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- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
The holiday season often brings out the best in us. December is historically the peak month for charitable donations, but in today's economy, charities, like retailers, are hoping the holiday season will serve another purpose--help them make up for lost ground.
The recession has made gifts that benefit both the charity and the donor more attractive than ever before. One of those gifts, a charitable gift annuity (CGA), returns a pension-like income stream back to the donor (and/or to another person). In today's low-interest-rate environment, charities find themselves in a unique position and are advertising returns double or triple those offered by your typical certificate of deposit. Who wouldn't want to possibly receive better returns while making life better for others? But before your client writes that check, be sure to review with him or her some best practices for evaluating CGAs.
The Benefits of CGAs
CGAs are very similar to charitable remainder annuity trusts, but they come free of the complexity associated with those vehicles. A donor makes a gift directly to the charity in return for the promise of a lifetime fixed income stream. The donor can start to receive benefits immediately or defer them for several years. For those who itemize deductions, the donation may provide an income tax deduction based on the difference between the donation and the present value of the projected annuity payments.
CGAs are also popular with charities. A quick Internet search will list programs offered by community foundations, colleges, museums, religious organizations, hospitals, social service organizations, and other nonprofit organizations. While the details vary among programs, the annuity rates tend to be standardized. Since 1927, the American Council on Gift Annuities (ACGA) has published suggested CGA rates for use by charities and their donors. Standardization allows smaller charities to compete with larger ones and helps makes the donor's decision less about the best rate and more about the charity's mission.
Understanding the Fine Print
The problem with CGAs is that there are several common misconceptions donors have about how they work. Some of the misunderstanding can be caused by an organization's own planned giving materials. Here is an example of one college's advertising:
By establishing a charitable gift, you can assure yourself of a fixed amount of income for the rest of your life. Ultimately, the principal used to generate income through any of these gifts will benefit the College. Establishing a charitable gift annuity is a great way to move funds from mature certificates of deposit (CDs), bonds, or appreciated stock into an instrument that will pay you an attractive interest rate with tax benefits.
For the philanthropic investor, this seems fairly straightforward, right? Unfortunately, this and other CGA advertisements can raise several red flags, in fact, there are four major misconceptions that we should address.
Misconception #1: An annuity rate and an interest rate are interchangeable terms.
You can see how a donor might assume that the college will preserve the entire donation for its charitable use while paying its current invested income to the donor. In fact, a portion of each payment is a tax-free return of the donor's principal. Annuity rates are based on the age of the donor(s) and the assumption that the charity will realize approximately 50% of the gift when the donor dies. The older the donor, the greater the annuity rate, but the interest rate assumption stays the same.
In 2009, the underlying assumed interest rate for calculating CGAs is 5.75%. When a 78-year-old donor is quoted a CGA annuity rate of 7.2% on a $100,000 gift, the charity will pay him or her $7,200 a year for life.
Misconception #2: A charitable gift annuity is a secured obligation.
Here is another excerpt from a charity's Web site: Your annuity payments are guaranteed for life, backed by a reserve and the assets of the American ______ Association.
The contractual promise to pay the donor an income for life is dependent on the charity's claims-paying ability. In the event of a bankruptcy, the CGA annuitant is a general, unsecured creditor. While it is extremely rare for a charity to fail on its CGA obligations, it has happened, and donors should ask what steps a charity has taken to safeguard its charitable gift pool.
Charitable investment assets have been victims of the economic downturn, mismanagement, and, sometimes and quite unfortunately, Ponzi schemes. It is estimated that eight out of ten CGAs are currently under water, requiring the charity to move general funds into the CGA reserve account to meet state requirements. While the vast majority of charities will meet their obligations to their donors, investment shortfalls can hamper the charity's mission--the very mission the donor decided to support.
Even if a charity goes bankrupt, the courts, as a general rule, have tried to protect the charity's obligations. In January 2009, the National Heritage Foundation (NHF) filed for bankruptcy protection and temporarily suspended CGA payments. Under court supervision, NHF resumed paying benefits but reduced the amount by 15%. Interestingly, NHF continues to solicit donations; you can download an application for a CGA from the NHF Web site.
Misconception #3: Someone is overseeing the charity's gift annuity program.
Unlike commercial annuity providers, there are no ratings agencies that report on the financial health of charities. Oversight of CGAs varies from state to state, and, to date, only 15 states require charities to submit annual reports on their CGA program. At a minimum, a charity must comply with state regulations on the minimum reserve requirement, but, as a best practice, it should invest the entire donation until the donor's death. The American Council on Gift Annuities Web site (www.acga-web.org), is a great place to investigate the CGA regulations in your state.
Misconception #4: The annuity is backed by an insurance company.
It is not common for a charity to reinsure its CGA, but if it does, it is the longevity risk that is shifted to the insurance company, not the risk of default. When a charity reinsures a CGA, it will use a portion of the donation to buy a commercial immediate annuity. Reinsurance allows the charity to put the balance of the gift to use rather than waiting for the death of the donor. Newer programs with a small number of donors and little in reserves will find this an attractive alternative, but it does not relieve the charity of its contractual obligation to pay an annuity. (In California and New York, reinsurance means that an insurance company underwrites the risk of default.) Note that not all states permit reinsurance.
Some CGA-Specific Concerns
With government support shrinking, charities need private donations more than ever to meet their challenges--and they are working hard to solicit them. If donors are looking at a charitable gift as an investment, however, additional due diligence is necessary.
Charitable organizations face several risks when offering a CGA program. The most pressing today is managing annuities issued in the late 1990s, when annuity rates were built on higher investment return assumptions. A prolonged bear market will continue to suppress recovery of recent investment losses. For charities that have spent a portion of the original gift while the donor is living, their gift annuities may now be underwater. And the charity may end up with very little to show for years of administration. Choose wisely.
Tere D'Amato is the VP of advanced planning at Commonwealth Financial Network, member FINRA/SIPC and a registered investment advisor, in Waltham, Massachusetts. She can be reached at firstname.lastname@example.org.