The charitable gift annuity is one of a number of donor-friendly solutions that nonprofit institutions can offer to donors. A charitable gift annuity (CGA) is a contract between donor and institution—the nonprofit receives a gift from the donor, and in return the donor receives an income stream from the nonprofit. CGAs are a fairly common option in the U.S.—according to a 2017 survey by the American Council on Gift Annuities (ACGA), more than 4,000 nonprofit institutions offered CGA options to their donor bases. Because the CGA is a contract, and not an investment vehicle, nonprofits have flexibility in how they plan to fulfill their contractual CGA payment obligations over the long term. The ACGA publishes recommended payout rates for CGA contracts and the vast majority of charities that offer CGAs use the ACGA suggested rates. However, the management of underlying assets in a gift annuity pool is a different matter. The question of how to allocate assets in these pools is highly dependent on the nonprofit’s circumstances, the regulations in the state in which it is domiciled, and a variety of other factors that need to be considered carefully by the nonprofit. CGAs AT A GLANCE A CGA is a contract between a charity and a donor. The donor gives a gift, and receives an income stream, generally for life. The structure may be attractive for those who wish to donate and provide a long-term foundation for a charity, but still require income from their assets during their lifetime. CGAs can be especially attractive in certain situations—for example, a donor may hold low-basis stock in a company that recently cut its dividend, and a CGA can help the donor convert that non-income-producing assets into a contract that pays an income stream for life. As such, CGAs are a helpful tool for charities that want to be thoughtful about how to structure gifts so that they can meet a donor’s goals. The ACGA suggests a set of payout rates for gift annuities that are designed to leave a 50% residuum (i.e., half of the donor’s original gift) to the issuing charity. The ACGA payout rates are based on a fairly straightforward set of calculations based on actuarial tables and long-term market return assumptions. The formula takes into account that CGA donors generally enjoy an extended life expectancy relative to the general population, and also assumes a 1% administration and investment management fee. In terms of estimating market return, the ACGA assumes that gift assets could be invested at 40% equities (modeled on the S&P 500® Index), 55% fixed income (modeled on 10-year U.S. Treasury bonds), and 5% cash. The ACGA’s calculated return assumption as of July 1st, 2020 is 2.75% net of administrative and investment fees. Charities often assume that the 40%/55%/5% allocation used by the ACGA in this calculation also serves as a recommendation for how they should invest their own gift annuity pools. This is not the case. While the prudent investment standard should apply here as with all fiduciary investment decisions, the range of options is fairly wide depending on the situation—from a model that resembles a pension portfolio to one that is closer to the Yale Endowment Model. It is critically important that each charity and its investment advisors select an investment plan appropriate for the charity’s specific circumstances and preferences. CHOOSING THE RIGHT INVESTMENT APPROACH There are numerous factors that are important in planning how to meet CGA liabilities and manage underlying gift annuity pools. First and foremost, the endowment or foundation needs to consider the CGA liabilities in the context of the institution’s broader financial picture. For example, a private university with, say, a $5 billion endowment and $10 million in gift annuity liabilities is likely to feel comfortable investing gift annuity assets in a more aggressive allocation, or perhaps simply invest the assets in the endowment itself; in this case, the liabilities may well be covered by available assets. On the other hand, an institution with, say, a $50 million endowment and $25 million of CGA liabilities would likely choose a more conservative allocation to help immunize those liabilities. State regulations also come into play when managing CGA annuity reserves. Various state insurance regulators seek to protect CGA beneficiaries from charities that might mismanage their reserves or otherwise be unable to meet payment obligations. California and Florida have investment restrictions on the reserves that charities must hold; California further places restrictions on how reserves must be invested (which has in the past made in difficult or impossible for Calif. charities to allocate 40% or more to equities in CGA pools). Another factor to consider is the concentration risk present in a charity’s population of annuitants. It is possible—and not uncommon—for a charity to have a handful of very generous donors whose gifts make up a large proportion of the charity’s CGA pool. If some or all of these donors live longer than expected, the health of the overall pool could suffer due to higher-than-expected payout obligations. Any notable investment underperformance during such a period could further worsen the shortfall. Other factors to consider include: The targeted residuum (i.e., higher or lower than the typical 50% The risk tolerance of the institution The desired variability in the asset to liability ratio The ability to deposit funds to bring reserve accounts up to state required minimums The availability of other liquid unrestricted assets to make payments on any contracts that might run out of money The expertise of staff and/or advisors to create, access, and manage well-diversified investment portfolios at reasonable costs Broad asset allocation factors across the institution’s various asset pools Reinsurance considerations (i.e., does it make sense to reinsure (typically with commercial annuities) large and/or at-risk contracts, or possible the entire CGA pool) Many institutions tend to invest their CGA assets in a similar manner, following the model implied by the ACGA’s payout rate calculation. But as we have discussed here, there is no right answer for managing CGA pools that fits every situation. Each organization must consider its own circumstances when thinking about how to invest the assets given to them, and that plan needs to monitored and revised over time as the annuitant pool, institutional factors and market conditions change. By thinking through the issues above, nonprofits can position themselves to properly manage these liabilities and make thoughtful, prudent investment decisions. The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. 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