8. Introduction to Charitable Gift Annuities, Part 1 of 3

8. Introduction to Charitable Gift Annuities, Part 1 of 3

Article posted in General on 28 December 2015| 3 comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 28 December 2015
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

8. INTRODUCTION TO CHARITABLE GIFT ANNUITIES, Part 1 of 3

Links to previous sections of book are found at the end of each section.

The essence of a Charitable Gift Annuity is that a donor makes a gift to a charity, and in return, the charity makes payments to the donor for life.  Despite the simplicity of this concept, Charitable Gift Annuities are a powerful charitable planning vehicle that can be used in a variety of situations with donors from a wide range of economic circumstances.  Like the more complex and expensive Charitable Remainder Trusts, Charitable Gift Annuities provide a source of regular payments to the donor.  Also, Charitable Gift Annuities create an immediate tax deduction.  Finally, when purchased with appreciated securities (or other appreciated assets), Charitable Gift Annuities provide the opportunity to defer capital gains taxes.  This combination of tax advantages and income creation make Charitable Gift Annuities attractive for both donors and charities in a number of situations.
The most common form of a Charitable Gift Annuity transaction is where a donor makes a gift to a charity, and in exchange, the charity makes payments back to the donor for the donor’s life.  The payments can be annual, semi-annual, quarterly, monthly, or even weekly.  A Charitable Gift Annuity is an example of a bargain sale.  A bargain sale occurs when the donor transfers a gift to a charity, and in return receives something worth less than the fair market value of the gift.  In this case, the donor receives an annuity (i.e., a stream of payments for life) in exchange for a gift.  The value of the annuity (as calculated by the IRS tables) must be less than 90 percent of the value of the gift.  Thus, the donor makes a bargain sale, gifting money or property and in return receiving something worth less than the gift.
The lifetime payments resulting from a gift annuity are based upon the size of the gift and the age of the annuitant.  (The “annuitant” is the person who receives payments for life.  The annuitant is typically the donor.  However, the donor could choose to purchase an annuity that pays to another person for the other person’s life.) As seen in the table, an older annuitant will receive larger annual payments than a younger annuitant for the same gift.  This difference exists because, on average, younger annuitants live longer and the charity will consequently have to make payments to younger annuitants for more years.  The annuity payment is typically fixed for the life of the annuitant.  For example, if a 55 year old purchased a $10,000 annuity she would receive $400 per year for life (assuming the charity was following the guidelines of the accompanying table).  This $400 payment never changes.  Thus, when the donor who had purchased the annuity at age 55 turned 85, she would still be receiving a $400 annual payment.  (However, if she were to purchase a new gift annuity at age 85, it would pay a higher rate, because of her older age.)  The higher payout rates at older ages help explain why these gift annuities are most popular with older donors.

This table shows the suggested rates from the American Council on Gift Annuities in 2015.  No charities are required to use these rates.  However, most do.  The intended goal of the American Council on Gift Annuities rates is to identify the payment level at which, on average, 50% of the face value of the initial transfer will remain with the charity at the annuitant’s death.  These suggested payout rates are based upon current interest rates and expected mortality.  The rates can be changed every six months to reflect underlying interest rates. 

This table reflects the remarkably low interest rates of 2015 when 1-year bank certificates of deposit paid about 1%.  Why do gift annuities seemingly pay so much more than bank certificates of deposit?  This is because in a gift annuity, the donor loses the principal.  A certificate of deposit generates income, but the principal is still owned by the depositor and can be withdrawn at any time.  A gift annuity generates only lifetime payments.  At death the payments end and there is no remaining asset in the donor’s estate.  Consequently, it is not appropriate to directly compare interest rates from a certificate of deposit with payout rates from a gift annuity.  (Indeed, such comparisons are explicitly prohibited when marketing Charitable Gift Annuities.)

