As I mentioned a few days ago, I had a conversation last week with Bryan Clontz, who I now consider the leading CGA risk expert in the country. If you followed my previous discussion on this topic, you should know that I've had doomsday concerns over the whole CGA business for some time.
You have to do some risk analysis on your CGA program! Especially if your entire CGA pool/reserve fund is just meeting New York's reserve requirement. According to Bryan, who confirmed my own guess-work, the New York reserve requirement is essentially the funds needed to cover the payments to the annuitants. The gravy to the charity are the funds above the reserve. (If you are not licensed in New York, and don't have such requirements, find out what it would be if you were licensed)
In other words, if you are struggling to meet New York's reserve requirement (going up again this year!), you potentially have an even bigger problem: your program might start losing money!
Maybe it's time to rethink your policies visa-vi how much you pull when a donor dies or whether you should issue annuities for related institutions or whether you should allow donors to designate the remainders of their CGAs?
Here is a link again to Bryan's site: http://www.charitablesolutionsllc.com/index.html I don't know if there is anyone else out there who can do a full fledged, professional risk analysis. Yes, he sells reinsurance - but contrary to popular planned giving thinking, reinsurance is an important option for gift annuity programs dealing with risk issues. I do my own "risk analysis" for clients but if my simplistic charts show too much red, I am sending you to Bryan.
Bryan gave me another great piece of "news" (at least news for me). Met Life very recently obtained an approved New York State reinsurance treaty.
Why is this important?
Up until now, only The Hartford was known for having the proper "treaty" in New York that would allow a charity to re-insure and not need to reserve on the re-insured portions of CGAs. Not that I don't love The Hartford, but it's always good to have price competition.
Showing posts with label risk. Show all posts
Showing posts with label risk. Show all posts
Tuesday, November 17, 2009
Wednesday, September 30, 2009
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.
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.
Wednesday, June 10, 2009
Gift Annuity Risk
Gift Annuity Risk
I was wondering if I am crazy or not. Was I the only one in the planned giving world ringing the alarm, calling out to whoever would listen, that many gift annuity programs might be in big trouble? When you are an alone alarmist, you have to start wondering.
At Planned Giving Day in New York a few weeks ago, I presented on a panel various “doomsday” projections about exhausting CGAs but the response was quiet – too quiet, like maybe people didn’t want to hear the message or maybe I was wrong. There was of course the misleading article in the Wall Street Journal, hardly backup for my theory that CGA programs in general could be in trouble.
Finally, Frank Minton on PGCalc’s latest webinar on Advanced Gift Annuities dedicated the first 20 minutes of his presentation, billed as a discussion on advanced and new gift annuity techniques, to “risk control.” And, listening to Frank’s presentation and seeing that he used similar projection models to what I use, mostly “what ifs” using assumed constant rates of return, I know I am not crazy.
Here is the bottom line in what I found with the NEW (February 2009) ACGA rate tables. If your program returns 4% a year constant returns, I feel comfortable saying that your program will never experience (or very rarely) exhausting CGAs. Great news if you think 4% is attainable on a consistent basis.
The problem is what are we to do with older annuities? Under the same analysis on ACGA rates a few years ago, I figured out that you need to return 5% a year consistent returns, to be generally safe from gift exhaustion. Less than that, not always safe.
But the problem gets even stickier. I know from experience that even the biggest and best gift annuity investment/administration providers have seen the CGAs pools on their watch drop over 25% in principal value since January 1, 2008. That is on the conservative side – I am sure many have lost more. And, as CGA payments don’t change, the rate of diminishing principal speeds up even if you return to “normal” investment returns. What I mean is that your program may seem ok but really it’s not – one big annuity that runs out of money could bring the rest of your pool underwater with it. You don’t want to be hoping that your donors don’t live into their 90s because their annuity principals will be gone and perhaps eating up the rest of your pool.
