Like most Americans, donors to charitable remainder trusts (CRTs) are concerned they may outlive their retirement nest egg. They also seek to leave a legacy to their desired charity after they have leveraged their assets to fund retirement. An innovative benefit rider offered through variable annuities–the guaranteed minimum withdrawal benefit (GMWB)–could help meet these objectives.
Once the donor has gifted property to a charitable remainder trust, and once the trustee has sold the gifted property, the trust is flush with cash. The trustee then must reinvest these funds to fulfill the terms of the trust provisions, which might be to distribute the highest amount of income for the longest period of time without the trust running out of money. The trustee might be seeking a “guaranteed” income stream for the donor and his or her spouse while assuring there is some remainder value going to charity after the income beneficiaries’ needs are taken care of.
Annuities can be appropriate investments for funding CRTs, providing features, benefits and guarantees that cannot be found in other investments. However, CRTs are complex trusts with specific requirements that must be legally met. Variable annuity living benefit and death benefit riders may be used in a CRT, but should be done only when the particular circumstances surrounding the trust dictate their use. The trustee should understand clearly the features of the riders and how they work with the CRT.
The living benefit rider provides a retirement income from a variable annuity. Many believe it provides a more attractive way of accessing one’s investment for retirement than annuitization, due to its flexibility. The GMWB is designed for the investor who is looking for a guaranteed withdrawal stream for a specified period or for life. The rider also assures that the trustee can recover 100% of the original investment (and, depending on the benefits terms, possibly more) over a period of years should the contract value fall to zero.
An optional benefit that can be obtained for an additional cost, the GMWB enables the trustee to take annual withdrawals equal to a fixed percentage, typically 5%-7%, of the guaranteed withdrawal balance no matter what happens in the market or how long the donor lives. The rider might feature benefits that go beyond a guaranteed return of premium by including a “step-up” provision, for example, which allows the trustee to increase the guaranteed withdrawal balance by locking in the higher contract value on the contract anniversary if it exceeds the previous guaranteed balance.
But a key question remains: Should a donor select a charitable remainder annuity trust or a charitable remainder unitrust to leverage the GMWB effectively? There may be situations in which a CRAT or CRUT would be appropriate for the donor who is seeking a fixed dollar amount that will not change in value, despite the performance of the underlying trust investments. However, while the CRAT ensures the donor will receive the same amount of money from the trustee, it does not adequately address problems that can arise for the trustee and the donor if the stock market drops, potentially causing the trust assets to lose all value. If a CRAT is selected, the GMWB may make sense if the trust payout matches the GMWB withdrawal.
Since most CRTs are established as CRUTs, let’s look at how the GMWB would apply in this situation. With a CRUT, the donor can receive a percentage of the account’s value each year, allowing the donor to participate in a market upturn while providing a hedge against inflation and maintaining purchasing power. Thus, the income from the CRUT can fluctuate in value, and if the donor decides to establish a CRUT, the GMWB can potentially be beneficial.
The trustee can choose any date during the first tax year to pay out income from the trust to the donor, so long as the parties to the trust continue to use that date for valuation going forward. The trustee could also choose the contract anniversary to ensure the living benefit withdrawal value is consistent with the CRUT payout. Assuming the annuity gains or loses value during the year, the available living benefit withdrawal amount will not match the income from the trust to the income beneficiary.
The annual step-up feature found in some living benefits riders can remedy this potential discrepancy between trust value and the benefit value. If the trust value goes down, the living benefit withdrawal may be more than the income beneficiary is entitled to receive, and the amount not distributed will need to remain in the trust and be re-invested. If the annuity gains value, then the income beneficiary may be entitled to more income than the living benefit withdrawal.
Additional withdrawals, should they prove necessary, may be made from the annuity–potentially voiding or reducing the living benefit–or from other investment sources in the trust. Ensuring that the trust value and living benefit value are in sync will eliminate this problem.
The living benefit can be offered in connection with a net income with make-up provisions CRUT (NIMCRUT), which is a CRT that allows the trustee to control the withdrawal of income from the trust through a net make-up account. In a NIMCRUT, the trust pays the lesser of net income or the trust payout rate. And the trust does not have distributable income until the trust actually receives a withdrawal from the annuity.
If the annuity is growing, the trust payout rate will be greater than the living benefit withdrawal, so there is no problem. When the trust makes the living benefit withdrawal, it is reported as net income. If the living benefit withdrawal is less than the calculated payout rate, the income beneficiary receives the living benefit withdrawal because it is the lesser of the two, according to Treasury Department regulations.
Ultimately, the trust would be creating IOUs that do not have to be distributed, but once the annuity value falls below the original premium withdrawal, the living benefit withdrawal will be too large and income cannot be paid to the client unless they have IOUs from previous years.
Let’s look at an example of the GMWB’s effectiveness. Suppose the donor is 65 years of age and gifts a $1 million vacation home to a charitable remainder unitrust. The trustee, after investigating the available investments, purchases a $1 million variable annuity with the sale proceeds of the house. The trustee wants to make sure the donor’s objective of receiving income for his life is guaranteed, so he purchases a GMWB within the VA with an annual step-up feature that can increase the income if the contract value increases. The GMWB begins generating income immediately, providing for a 5% annual withdrawal and yielding for the donor a minimum of $50,000 a year for life.
When using a GMWB in a CRT, all benefits and risks must be taken into consideration. The income stream in the trust should be based on what is best for the client, not on the living benefit. The use of a living benefit should be addressed in coordination with the trust payout, with the trustee making sure that the allowable trust payout amount is not exceeded.
In addition, exceeding a living benefit allowable withdrawal can have negative consequences. The use of living benefits is intended to protect the income recipient and does not offer additional value to the charity. If the parties proceed with caution and know all the facts, a VA using a GMWB can be an appropriate and suitable investment in a CRT, providing an income during the life of the donor and death benefit protection to the charity.