It is often wise for a charity to present more than one rate in a proposal to an individual donor.  The suggested rate from the American Council on Gift Annuities could be termed the high rate (e.g., 4.0%) along with alternatives for a medium rate (e.g., 3.0%) and a low rate (e.g., 2.5%).  Why would a donor voluntarily choose the medium or low rates?  This is because, fundamentally, the donor desires to benefit the charity and advance its cause.  If the lower rate can meet the donor’s income target it will generate a greater benefit for the charity (and a greater tax deduction for the donor).  Many charities leave substantial gifts “on the table,” by simply assuming that the donor will always want the highest rate from the charity, rather than presenting proposals that include three different rate options.

Using the previous rate table, if a donor aged 55 gave $100,000 in publicly traded securities to a charity in exchange for a Charitable Gift Annuity, the charity would make $4,000 annual payments back to the donor for the donor’s life.
As mentioned previously, the American Council on Gift Annuities suggested rates are intended to leave half of the face value of the initial transfer available for the charity at the death of the annuitant (assuming that the charity makes the lifetime payments using interest and principle from the initial gift).  This does not mean that the value of a Charitable Gift Annuity to a charity is half of the amount transferred by the donor.  Although the charity is projected to receive half of the face value of the initial transfer, the charity must typically wait many years for this to occur.  For example, a $10,000 gift annuity by a 30-year-old donor may be projected to ultimately result in a $5,000 residual going to the charity (after the lifetime of annuity payments are made to the donor); the charity must still wait an average of approximately 50 years to receive this $5,000 residual.  The right to receive $5,000 in 50 years is worth far less than $5,000 today.
In order for a Charitable Gift Annuity to be considered a charitable arrangement for tax purposes, the annuity must be worth less than 90% of the value of the gift.  This does not mean that the charity need only be projected to have a residual of more than 10% after making a lifetime of annuity payments.  The projected residual amount comes to the charity only after years of waiting, so at the time the Charitable Gift Annuity is purchased the residual is worth much less than its future projected value.  For example, the present value of an expectation of receiving $5,000 in 50 years is worth far less than $5,000 today. 
Although many Charitable Gift Annuities are relatively small, their usage is so common that, when combined, they constitute a $15 billion segment of charitable planning.  The relatively small minimum size of Charitable Gift Annuities is part of the reason why they are so popular.  Because gift annuities are issued by each individual charity, the minimum amounts depend upon the policies of each charity.  However, it is not uncommon to find Charitable Gift Annuities available at the $5,000 or $10,000 level.  This low entry level also allows hesitant donors to “experiment” with planned giving.  It is not uncommon to see donors purchase a series of small Charitable Gift Annuities before increasing the size of gift annuity purchases.  By giving donors experience with gifts that pay income, Charitable Gift Annuities can also serve as a gateway to more expensive and complex vehicles such as Charitable Remainder Trusts.

Data from the 2013 American Council on Gift Annuities survey of Charitable Gift Annuities shows that the average age of an annuitant at the time of making the gift was 79 years old.  According to that survey, 89% of all Charitable Gift Annuities were purchased by donors aged 71 to 84.  This attraction for older donors makes sense, both because of their post-retirement interest in secure lifetime payments and because of the sharp divergence between interest rates and lifetime payout rates available at older ages.  In 2013, BNY Mellon Wealth Management reported that the majority of their more than 3,000 Charitable Remainder Trusts were established by donors aged 70 to 74 (See James, R.  N.  III & Franey, J., 2013, Trending forward: Emerging demographics driving planned giving.  National Conference on Philanthropic Planning, Minneapolis, MN).  This suggests that the peak age for Charitable Remainder Trust establishment is about five years younger than the peak age for Charitable Gift Annuity purchase.  Other research suggests that the peak age for producing matured charitable bequest gift dollars is about 88 years of age (See James, R.  N.  III, 2013, American Charitable Bequest Demographics, 1992-2012).  With upcoming increases in the population of older age groups, a demographic effect would be felt first in Charitable Remainder Trust establishments, second in Charitable Gift Annuity purchases, and last in matured charitable bequests.

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