When a charity receives a gift annuity, it has the option to retain the annuity contribution amount in a designated reserve fund or to reinsure. If the charity retains the contribution, it is self-insuring the gift annuity. In that case, the contribution is invested and the charity makes payments from the fund.

An alternative is for the charity to pay a premium to a financial services company that will then make the required annuity payments. The second choice is commonly called "reinsurance" of the gift annuity.

Should a charity reinsure? Reinsurance involves evaluating the factors that will benefit the charity with self-insurance or the favorable factors that might lead to reinsurance. The primary questions relate to the life expectancy of the donor, the estimated return of the charity's annuity reserve fund and the cost of reinsurance.

Questions and Answers on Gift Annuity Reinsurance

Q. How does the IRS value a charitable gift annuity?

A. The IRS uses mortality tables from the year 2000 and an interest rate. Each month, the IRS publishes a revenue ruling that sets forth the applicable federal rate (AFR) under IRC Sec. 7520.

Based on that mortality table and the age of the individual, the IRS is able to determine a probable life expectancy. Using the funding amount and assuming earnings at the AFR for the month of the gift (or one of the prior two months), the IRS can determine the fund that would be required to pay the individual for the projected life expectancy.

Example I - Ms. Donor Age 80 and the IRS

With an 80-year old donor and a gift annuity funded with $100,000 of cash, the IRS projects an expectancy between nine and ten years. If the annuity reserve fund earns at an applicable federal rate of 3.2%, the amount necessary to make the payment for that period of time is $49,774. The IRS assumes that the charity sets aside this amount, earns 3.2% and the donor dies precisely on time at the anticipated expectancy.

Based on these assumptions, the $49,774 fund plus interest earned during the 10 years will be sufficient to make all annuity payments.

Because Ms. Donor transferred $100,000 cash to fund the gift annuity, the balance of $50,226 is a charitable gift. Even though most charities will transfer the full $100,000 to the gift annuity reserve account, the IRS permits this donor to take a present value charitable deduction for $50,226. The $49,774 amount is the "investment in the contract" for Ms. Donor.

Q. How does an insurance company value a gift annuity for reinsurance purposes?

A. The insurance company follows a method similar to the IRS calculation. The actuary for the insurance company determines a probable life expectancy, which is likely to be two to four years longer than the IRS expectancy. Based on that expectancy, the required payment and an estimated earnings rate, the actuary determines the fund amount necessary to pay the annuity for the projected expectancy. This value plus profit and overhead is the reinsurance premium.

Example II - Ms. Donor Age 80 and Reinsurance

For example, Ms. Donor contributes $100,000 for a gift annuity paying 7.1% based on her age of 80. After completing the above calculation, the insurance company might decide to set a reinsurance premium of $66,000. This amount would be sufficient to pay her $7,100 annuity for her life expectancy. All of the principal and earnings would be used for that purpose. There also would be a portion of the $66,000 that covers expenses, overhead and profit for the insurance company.

If a charity chose to reinsure the gift annuity, then it would make payment of the $66,000 to the insurance company. Assuming that the insurance company is highly rated with substantial reserves so that it is in business during the lifetime of Ms. Donor, the charity is relieved from further obligations. Because Ms. Donor transferred a $100,000 to the charity, the charity gift amount is a present value of $34,000.

Ms. Donor still receives the $50,226 charitable deduction, unless the gift annuity contract has required the gift annuity to be reinsured. In virtually all cases, the charity is not required to reinsurance the gift annuity contract and simply chooses, as an investment option, to use the reinsurance through the financial services company. In this latter case, Ms. Donor receives the charitable deduction.

Q. If a charity maintains a gift annuity reserve fund, how should it calculate the gift and "self-insurance" amounts?

A. Most charities will transfer the full $100,000 contributed by Ms. Donor for her gift annuity into the reserve fund. However, the charity can effectively follow a similar method to that used by the IRS or the insurance company.

The charity is acting as its own insurance company. An insurance company sets aside a reserve fund to cover payments. The reserve fund is invested. Based upon the projected life expectancy of the donor and earnings rate, the reserve fund is calculated to be sufficient to make all of the payments.

A charity could internally create "Fund A" as a gift fund and "Fund B" as the gift annuity contract fund. This method enables the charity to estimate with reasonable accuracy the amount of the gift and the reserve needed to be set aside for the gift annuity contract.

Q. How would the charity set up their internal gift and contract funds for Ms. Donor?

A. Assume that Ms. Donor has transferred $100,000 for a gift annuity for a person age 80. The annuity pays 7.1% or $7,100 per year. In order to calculate the amount necessary to set aside for the gift annuity reserve, the charity will need to estimate life expectancy and also the reserve earnings rate.

