by Robert F. Sharpe, Jr.

According to various industry studies, charitable gift annuities are the second-most popular planned giving strategy after bequests. Although very popular due to their relative ease of use with donors and planned giving professionals, the economics of gift annuities and their attractiveness when compared to traditional investment alternatives can some-times be a mystery.

Defining the gift annuity

In a nutshell, a gift annuity is a gift planning alternative that provides regular, fixed payments to a donor as part of a gift exchange. Payments from gift annuities are normally structured for the life-time of the donor and, in some cases, another beneficiary.

Typically, the gift is one of cash or securities, but due to the tremendous increase in value of real estate there has been a growing interest in funding gift annuities with real estate. Following recent legislation in the state of New York, all states now permit the use of real estate to fund a charitable gift annuity.

While gift annuities are usually marketed to donors as a practical way to make a larger gift, donors are sometimes encouraged to look to a gift annuity as an alternative source of higher income rather than a commercially available fixed-income investment such as tax-exempt bonds, corporate bonds, Treasury bonds, or a commercially issued lifetime annuity. Unfortunately, this may not be the wisest way to communicate the benefits of gift annuities. Let’s see why.

The features of a commercial annuity

The gift annuity is perhaps most akin to commercially available annuities issued by insurance companies. When comparing commercial annuities to gift annuities, commercial annuities will almost always pay higher rates. It is important to know that there are a number of variations on the structure of commercial annuities, and it is vital to compare “apples to apples.”

The following is a summary of the most common options available for commercial annuities:

Straight Life Annuity: Provides a guaranteed income for the balance of the annuitant’s life. This option provides the highest income to the annuitant(s). At the death of the annuitant(s), the insurance company retains any balance remaining of the original investment. The risk of ‘running out of money’ due to longevity has been transferred to the insurance company. Conversely, in the event of earlier than normal death, the insurance company enjoys a windfall. This option can be for a single life, or for a Joint and Survivor, meaning that as long as one of the annuitants is alive the insurance company will continue to pay an income until the survivor dies.

Life Income-Installment Refund Option: Like the straight life option, the installment re-fund annuity will pay an income for the balance of the life/lives of the annuitant(s). However, if the annuitant(s) dies before receiving the original investment back, a named beneficiary(ies) will continue to receive payments until such time as the entire amount transferred to fund the annuity has been recouped.

Life Income with Period Certain: The annuity will pay an income for the life of the annuitant, but in the event of the death of the annuitant before the ‘period certain’ number of years expires, payments will continue to another named beneficiary(ies) for the balance of any guaranteed time period. The longer the ‘period certain’ years, the lower the income will be.

The chart to the right compares the payments to a 70-year-old woman from a straight life annuity to a 10-year certain annuity payout option, assuming a $30,000 annuity.

Note that, as might be expected, the straight life commercial annuity that pays only for the life of the annuitant pays more than the 10-year certain annuity that guarantees payments will last for at least 10 years regardless of when the person passes away.

How is a charitable annuity different?

Immediate payment charitable annuities, on the other hand, come in just one form: the “straight life” annuity. The donor transfers funds to a charity that agrees to make fixed payments for however long that person might live. If the donor dies earlier than his or her life expectancy, the charity receives more than would otherwise be expected. Conversely, if the donor lives past normal life expectancy, payments continue. Payments are structured so that, on aver-age, approximately 50% of the amount funding the gift annuity remains as the “residuum” at the death of the annuitant(s).

In the case of the 70-year-old above, under the gift annuity rates recommended by the American Council on Gift Annuities (ACGA), the donor would receive 6.5% for life. That is substantially less than the 8% she would receive from a straight life commercial gift annuity. As the chart on the right illustrates, her after-tax income from the gift annuity is less than what would be received from either of the two types of commercial annuities illustrated above.

The greater economic benefit from the commercial gift annuity is largely due to the fact that the amount that is designed to be left to the charity in the case of a charitable annuity (50%) is substantially more than the “residuum” built in for the insurance company, and the fact that less of the payments from the commercial annuity is taxable to the recipient because more of the payment is composed of return of a larger amount of the donors’ principal.

Effect of tax deduction

But what about the charitable deduction that is allowed in the case of a charitable gift annuity that is not available when one funds a commercial annuity? In the case above, a donor would be allowed to deduct 40% of the amount transferred for the charitable gift annuity, or $11,885. If the donor is subject to the highest federal tax bracket of 35%, this results in an income tax savings of $4,160. The after-tax cost of the gift annuity is then $25,840. If you consider the amount of the gift annuity payments as a percentage of the $25,840 after-tax “cost” of the gift annuity, the effective rate on the charitable annuity rises from 6.5% to 7.5%, much closer to the 8% paid by a comparable commercial annuity. After payment of income tax on the gift annuity amount, however, the net rate paid by the commercial annuity is 7.31% compared to 6.45% for a charitable gift annuity.

Thus, even after considering the tax benefits associated with a charitable gift annuity, a commercial gift annuity will normally provide significantly higher after-tax income than its charitable cousin.

The importance of donative intent

Experience shows that organizations who enjoy the most success with gift annuities tend to be those who market them to relatively long-term, older donors who would otherwise fit the profile of a prospective bequest donor. While gift annuities may not be the best “invest-ment” when viewed from that perspective, they may be extremely attractive when compared to a traditional bequest via one’s will.

Returning to the case of the 70-year-old donor mentioned above, consider the appeal a gift annuity might have when compared to a bequest. If the donor does not have a taxable estate, there would be no tax benefits from a charitable bequest. On the other hand, if she used $100,000 in cash that had been earning 3% to fund the gift annuity featuring largely tax-free payments twice as large, as well as a $40,000 tax deduction, she might well prefer the gift annuity. From the charity’s perspective, the gift annuity is irrevocable and may ultimately yield more charitable benefit than the bequest alternative should the donor’s assets be depleted by medical and other expenses prior to her demise.

If the donor did, in fact, have a taxable estate, the amount used to fund the gift annuity is removed from her taxable estate, just as in the case of a charitable bequest. The difference is that the donor enjoys increased income that is largely tax free and income tax savings during lifetime in addition to an eventual reduction in estate taxes.

In conclusion, a basic understanding of the economics of charitable gift annuities versus commercial annuities can be very helpful. While the financial benefits of a gift annuity can be vital when a donor is deciding how to best make a gift, there are better investments that are broadly available to persons who are only interested in the highest return on their investment dollars. For that reason, it is best to focus attention on those who have proven interest in furthering your mission, and to introduce the gift annuity as an exciting way to do more than they might have otherwise thought possible.

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