The economic crisis has dominated the headlines since September 2008 and taken its toll on individuals and institutions alike. Few have been immune to the effects of a volatile stock market, low interest rates, rising unemployment, tight credit markets, and plunging real estate values.
Today, leaders at many colleges and universities are trying to manage the adverse effects of depressed endowments and a precipitous drop in private donations. Two of the most highly publicized examples have included a university in the Northeast that was forced to consider selling a 6,000-object art collection to raise funds and one Southern college's decision to put its president's home on the market in order to cut operating costs.
Further, all this is occurring at a time when the financial pressures facing universities, such as higher operational costs and a greater need for financial aid, continue to mount and intensify. Now more than ever, keen fiscal management is a critical discipline needed at institutions of higher education where every program and department has probably been or will likely be evaluated by its financial impact on the overall organization.
In light of the current economic environment, many institutions have begun to examine more closely charitable gift annuities as a planned-giving program. A review and evaluation of a charitable gift annuity program is important, because it can impact both financial risk management and development opportunities.
A charitable gift annuity arrangement is a contract between a donor and the university. The donor makes a contribution to the school and, in return, receives an income for life, as well as a charitable tax deduction. By entering into these arrangements, universities have, in effect, entered into the insurance business.
Charitable gift annuities are increasingly appealing to people seeking additional income, typically in retirement, and who are also philanthropically minded. The bottom line is that they are a good way to attract new donors, especially in this economic climate.
From a risk management perspective, one financial aspect of charitable gift annuities is that they can expose the university to a number of risks, such as market risk and longevity risk. Both of these risks can potentially impact the gift that the university ultimately receives.
With market risk, the volatility of returns inherent in the financial markets can negatively affect the investments that the university relies upon to produce the income needed to pay the donor.
Longevity risk poses a different kind of threat. The longer the donor lives, the more payments they are entitled to receive. Thus, a long life for the donor can mean less money—and in some cases, no money—left for the university and its programs. A charitable gift annuity program can in fact subject an institution to serious financial uncertainty.
An effective way to help eliminate the uncertainty created by these risks is through an arrangement commonly known as "reinsurance." In such an arrangement, the university uses a portion of the donor's gift to purchase a single-premium immediate annuity from an insurance company. The income generated by this immediate annuity is set up to match the university's obligation to its donor under the charitable gift annuity. The insurance company, as a result, assumes the investment risk underlying the gift annuity, thus eliminating the possibility that the university's investments cannot support the gift annuity payments. In addition, longevity risk is also transferred to the insurance company, thereby removing the risk that the donated assets will be diminished due to the donor living beyond his/her life expectancy.
Another aspect of charitable gift annuities is that they are illiquid—meaning the portion of the donation that's not needed to support the gift annuity payments may not be available to the university until some point in the future when the gift annuity terminates. This could be decades into the future. So, in effect, the more gift annuities a program has, the more illiquid assets it must maintain.
Through a reinsurance arrangement, an institution can gain access immediately to the gift portion of the donation. (Note: Because state laws vary on the use of immediate annuities to reduce reserves that charities must maintain in connection with gift annuities, it's important to consult a legal advisor on this issue.) Since the insurance company is now providing income that matches the university's gift annuity obligations, the remaining funds (those not used to purchase the commercial annuity) are freed up and available for the university's programs. What's more, these freed-up funds may actually exceed the present value of that portion of the gift that becomes available in the future when the gift annuity obligation ends.
Insurance companies are well suited to take on the risks associated with annuity payment obligations. Insurers typically deal with tens of thousands of lives, and although they face the same market and longevity risks mentioned earlier, the risks are spread over all those lives. This concept is known as "risk pooling" and the law of large numbers. It's used by insurance companies that have the scope and scale needed for effective risk management.
Therefore, the negative impact that one life can have on the entire portfolio of annuities is significantly less for an insurance company than it would be for a university, which has far fewer lives over which to spread the risk. Simply put, through reinsurance, colleges and universities have a ready way to utilize the advantages of the risk pooling employed by insurance companies.
Reinsurance also provides universities with a high degree of flexibility in gift annuity program implementation. Institutional leadership can examine the total book of existing gift annuities and determine which ones should be reinsured in order to strengthen the overall position of the institution. For example, they may decide to reinsure the largest annuities to limit the exposure concentrated in just a few lives. The university may also consider reinsuring multiple annuities issued to the same donor to limit the potential impact one life can have on the program's total performance. The same flexibility applies to new gift annuities, as well.
In one of the toughest fundraising climates on record, a charitable gift annuity program can be advantageous for attracting new donors. As reinsurance strengthens the underlying gift annuity program, it supports marketing opportunities for the development office. The charitable gift annuity program may attract additional donors utilizing reinsurance, because:
- In many cases, the gift portion may be used right away, which means donors will get to see their money doing good for the university while they're still alive. Promoting this benefit may potentially attract additional donations.
- It can be reassuring for donors to know that the income obligation is now backed by a large and financially sound insurance company (whose financial resources may be more substantial than those of the school).
In these challenging times, charitable gift annuities may also attract donors who would otherwise give an outright gift, but who are not in as generous a position as they once were. The prospect of receiving a lifetime income from the university may entice such potential donors to consider giving to the school even in this belt-tightening environment.
Over the past year, many universities have seen their gift annuity programs become potential drains on their endowment pool instead of contributing to it. This comes about as a result of risk taking and circumstances far beyond the control of any program director.
Reinsurance has emerged as a sound solution for many of the financial challenges that can strike a gift annuity program and erode its prime objective—to generate additional resources for the college or university.
To summarize, reinsurance can help an institution:
- Transfer significant risks inherent to the program—such as longevity and market risks— to an insurance company.
- Put donor funds to work immediately.
- Provide flexibility in limiting negative exposure posed by just a few lives.
- Better forecast the funds that will be available for specific programs.
When considering reinsurance, it is crucial to consider the financial strength of the insurance company. While the insurance company assumes the risks associated with a gift annuity program via the immediate annuity, the obligation to pay the donor remains that of the school. Selecting a financially strong insurance company will only solidify the gift annuity program. It can also provide an extra degree of comfort to donors entering into a gift annuity contract with the university.
A well-designed charitable gift annuity program can be a great asset for any school or charitable organization. A decision to utilize reinsurance will help an organization make the most of its program by helping it limit its downside while expanding opportunities for continued growth.
Bob Rock is senior vice president of Retirement Income Security Operations at New York Life Insurance Company.