The Deferred Gift Annuity Surprise
I found a recipe for Cherry Surprise Cookies. The surprise is a nugget of chocolate inside the cookies. Like these delicious-sounding cookies, deferred gift annuities can come with a surprise. The surprise can be pleasant like chocolate or dreadful, as in losing lots of money.
The deferred gift annuity is an attractive arrangement for those who want fixed, guaranteed income, but don’t need the income immediately. Donors like deferred annuities because the annuity rate can be quite attractive. The annuity rate advantage comes from the magic of compounding. (The eighth wonder of the world, according to Einstein!)
The deferred annuity rate is calculated in two steps. First, the rate is based on the annuitant’s age as of the “annuity starting date,” the first day of the period at the end of which the annuity will make its first payment. Since the annuitant is older, the annuity rate will always be higher than if the annuitant took immediate payments. But it gets better. Second, the annuity rate is compounded annually by the prevailing ACGA net investment rate assumption. Right now, this rate is 2.75%. The compounding accrues from date of gift to the annuity starting date.
Donors Love Deferred Gift Annuities
Here’s an example. Shaila is 65 and establishes a $100,000 deferred annuity on August 2, 2021, that will begin making quarterly payments on September 30, 2031, so the annuity starting date is July 1, 2031. She will be 75 on that date. The immediate annuity rate to which she would be entitled at age 75 is 5.4%. It is 9.9123 years from August 2, 2021, to June 30, 2021. (The deferral period ends on the first day of the quarterly period that ends on September 30, 2031.) Because of the magic of compounding, Shaila is entitled to an attractive annuity rate of 7.1% when her payments begin at age 75.
Charities May Love or Hate Deferred Annuities
All is well for Shaila. What about the charity that issued the annuity? Assume that the deferred annuity was established in 1999 on the verge of the tech bubble bursting. The S&P returns for 2000 to 2002 were -8.10%, -11.89%, and -22.10%. Assume net investment returns for the balance of the deferral period equaled the ACGA assumption of 2.75%. Assuming Shaila lives to life expectancy, the annuity will run out of money, and the issuing charity will be in the red to the tune of $34,841. Surprise! Not only is the charity out of pocket for the annuity, but there have been indirect costs for the fundraiser’s time and administrative staff time to establish and administer the annuity.
There can also be a happy surprise. Gift annuities are usually invested conservatively. Assume the charity’s annuity reserves earned a modest 4% constant net return every year. The residuum from Shaila’s annuity would be $108,995. That’s a little over twice the ACGA assumption of 50% of the donor’s original gift. Another surprise, but a pleasant one.
Avoiding Negative Deferred Annuity Surprises
Achieving solid gift annuity reserve investment returns, following the ACGA rates, and monitoring annuity market values can keep deferred gift annuities out of trouble. Investment returns during the deferral period need to be like Goldilocks’s porridge, not too hot, not too cold, but just right. Losses due to equity risk during the deferral period can spell disaster for deferred annuities. The impact of negative or anemic returns is to increase the effective payout by reducing the annuity principal. Overly conservative investment in fixed income arrangements can cause the principal to fall behind the compounding rate of a deferred annuity. “Just right” investing will match or exceed the compounding rate without exposing the gift annuity reserve to excessive fluctuations in value.
The ACGA uses conservative assumptions in setting immediate and deferred gift annuity rates. Gross investment returns are 3.75% with a 1% management fee. Therefore, net returns both for rate setting for immediate annuities and compounding for computing deferred annuities is based on net returns of 2.75%.
At the other extreme is risk avoidance at the expense of returns. As of this writing, the best CD rate for terms exceeding 5 years is 1.1%. A 20-year Treasury note yields 1.753%. Investment grade bonds offer higher yields but carry their own risks. Bonds are less risky than stocks, but that does not mean there is no chance of losing principal. Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up. Inflation can also erode the returns on bonds, as well as taxes or regulatory changes.
Gift annuity administration should include monitoring the value of individual annuity contracts. That is the only way to know if an annuity is making or losing money. There are options to address deferred annuities that are losing money. Annuitants may surrender their income interest either in whole or in part. This relieves the issuing charity of liability for paying the annuity. Alternatively, annuitants can cash out their annuity. The annuitant receives a lump sum payment equal to the present value of their future payments. The issuing charity receives the balance, if any, and is relieved of the liability of making payments. These risk control strategies only work when the charity knows the value of each of its annuity contracts.
Deferred annuities offer a flexible solution for donors who want future income at attractive rates. All annuities require scrutiny before acceptance and careful management and monitoring once in place. Deferred annuities deserve scrutiny to avoid a negative surprise. The compounding of the deferred annuity rate generates future liabilities that require careful management. Doing so will avoid unpleasant surprises and could yield happy surprises.