In the June 2006 issue of Give & Take, the page 1 article “Understanding the ‘Gift’ in ‘Annuities’” explored the differences between charitable gift annuities and commercial annuities. In response to this article, we were contacted by a number of readers who raised a similar question. As one reader put it: “Would not the difference in residuum assumptions you discuss in the article allow a charity to offer gift annuities which it could then ‘reinsure’ through the purchase of a lower-cost commercial annuity and then realize the difference to meet immediate needs? The charity would then enjoy the money up front rather than years later and reduce the risk of funding the annuity. Thanks for any insight into this.”
It can indeed be possible in many cases to do what the reader suggests. This concept, commonly known as charitable gift annuity reinsurance, may be a good option for some organizations under certain circumstances.
To understand more about the concept of gift annuity reinsurance, let’s start with a basic review of how gift annuities work.
Gift annuities 101
When a donor enters into a charitable gift annuity agreement, the nonprofit organization agrees to pay the donor a fixed amount for life in exchange for an irrevocable gift of cash or other property. Since the transaction is partially a gift to charity and partially an annuity for the donor, the donor is entitled to an immediate income tax deduction, and a portion of the payments are free from income tax as well because they are deemed to be a return of the donor’s investment in the annuity portion of the gift. A donor’s gift annuity payments are fixed at the time of the gift and will not vary. In addition, the donor’s payments are backed by the full assets of the charitable organization, regardless of changes in the economy. This promise of fixed, secure income payments is very attractive to many donors who would like to provide for a bequest or similar gift to their favorite charitable organization, but also desire a steady source of income in their later years.
Risks inherent in gift annuities
From the donor’s perspective, a charitable gift annuity offers a wonderful opportunity to benefit an organization they wish to support while at the same time receiving guaranteed payments for their life and perhaps that of a spouse or another loved one as well. From a nonprofit’s perspective, however, a charitable gift annuity does not come without risks.
One risk for the charity involves the investment of gift annuity funds. Most nonprofits “pool” gift annuity funds and invest them in a managed portfolio. When recommending gift annuity rates, the American Council on Gift Annuities (ACGA) assumes that for immediate payment gift annuities the funds will earn 6.25% and that annual administration costs will not exceed 1% of the annuity reserve fund. (For more on the assumptions underlying ACGA rates, see www.acga-web.org.) If returns on the invested gift annuity funds are less than expected, the nonprofit bears the risk that it will not earn the required amounts over time and the fund could thus be exhausted while payments to one or more donors are still due.
Another concern for the charitable organization is that one or more gift annuity donors could live longer than expected. This is something referred to as “mortality risk.” Because gift annuity payments are guaranteed for as long as the annuitant lives, the nonprofit is under a contractual obligation to pay them even in the event the annuitant outlives his or her life expectancy. As mentioned in the June issue of Give & Take, depending on the age of the annuity donor, there may be less of a cushion on earnings in the case of younger donors who outlive their life expectancy, which in turn could lead to less funds being left for charitable use at the death of the annuitant.
Some charities that began gift annuity programs in recent years now find themselves in a less than desirable position because they began their programs at the height of investment market values. They experienced less than desired returns in the early years and now have substantial gift annuity payment risks with little cushion.
Reinsure for reduced risk
To minimize the risks associated with offering and administering charitable gift annuities, some charitable organizations decide to purchase commercial annuity policies as a way of backing their gift annuity payment obligations. They may decide to take this approach with all or a portion of their gift annuity obligations, depending on the size of the gift annuity, age of donors, the nature of their mission, and other factors.
Sometimes referred to as “gift annuity reinsurance,” this is a process in which a nonprofit purchases a commercial single premium immediate annuity that makes payments equal to the amount owed to the gift annuitant. While the charity is owner and beneficiary of the commercial annuity policy, it is still obligated to make the gift annuity payments for the life of the donor. Reinsurance allows the charity to transfer the main investment and longevity risks to the life insurance company issuing the new annuity.
Let’s look at an example of how gift annuity reinsurance works. Mr. and Mrs. Donor, age 64 and 62, have recently entered into a gift annuity in the amount of $1 million. The American Council on Gift Annuities’ payment rate is 5.5%, or $55,000 per year. Payments will continue for the life of both donors. They have an estimated joint life expectancy of 27 years. The charity will bear the risk that one or both of the annuitants will outlive their life expectancy and/or the possibility of lower than expected returns on the gift annuity reserve fund. Assuming an estimated return of 8% on funds it is investing outside its gift annuity reserve funds, the present value of the amount the charity anticipates it will receive at the death of the surviving annuitant is just over $100,000.