Example III - Ms. Donor Age 80 and Charity Self-Insurance

A life expectancy based on the tables used for IRA calculations for an individual age 80 is approximately 10 years. The charity makes conservative projections based on its annuity reserve earnings rate and estimates that the donor may outlive life expectancy. A reasonable series of projections would be the donor living for 12 years to age 92, for 16 years to age 96, or for 20 years to age 100. As the expectancy estimate increases to life expectancy plus six years (age 96), or life expectancy plus 10 years (age 100), the probability that Ms. Donor will survive that long decreases significantly.

For the second part of the calculation (the estimated return rate), the charity projects 6% return. This is based on a fairly typical gift annuity reserve portfolio that is 40% equities and 60% bonds. While the 75 year average for this portfolio is approximately 7 ½% to 8%, the charity estimates a conservative 6% return because the duration is about ten years.

Based on a 6% return and survival to age 92 (12 years), the charity fund is $63,602. Over the 12 years, this amount plus 6% interest will be sufficient to pay the $7,100 annuity each year. At the end of 12 years, this fund will be completely exhausted to zero.

However, the remaining $36,398 is a charitable gift. This amount could be maintained for the life of Ms. Donor in Fund A and that principal plus growth would be available when she passes away. This is the common pattern for most charities. The full amount of the gift annuity is transferred to the fund and the remaining balance at the demise of Ms. Donor is then an unrestricted gift to the charity's general fund.

However, if Ms. Donor lives 16 years then a larger fund must be set aside. The amount of $75,274 is sufficient to pay the $7,100 for 16 years.

Finally, if Ms. Donor survives 20 years to age 100, then $84,519 must be set aside in the annuity self-insurance fund or reserve. That would leave just $15,481 for the charitable gift.

Q. With this gift annuity, should the charity reinsure?

A. That is the key question. There are several other factors that will be answered in greater detail in a future article. However, the basic numbers indicate that if Ms. Donor passes away within a 12 year period, the charity would receive $36,398 with self-insurance, rather than $34,000 with the reinsurance. Therefore, the charity would receive $2,398 more if Ms. Donor passes away within two years of the IRS expectancy.

However, if Ms. Donor takes her vitamins, enjoys her morning walk and lives well past normal expectancy, then reinsurance becomes more attractive. With a maturity for Ms. Donor after 16 years at age 96, the charitable gift is reduced to $24,726 with self-insurance, compared to $34,000 with reinsurance. (This assumes that the reinsurance premium is $66,000, which may or may not be the amount the insurance company is going to charge for that annuity.)

If that is the correct reinsurance premium, the charity receives $9,274 in greater gift benefit by reinsuring.

Finally, if Ms. Donor is blessed with great longevity and lives to be 100, then the charity that reinsures will have a significant benefit. The gift with reinsurance of $34,000 is $18,519 more than the charitable gift of $15,481 without reinsurance.

Q. Are there other potential investment options for comparison purposes?

A. Investment companies always say "prior performance is no guarantee of future returns."

However, Professor Jeremy Siegel of the Wharton School has compiled stock data for 200 years. Professor Siegel notes that there has been a 7% real rate of return over 200 years. When displayed on a logarithmic scale, the 7% real rate of return is a straight line.

On several occasions in the past 100 years the stock market valuations have trended up to 45% above or below his 7% real return projection. However, even when the markets were high or low, within a period of five to 15 years the markets returned to the 7% trend line.

Therefore, it is logical to assume a position similar to the trend line of Dr. Siegel and determined the potential result if stocks and bonds were to have comparable returns. For example, assuming a base year of 1935, 1948 and 1977 and averaging the three returns for the following 16 year period, it is possible to obtain an annual stock and bond return rate that has some reasonable prospect of reflecting the forthcoming 16 years.

Based on the assumption that the portfolio includes 40% stocks and 60% bonds and the averaged returns reflect the 16 year periods following 1935, 1948 and 1977, the amount that would need to be set aside in the contract fund by the charity would be $61,268. This would leave $38,732 as the charitable gift.

If a charity chose to reinsure, the cost of reinsurance of $4,732 would then reduce the gift to $34,000.

Q. What can a gift planner or professional advisor for a charity conclude about reinsurance?

A. It is useful for the Chief Financial Officer (CFO) of a charity to conduct this type of analysis. There are occasions when a reinsurance plan is logical. In most circumstances the reinsurance plan does involve some cost to the charity, but it also relieves the charity of the risk that the donor may live to a very senior expectancy.