FASB Liability vs. Required Reserves

The issue of FASB Liability and Required Reserves for CGA programs is an advanced one but I encourage newcomers to the field to read this post anyway (I will try to explain it well and this will give you solid background info that will help you further understand gift annuity programs).

The question hit me last week. One of my client's requested a FASB liability report for their auditors and something struck me as wrong in the report given by the investment/administration provider.

Firstly, what is FASB and what is this liability report?

FASB stands for Financial Accounting Standards Board. Basically, auditors and finance/accounting staff of all types of entities try to follow their standards (they are not actually legal standards - a discussion for another post - but we try to play nice with them anyway).

The FASB liability report? In regards to charitable gift annuities, FASB has standards for institutions to determine the value of the "liability" of each gift annuity contract. In other words, the estimated amount needed to pay the donors for the rest of their life expectancies.

This needs explanation because it is a crucial point in understanding gift annuities and the various calculations involved (charitable deduction, booking value, reserves, etc...).

Ask yourself (out loud and slowly) this question: How much money do I need today to pay this annuitant his/her gift annuity for the rest of his/her life (assuming the money is invested and growing at a fixed rate)? We know how much has to be paid: the fixed annuity payment. We know for how long: the rest of his/her life expectancy. The only question is how much investment growth will their be?

Let's make this very practical. 72-year-old donates $10,000 today (Sept. 2009) for a one-life, immediate payment gift annuity of 5.9% (according to the ACGA recommended rate) for his/her life. This imaginary donor will be entitled to receive $590 a year for the rest his/her life - 14.5 years according to the life expectancy table. Without any investment return in the picture, we will pay this donor $8,555. (Don't get side tracked with questions like what if this person gets sick or alternatively eats lots of yogurt - all the accountants want is a projection of what the cost may be TODAY of this gift - who knows what will really happen)

Ask yourself this next question: Do I really need the full $8,555 in the bank to pay this annuity over 14.5 years? Well, if we can assume an investment rate of return - a fixed rate, of course, because anything else would be too difficult to deal with - we really don't need the full $8,555 in our investment account.

If we assume a fixed rate of investment return of, let's say, 3.4%, you would only need $5,671.60 in the bank today (earning 3.4% per year) to pay our annuitant his $8,555 over the next 14 years.

I chose 3.4% because it happens to be the current "Discount Rate" of the month (otherwise known as the Applicable Federal Rate - AFR - issued monthly which charities use for these calculations/assumptions). So, $5,671.60 is the actual FASB liability of this gift, as of today.

As an aside, your planned giving software simply subtracts the liability from the gross gift amount to give you the charitable deduction. In other words, the charitable deduction is the gross gift amount minus the money needed to cover the payments to the donor (based on the assumptions we discussed). Additionally, you should note that the lower the Discount Rate, the more money you need to cover the payments since your you are, in theory, earning less on the investments needed to pay the annuitant.

Now that we have these concepts done, back to my issue.

My question on the FASB liability report, that came from standard planned giving administration software, was this: the report showed that it used the AFR/Discount Rate/assumed rate of investment return of the month that each gift was originally created (not the current rate of assumed returns).

This confused me. I had assumed that a FASB liability report would want to show us what the liability is TODAY (using today's life expectancies and using today's investment assumptions). It turns out, FASB itself apparently lets auditors choose whether they want to calculate the total liability using the original AFRs of the gift annuities or the current AFR, at least this what people tell me.

Problem #1: the liability will be very different between the two "options." Today's rates are very low - 3.4% to be precise. But many gifts in the pools I work with were created when the AFRs were 6% or higher. My thought is this: if you want to make a projection into the future, knowing what we all now know (but didn't dream of a few years ago), I would say the lower expectation of 3.4% makes sense. And, the lower expectation would mean a greater amount of money is needed in the bank to ensure that you have the funds needed to make these payments.

Problem #2: I had assumed that the standard required reserve (for New York in particular) was the FASB liability plus a percentage above it as a further cushion required by New York. Could it be true that we have a choice on how we calculate the FASB liability when we do our New York annual report?

A quick call to the New York State Department of Insurance's head actuary solved this quandary pretty quickly. The answer to the question of whether New York requires you to calculate your reserve by using either the AFR of the original gift date or the current AFR was....NEITHER.

New York State actually has their own assumed rate of return depending on the year of the gift. It has ranged between 5.25% and 5.5% for the past few years. Why? The actuary told me the logic: they are assuming that you (the charity) are purchasing long-term treasury type assets (20 year treasuries), therefore the assumed rate of return should really be based on the typical type of long term bonds you should have purchased in the year of the gift.

This actually made a lot sense a few years ago when New York basically required that the required reserves be invested strictly in things like treasuries. The problem is this: the New York legislature actually changed the investment requirements to a prudent investor standard a few years ago. Now, it is up to the investment manager to invest as they feel appropriate. (for a time in 2008 and 2009, 20 year treasuries dropped below 4% - not great for CGAs - but they are now back over 4% since April and do make sense). See my post on CGA risk for further discussions on investments and risks to CGA programs: http://plannedgift.blogspot.com/2009/06/gift-annuity-risk.html

If New York didn't require an additional percentage of reserves, I would be saying that charities following New York's reserve requirements were under-reserved! They are requiring charities to use relatively high assumed rates of return for their reserve requirements (and artificially lowering the amounts of funds needed to cover the payments - assuming more realistic returns).

Back to FASB and to bring this discussion to a close. Apparently the accounting board doesn't really have an opinion on whether one should base their liability calculations on the assumed rates of investment returns when the CGAs were created or on current rates of return. My thought is that since we use the new life expectancy of the donor, why not use the new investment return assumptions (seems more realistic to me).

In any case, I have been providing accountants and auditors with various reports and calculations for years upon years, and I have no memory of any of them ever coming back to me with a question. In other words, I don't believe the auditors really understand this stuff so they just take what we give them and move on. And, maybe FASB has an opinion on the topic but no one seems to know it.