Understanding the ‘Gift’ in ‘Annuity’ | Sharpe Group
Posted June 1st, 2006

# Understanding the ‘Gift’ in ‘Annuity’

According to the American Council on Gift Annuities (ACGA), some 4,000 organizations and institutions now issue charitable gift annuities. Among the most popular gift planning tools, gift annuities offer donors an opportunity to make a gift of relatively modest amounts while retaining a fixed income for life.

The ACGA periodically recommends payment rates, which most charities follow. See examples of currently recommended rates reproduced in the chart below.

## How rates are determined

The rates recommended by the ACGA are designed to assure that approximately 50% of the amount transferred will ultimately be available for charitable use at the death of the donor, assuming the funds earn a return of 6% and that annual administrative expenses do not exceed 1%. This amount is known as the “residuum.” The older a donor is at the time he or she enters into a gift annuity agreement, the higher the payment will be. Over a shorter life expectancy the charity can pay more of the original contribution back to the donor while still achieving at least a 50% residuum. Rates based on the lives of two persons are somewhat lower than the rate for the younger person’s life alone because the rates must take into account the possibility that one of the annuitants will outlive his or her life expectancy.

## Comparing two annuitants

While the higher rates for a 90-year-old may seem difficult for a charity to pay, consider that this person’s life expectancy is only five years. If the funds used to create a \$10,000 gift annuity earn 6%, the administration cost is 1%, and the payout is 11.3%, then the expected residuum is \$6,518. Note this residuum amount is more than 50% because the rates for older donors are capped at lower amounts than could actually be paid and still result in a 50% residuum. The present value of this amount discounted for inflation at 3.5% for five years is \$5,487. If the donor should live five years past his or her normal life expectancy and reach the age of 100, there would still be \$2,075 remaining with a present value of \$1,471.

Compare this to the case of a 60-year-old gift annuity donor receiving a much lower payment of 5.7% over a 24-year life expectancy. At the end of 24 years, a \$10,000 gift annuity should yield a residuum of \$6,884, slightly more than in the gift annuity for the 90-year-old. Despite the higher residuum, however, the present value of this amount is \$3,014, much less than in the case of the older donor. If the 60-year-old donor lives five years past life expectancy, the residuum will be \$5,637, with a present value of \$2,078.

There is less of a cushion on earnings, however, in the case of the 60-year-old. If the return on annuity reserves is just 5%, the residuum for the 90-year-old drops just 7% from \$6,518 to \$6,046 while the residuum for the 60-year-old drops by over 50% from \$6,884 to \$3,355.

The above analysis illustrates why many charities will place age and/or dollar limits on gift annuities they will accept from younger donors while not being as concerned about high payout rates for gift annuities with older donors.

## The commercial alternative

In recent years commercial insurance companies have become more active in marketing annuity contracts that are similar to charitable gift annuities. Like a gift annuity, commercial annuities make fixed, lifetime payments to an annuitant.

The difference is that commercial annuities normally pay significantly higher rates than charitable gift annuities because insurance companies structure their rates with the expectation of a much lower residuum.

For example, let’s look at a 78-year-old, the average age at which a donor enters into a charitable gift annuity according to the ACGA. The ACGA recommended rate at that age is 7.6%. The expected residuum in 10 years on a \$10,000 gift annuity is \$6,729. If a commercial insurance company assumes the same 6% earnings amount and 1% expense factor, it can pay a 78-year-old 11.1% for life (rate quoted recently by a well-known commercial insurer) and still be left with a remainder of some \$2,327. The fact that commercial insurers “price” their annuities with an expected residuum of much less than 50% explains in part why commercial annuities often pay rates that are significantly higher than charitable gift annuity rates.

But what of the charitable income tax deduction, you might ask? Doesn’t that give the charitable gift annuity an advantage? For a \$10,000 gift annuity entered into by a 78-year-old, the charitable income tax deduction is approximately \$4,984. If the donor is in the highest federal income tax bracket of 35%, his or her tax savings is \$1,744. Because of this savings, the “net cost” of the gift annuity drops to \$8,255. If we then consider the gift annuity payment of \$760 per year as a percentage of that amount, the effective after-tax rate rises to 9.2%, still less than the commercial rate of 11.1%. For a person in the 25% tax bracket the effective after-tax rate is 8.7%. On top of that, a higher percentage of the payment from the commercial annuity is received free of income tax as a return of principal because the commercial rate is higher, resulting in more principal being returned to the payment recipient.

## Marketing “do’s” and “don’ts”

The above illustrates why those with no donative intent who respond to ads touting the “higher returns” of gift annuities when compared to other investments will rarely complete a gift annuity after exploring non-charitable alternatives. The truth is that those looking for the greatest returns can arrange for higher payments from commercial annuities and other investments. Marketing materials that compare gift annuity rates to returns on certificates of deposit and money markets, or imply that tax savings give an advantage to charitable gift annuities are simply not comparing apples to apples. A donor can access the funds when needed in the case of CDs, bonds, and money market funds. That is not the case with gift annuities. Keep in mind the fact that a donor is entering into an annuity transaction for less than he or she could receive from a commercial annuity. That is why there is an income tax deduction equal to some portion of amount contributed for a charitable gift annuity.

When marketing charitable gift annuities, it is important to describe them correctly and not compare them to pure investments that feature very different costs and benefits. This is not merely a question of ethics or “best practices.” It is the law. In 1995, Congress passed legislation known as the Philanthropy Protection Act, mandating that gift annuities remain exempt from federal securities regulation under certain conditions, including the condition that prospective donors be supplied with information that accurately describes how a gift annuity works. Marketing materials that inaccurately compare gift annuities with other investments may thus give rise to serious questions under federal and state securities laws. The insurance regulators of many states also take an interest in how gift annuities are portrayed. One of their main concerns is also to protect their citizens from misrepresentations.

For over a century, gift annuities have proven to be an excellent way for many to make charitable gifts, offering benefits not available through a bequest by will or certain other gift planning tools. Gift annuities should, however, be marketed as another opportunity for a donor to make a gift that might not otherwise be possible to persons who possess donative intent similar to that required for a charitable bequest. A gift annuity is not a way to “do good” while also achieving superior investment returns.

The publisher of Sharpe Insights is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Sharpe Insights may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.