The charity decides to reinsure the gift annuity with a commercial insurance policy. After payment of the premium, some $200,000 is available to meet the immediate needs of the charity, approximately twice the amount of the present value of the residuum that it is estimated would be received 27 years from now.
Pros and cons
What are the pros and cons of gift annuity reinsurance? Let’s first examine the drawbacks:
The charitable organization will realize less money when an annuitant dies earlier than expected. When a donor passes away earlier than his or her life expectancy, the donor will have received fewer payments than the organization planned to make and less of the amount originally contributed will have been returned to the donor as tax-free return of principal. Therefore, at the donor’s death, more funds are available for the organization’s charitable purposes than was originally expected. If the organization had opted to reinsure, the overall amount received would be less than if self-insured.
A charity may be able to achieve higher rates of return on its gift annuity reserve investments. Some organizations have enjoyed stronger investment performance on their gift annuity reserve pools over the years, allowing the nonprofit to maximize the remaining gift amount. These organizations may realize more from their annuity program versus reinsurance due to the excess return generated by the investment pool.
Some donors may have a negative view of gift annuity reinsurance. Some annuitants may be under the impression that all of the funds they transfer to create their gift annuity will eventually go to the charity. Therefore, some donors may see reinsurance as a “shortcut” on the part of the nonprofit—simply a way for the charity to get a small amount of their money now, instead of what the donor perceives will be a much larger gift at their death. The annuity rates anticipate an average of about 50% of the amount of the gift will remain for charitable use under standard rate setting assumptions. This concept should be thoroughly communicated to the donor.
On the other hand, there are several pros to gift annuity reinsurance, including:
The nonprofit organization’s risks are reduced. Through reinsurance, a charity to a large extent shifts the risk of a donor living longer than anticipated to the insurance company that issues the commercial annuity. Reinsurance also reduces or eliminates the risks associated with poor investment returns for a smaller gift annuity program or one that is just starting out. When a charity is organizationally risk averse, or a gift annuity program is relatively new, smaller, and/or the organization is financially constrained, reinsurance may provide the security necessary for success in the gift annuity arena. In some cases where a charity has a number of smaller gift annuity contracts, it may decide to insure the occasional larger annuity if the annuitants are relatively young.
Donors and charities alike want to put a portion of the gift annuity funds to work immediately. The opposite of the drawback listed above, many donors may discover that reinsurance of gift annuities provides a means by which their funds can start working for their charitable interest sooner rather than later, while still offering the donor a dependable source of additional lifetime income. Much like the donor of an outright gift, annuitants whose gift annuities are reinsured may enjoy knowing that their gifts are helping others now while they are alive to see them in action.
To reinsure or not to reinsure?
To avoid any pitfalls, charitable organizations and institutions should carefully develop policies and procedures to help determine if and when reinsurance is an option for them. There are many questions to consider, such as: Should you reinsure some or all of your gift annuities? Will you reinsure gift annuities for donors of a particular age, or evaluate each gift annuity at the time it is funded? At what gift amount would you consider reinsuring a portion of a gift annuity? Should this depend on circumstances at the time? At what gift amount would you decide to reinsure the entire gift annuity? How do you disclose the reinsurance option with your donor and when? Which insurance companies/reinsurance providers will you work with when reinsurance is deemed appropriate? How will reinsured gift annuitants receive their payments? Who will be responsible for tax reporting?
You must also keep in mind that even when a gift annuity is reinsured and backed by a commercial insurance carrier, the liability to make lifetime payments to the annuitant remains with the charity. If the insurance provider defaults, the charitable organization is still required to fulfill the payment obligation of the gift annuity agreement. Therefore, a gift annuity reinsurance provider should be chosen carefully.
Will every charitable organization need or want to reinsure all of their gift annuities? Probably not in the case of most who issue charitable gift annuities. As with many things, one size does not fit all, and the decisions regarding reinsurance must be carefully weighed by each nonprofit based on its unique characteristics and goals. But, for certain organizations that want to decrease the risks involved with all or a portion of their gift annuities, reinsurance may be the right fit.