In the midst of working through sticky situations for clients, I finally started feeling a ray of hope. Not that all will be well with every annuity out there – certainly not – as many are paying the price now for offering rates over the ACGA tables, or for the ACGA rates being too high, or for sloppy oversight, or for uncontrolled gift acceptance policies, or for small organizations taking on CGAs when they shouldn’t have, or taking on CGAs much too large for certain organizations.
The point is that proceeding carefully from this point forward can rescue your CGA program from “doom” that might be coming. Wake up now. Ask your provider for an updated “market value” report showing the current value of every annuity. Create an excel spreadsheet calculating what happens to the principal of each annuity under different flat rate assumptions over the next 10 to 20 years. Here is my super-secret excel formula for doing this: =(C1*$A1)+C1-$B1, column A is the assumed rate of return, column B is the fixed annuity payment, column C is current principal, put the formula in column D and then drag it over the next 10 to 20 columns. The $ sign keeps rate of return and payment amount fixed – the rest changes column by column – year by year. If you have trouble doing this, get someone from the finance department to help you.
You will start to see when CGAs are approaching negative. Maybe you will see an exceptionally large CGA that not only might run out of funds in 4 or 5 years, but will literally eat up the rest of the pool should it exhaust. It might be time to meet with that donor to see if he or she will take a lower income stream or would even give up all of the income.
New annuities are great for struggling pools as long as the pool isn’t so far depleted that news funds will only just push off the inevitable exhaustion of the whole pool – that really is more like a Ponzi scheme.
Perhaps it’s time to ask new CGA donors if they will take less than the ACGA rate – preserves a bigger remainder gift and bolsters the whole CGA program.
The biggest change though has to be your “remainder” policy. Dig deep enough into the CGA concept and you will find that the CGA program rests on the theory that “you win some and you lose some.” In other words, “profits” from annuitants dying before life expectancy should cover “losses” from those outliving their life expectancies. But most organizations pull 100% of an annuity’s funds when an annuitant passes away leaving a pool that is filled only with the “losers,” those outliving their life expectancies. Coupled with unexpected 25% investment losses in principal this past year and this is why we’ll soon start seeing CGA programs fail.
You should consider developing a policy to leave something from every annuity in your CGA reserve account – look at it as a rainy day fund. One large charity I know actually leaves all of the “liability” portions of each matured annuity in its reserve – creating an unrestricted endowment within their CGA reserve account. Even after years of offering even higher than ACGA rates, this past year’s market losses didn’t have a material impact on their program.
And, in dealing with a fund currently in danger of exhaustion – or at least a few years away, one solution after adding the proper reserves that the New York State Department of Insurance requires (and not a bad idea for non-New York licensed issuers either) is to leave 100% of new matured annuities in the fund until the pool has recovered. I know that your donor’s wishes may be delayed a bit, but you also have to make sure your program and organization is solvent.
Eventually, with careful supervision and understanding that CGA programs don’t run on autopilot, your program can be back on track for providing long-term financial resources for your institution.
Jonathan Gudema, Esq.
Changing Our World, Inc.
I was wondering if I am crazy or not. Was I the only one in the planned giving world ringing the alarm, calling out to whoever would listen, that many gift annuity programs might be in big trouble? When you are an alone alarmist, you have to start wondering.
At Planned Giving Day in New York a few weeks ago, I presented on a panel various “doomsday” projections about exhausting CGAs but the response was quiet – too quiet, like maybe people didn’t want to hear the message or maybe I was wrong. There was of course the misleading article in the Wall Street Journal, hardly backup for my theory that CGA programs in general could be in trouble.
Finally, Frank Minton on PGCalc’s latest webinar on Advanced Gift Annuities dedicated the first 20 minutes of his presentation, billed as a discussion on advanced and new gift annuity techniques, to “risk control.” And, listening to Frank’s presentation and seeing that he used similar projection models to what I use, mostly “what ifs” using assumed constant rates of return, I know I am not crazy.
Here is the bottom line in what I found with the NEW (February 2009) ACGA rate tables. If your program returns 4% a year constant returns, I feel comfortable saying that your program will never experience (or very rarely) exhausting CGAs. Great news if you think 4% is attainable on a consistent basis.
