Investing Charitable Gift Annuity Assets

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1 Investing Charitable Gift Annuity Assets Thursday, April 6, 2006 J. Scott Kaspick Managing Director David A. Libengood Relationship Manager KASPICK & COMPANY, LLC Redwood Shores, California Boston, Massachusetts

2 Investing Charitable Gift Annuity Assets J. Scott Kaspick David A. Libengood AGENDA In scope a) Regulatory environment as it pertains to investing gift annuity assets b) Financial risks to the charity c) Basic portfolio design and execution for gift annuity assets d) Assessing your investment decision e) What it all means for best practice policies and procedures Out of scope a) Regulations not having to do with investments b) Legal and regulatory risks c) Risks to the annuitants d) Reinsurance issues and possibilities CONTEXT FOR UNDERSTANDING INVESTMENT ISSUES Assumptions behind the ACGA rate tables a) 50% residuum target in nominal dollars (not inflation-adjusted) b) Expected contract horizons are determined using Annuity 2000 tables, and further assuming all donors are female, with a 1.5 year age set-back c) 1% management / administration expenses d) Portfolio allocation of 45% equities, 55% bonds, and 5% cash e) 6% annual total return before fees or 5% after fees

3 Regulatory environment as it pertains to investing gift annuity assets a) Unregulated states (state law is silent or exempts charities from registering) b) States that require reserve accounts c) States that impose investment restrictions on reserve accounts i) California and Florida Maximum of 50% of reserve in equity investments ii) Wisconsin Maximum of 20% d) Recent evolution toward more investment flexibility NY Now applies a prudent investor standard, in place of a cap on equities NJ and AR Have also moved to prudent investor standard CA Now caps equities in the reserve account at 50%, up from 10% RISKS FACED BY CHARITIES OFFERING GIFT ANNUITIES Risks should be assessed within the context of the individual institution a) The total size of the gift annuity program relative to the charity s unrestricted assets b) Financial health of the charity c) Risk profile of the charity d) Age of the program Risks outside of the charity s control a) Mortality risk donors live longer than expected based on mortality tables b) Market risk charity does not achieve the long-term expected return, or experiences a prolonged market downtown (particularly at the start of a contract) Risks within the charity s control a) Rate risk charity issues gift annuities at rates higher than ACGA rates b) Spending risk charity spends a portion of the gift before termination c) Funding risk funding assets do not sell right away (e.g., real estate) or sell for less than the gift value d) Size risk charity writes very large gift annuities e) Concentration risk a disproportionate amount of the dollar payments from the gift annuity program are made to one annuitant, or a few annuitants f) Fee risk charity pays too much for the management of its program

4 Other risks a) Start-up risk charity has a relatively new planned giving program that did not experience the 90 s bull market b) Regulatory risk charity is constrained in its investment strategy by regulators c) Prior misfortune risk poor policy decisions and/or unsuccessful investment strategies of predecessors put the program assets at risk today Implications of these risks a) Contracts run dry and the charity must make payments from some other source b) Residuary amount does not meet the intended gift purpose ASSESSING YOUR INSTITUTION S RISK To understand the primary risks in your portfolio of gift annuity contracts, begin by collecting data about each contract a) Gift amount b) Gift date c) Current market value (assumes gift annuity pool is unitized) d) Annual payment e) Payment frequency f) If deferred, the date of the first payment g) Horizon (genders and dates of birth) h) Annuity 2000 liabilities i) Designated use of contract residual amounts Research the following about your program a) Current investment strategy and long-term expected returns b) Prior gift acceptance and investment policies c) Prior years investment performance Do some basic calculations a) Calculate the pool s effective payout rate and the weighted average horizon and compare to ACGA rates b) Calculate the Annuity 2000 liability for each contract; compare to its market value c) Roll up the liability/market value comparison to your entire program d) Examine the concentration of annuitants (in terms of annual payments) e) Identify any underwater contracts (contracts where there are no assets left)

5 INVESTMENT PLANNING STEPS Basic investment planning steps are similar to endowment or planned gift portfolios a) Review the investment objectives b) Understand the primary risks c) Establish a long-term asset allocation policy, paying close attention to diversification d) Determine market style exposure (value vs. growth, active vs. passive) e) Select investment managers f) Rebalance the portfolio regularly g) Codify the investment objectives and policies in a written document h) Revisit policy decisions regularly and whenever you consider a large new contract Stress your investment decision and look at the results a) Reduce assumed investment returns b) Lengthen mortality assumptions c) Focus on the largest contracts, and the underwater contracts d) Look closely at the contracts written in , near the peak of the market e) Determine the extent of the charity s exposure by subjecting suspect contracts to downside risk analysis f) Consider Monte Carlo simulations to frame probabilities for discussion with senior staff and trustees Portfolio execution best practices a) Unitize your portfolio of contracts b) Put in place an efficient custody structure, given state regulations c) Promptly sell donors donated securities d) Have in place a disciplined rebalancing policy e) Pay low (reasonable) fees f) Tightly manage cash

6 WHAT ARE THE POLICY IMPLICATIONS? Some best practices a) Develop a written policy statement for your gift annuity program Minimum ages for gift annuities (current and deferred) Maximum gift amounts Acceptable funding assets Gift acceptance decision-making process b) Follow ACGA rates c) Do not spend any of the donated assets prior to termination d) Develop acceptance policies and analytical approaches for dealing with gifts of illiquid assets (e.g., real estate) or don t accept them e) Determine a maximum liability per annuitant f) Determine a maximum program liability g) Develop a policy for dealing with underwater contracts before you have any (or at least well in advance of their market values going negative) h) Involve your senior staff and the trustee investment committee in a periodic review of the program Remediation efforts for underwater contracts a) Make payments from operating funds b) Make payments from total gift annuity program assets (but be aware of the impact on other contracts including ones with restricted purpose residual interests) c) Set aside residual distributions from terminated unrestricted contracts d) Impose a tax on all terminating contracts e) Impose an annual tax on all contracts in the pool to fund a reserve f) Ask the donor to give up his/her income interest