reinsurance to mitigate the overall investment risk to the pool from a single or limited number of contracts. 30


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