The problem is what are we to do with older annuities? Under the same analysis on ACGA rates a few years ago, I figured out that you need to return 5% a year consistent returns, to be generally safe from gift exhaustion. Less than that, not always safe.
But the problem gets even stickier. I know from experience that even the biggest and best gift annuity investment/administration providers have seen the CGAs pools on their watch drop over 25% in principal value since January 1, 2008. That is on the conservative side – I am sure many have lost more. And, as CGA payments don’t change, the rate of diminishing principal speeds up even if you return to “normal” investment returns. What I mean is that your program may seem ok but really it’s not – one big annuity that runs out of money could bring the rest of your pool underwater with it. You don’t want to be hoping that your donors don’t live into their 90s because their annuity principals will be gone and perhaps eating up the rest of your pool.
In the midst of working through sticky situations for clients, I finally started feeling a ray of hope. Not that all will be well with every annuity out there – certainly not – as many are paying the price now for offering rates over the ACGA tables, or for the ACGA rates being too high, or for sloppy oversight, or for uncontrolled gift acceptance policies, or for small organizations taking on CGAs when they shouldn’t have, or taking on CGAs much too large for certain organizations.
The point is that proceeding carefully from this point forward can rescue your CGA program from “doom” that might be coming. Wake up now. Ask your provider for an updated “market value” report showing the current value of every annuity. Create an excel spreadsheet calculating what happens to the principal of each annuity under different flat rate assumptions over the next 10 to 20 years. Here is my super-secret excel formula for doing this: =(C1*$A1)+C1-$B1, column A is the assumed rate of return, column B is the fixed annuity payment, column C is current principal, put the formula in column D and then drag it over the next 10 to 20 columns. The $ sign keeps rate of return and payment amount fixed – the rest changes column by column – year by year. If you have trouble doing this, get someone from the finance department to help you.
You will start to see when CGAs are approaching negative. Maybe you will see an exceptionally large CGA that not only might run out of funds in 4 or 5 years, but will literally eat up the rest of the pool should it exhaust. It might be time to meet with that donor to see if he or she will take a lower income stream or would even give up all of the income.
New annuities are great for struggling pools as long as the pool isn’t so far depleted that news funds will only just push off the inevitable exhaustion of the whole pool – that really is more like a Ponzi scheme.
Perhaps it’s time to ask new CGA donors if they will take less than the ACGA rate – preserves a bigger remainder gift and bolsters the whole CGA program.
The biggest change though has to be your “remainder” policy. Dig deep enough into the CGA concept and you will find that the CGA program rests on the theory that “you win some and you lose some.” In other words, “profits” from annuitants dying before life expectancy should cover “losses” from those outliving their life expectancies. But most organizations pull 100% of an annuity’s funds when an annuitant passes away leaving a pool that is filled only with the “losers,” those outliving their life expectancies. Coupled with unexpected 25% investment losses in principal this past year and this is why we’ll soon start seeing CGA programs fail.
You should consider developing a policy to leave something from every annuity in your CGA reserve account – look at it as a rainy day fund. One large charity I know actually leaves all of the “liability” portions of each matured annuity in its reserve – creating an unrestricted endowment within their CGA reserve account. Even after years of offering even higher than ACGA rates, this past year’s market losses didn’t have a material impact on their program.
And, in dealing with a fund currently in danger of exhaustion – or at least a few years away, one solution after adding the proper reserves that the New York State Department of Insurance requires (and not a bad idea for non-New York licensed issuers either) is to leave 100% of new matured annuities in the fund until the pool has recovered. I know that your donor’s wishes may be delayed a bit, but you also have to make sure your program and organization is solvent.
Eventually, with careful supervision and understanding that CGA programs don’t run on autopilot, your program can be back on track for providing long-term financial resources for your institution.
Jonathan Gudema, Esq.
Changing Our World, Inc.
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