Annuity Quandary

The economic downturn has turned the business of higher education into a school of hard knocks, forcing investment chiefs to rethink strategies that may have been highly lucrative just a few years ago. While there are indications that some colleges will re-evaluate their overall investment approaches, it’s likely that they’ll reserve the most conservative strategies for assets garnered through annuities, which are gifts colleges can't fully collect until after the donor's death.

Colleges have increasingly made annuities part of their fund raising portfolio in recent decades, in large part because they give peace of mind to donors who want to pledge gifts but worry about needing money in the future. The arrangements allow donors to give cash or other assets in exchange for lifetime monthly payments of pre-designated amounts. The colleges get to keep whatever is left when the donor or donors die, and typically that’s about 50 percent of the value of the initial gift. While the donor or donors oftentimes receive the annuity payments themselves, there are arrangements in which a donor can designate another annuitant.

The annuity system has worked so well for colleges and other charities that they’ve entered into more and more such arrangements in recent years.

But there’s a significant difference between annuities and other types of gifts, and it has everything to do with the strings attached. Colleges that saw endowments plummet in the last year have simply had to learn to do more with less, but obligations to make monthly annuity payments don’t cease simply because market losses significantly devalued the initial gift. In other words, colleges are on the hook to pay up regardless of circumstances.

Annuity experts have long advised charities to play it safe with investing these gifts, precisely because the payments extend for periods that aren’t precisely predictable. Several states even have rules that govern how annuities can be invested. Despite that advice, however, some college investment managers may now have learned the hard way about investing annuities with caution, according to Frank Minton, senior advisor for PG Calc, which advises charities and colleges on planned giving.

“I would say that charities have become more conscious of the risk in gift annuities than they were in the past, and some of them are certainly re-assessing how they invest gift annuity reserves,” Minton said. “That certainly has been a consequence of the last year.”

As a general rule, it’s prudent for college managers to employ a more conservative investment strategy with annuities than with endowments as a whole, opting for safer and lower-returning instruments like bonds, as opposed to equities, Minton said. That hasn’t always happened in recent years, however.

“I think there were a number of charities that invested too much in equities and maybe the sustained bull market lulled charities into a sense [of security],” he said. “Maybe it caused some charities to not fully recognize the risks inherent in heavy equity investments.”

California, Wisconsin and Florida actually restrict the amount of gift annuity reserves charities and colleges can invest in equities, but regulations are not as strict across most of the nation.

High Returns Provided Cushion

While colleges may move toward ever more conservative investment approaches in the future, the more aggressive tactics some employed with annuity gift investments in recent years may prove a saving grace of sorts. Colleges that invested annuity gifts just as they did their endowments likely saw significant returns, better positioning them to absorb the heavy losses that have occurred since September.

At Duke University, annuity gifts are invested in the same way as endowment funds are, according to Phillip Buchanan, vice president of gift planning. Duke, one of the nation’s wealthiest universities, saw its endowment drop by 19 percent between July and December of last year. Even so, those losses came on the heels of record returns for Duke, and Buchanan says previous investment success largely insulated the university’s annuities.

“We’re a long way from losing money on any gift annuity we’ve done, even in the last couple of years,” he said.

Given the payment obligations that annuities create for universities, some have questioned whether fund raisers will move away from annuities altogether amid the downturn. Duke currently has about 360 gift annuities, however, and Buchanan says the university doesn’t plan to slow its growth in that area.

“I went to our leadership and said, ‘The market’s crashing, do we want to rethink what we’re doing with gift annuities?’ and the response was no,” he said.

The use of gift annuities among charities and colleges has steadily grown in the past several years, according to the American Council on Gift Annuities. In a 2004 survey of nearly 830 charities, about one quarter said they had started a gift annuity program in the past five years. The size of the gifts has also increased, climbing from an average of $30,182 in 1999 to $59,926 in 2004, the survey found.

In an environment where even wealthier donors are worried about their financial futures, gift annuities are likely to grow even more, according to Robert Sharpe, a charitable gift planning consultant and president of the Sharpe Group. Colleges, however, may be less inclined to enter annuity agreements with younger donors, hoping to lessen the risk of long-term payouts.

“[Colleges] should probably be very careful about new annuities and they should probably consider raising the minimum age for which they do annuities,” Sharpe said. “But not doing annuities and trusts in this environment, that’s not going to happen.”

Stopping Payments Not an Option

Some have raised concerns about whether charities that have fallen on hard times would begin to default on annuity payments. After the National Heritage Foundation filed for bankruptcy, for instance, annuity payments stopped for many donors. That incident prompted The Wall Street Journal to report that charitable gift annuities “don’t always deliver what they promise.”

The Journal article has drawn considerable criticism from charitable giving planners, who say the newspaper falsely described isolated incidents as a growing trend. If annuity gifts went under water, colleges would be obligated to find money elsewhere to make monthly payments, according to Ronald Brown, director of gift planning at Princeton University.

“If we had to sell our main administration building in order to make those payments, God forbid, we’re [still] required to make the payment,” he said.

But as more colleges face financial difficulties, might they look to donors to forgo annuity payments? Legal restrictions don’t allow withholding of payment even with the annuitant’s permission, Brown said. There are circumstances, however, where an annuitant returns payments to a college, according to Sharpe.

“I do think some people would give the payments back for a few years if they don’t really need it right now,” he said. “It’s certainly a legitimate thing to consider in this environment.”

Annuities Less Common for Small Colleges

Given the risks associated with gift annuities, some less wealthy institutions have been reluctant to enter into such agreements. McLennan Community College in Waco, Texas, for instance, has held off on starting an annuity program.

"Small operations usually don't get involved with charitable gift annuities at all because they can't spread the risk," said Harry Harelik, executive director of the McLennan Community College Foundation.

McLennan's endowment has assets of about $7 million, and Harelik says he thinks an institution would need between $30 million and $40 million to safely shoulder the risk of gift annuities. That said, small colleges have other options. McLennan is considering the possibility of investing annuities with the Waco Foundation, an outside group that could manage the college's annuities along with the assets of several other charities and organizations, thereby spreading the risk.

Harelik says recent media reports, specifically the Journal's piece, have given some donors the jitters about annuities. The risk, however, is "more scary than it is real," he said.

"They are not going to be putting all those dollars in a risky market investments," Harelik said. “If they’re doing things properly I don't think there should be great cause for concern."