Chapter 12

PRESENT VALUE AND THE DISTANT FUTURE — PLANTING TREES AND LEAVINGA LEGACY

About two years ago, my wife and I bought a small farm north of San Francisco. With eight acres and two (rundown) houses on the property, it was only an hour away from our jobs and therefore an ideal short-term weekend getaway, a long-term retirement home for us, and maybe—if we are lucky—a place where our son and his family might one day come and stay. I can’t honestly say that I did a Present Value analysis when we bought the place. The simple fact was that we saw the property and just fell in love with it. But that being said, now that we own it, we are constantly having to make decisions that have Present Value at their core.

Most of those decisions are of a mundane, day-today type that we talked about in chapter 2 (e.g., whether to rewire one of the houses, put a new septic system in, and/or convert to solar energy), but more than a few are decisions whose future consequences extend beyond our lifetime. For example, the people who owned the property before us had a variety of animals. There were horse stables, chicken coops, and several fenced-in pastures for goats and sheep to graze. This is not our kind of farming, and so over the last several months we have been dismantling the infrastructure designed for livestock and thinking about what to put in its place.

Much of the property we want to keep clear and beautiful for walks and contemplation, but we also want the place to produce food, so we are now in the process of designing and planting an orchard, and here is where the Present Value considerations get very interesting. The variety of fruit and nut trees that could grow and flourish in this part of the country is quite large. Citrus, stone fruit, apples, pears, persimmon, pomegranates, avocados, olives, and a dozen kinds of nut trees are all possibilities, and each variety has its own particular personality and characteristics. In particular, each type of tree will take a certain number of years before it starts producing fruit and then have a productive lifespan that will vary considerably from tree to tree. Beyond that, each one will require a different level of care and have a different “risk profile” that will include not only the variability in year-by-year yield, but also the risk of early demise through disease or weather catastrophe. In short, with fifty trees to be planted, we have fifty different Present Value decisions to make.

It was also sobering to realize that at our age, the orchard we are planting will be around for decades after we are gone, and so the Present Value calculations we do need to take this into account. Unlike the time horizon we talked about earlier, we do care and place value on what the orchard will look like and produce after we are gone. It is a legacy that we will leave to our son and/or to those that may own the property in the future, and it has caused us to think hard about that distant future and make choices that go beyond those of chapter 11, where money doesn’t matter, to those where we are not even the ones who will face their consequences. Counterintuitive as it may be, I believe that Present Value thinking is just as important here as in any of the other types of choices we have discussed previously.

Leaving a Legacy

Much of this book has been focused on becoming conscious of the “time horizon” that is inherent in every decision that is based on Present Value. And there is no time horizon starker than one’s own death. None of us like to think about our eventual demise, but there are many decisions we make (or should make) whose consequences extend beyond our lifetime. The entire life insurance industry is built around the proposition that individuals should think about the next generation and what we will leave behind. As a result of our difficulty in thinking truly long term, they say that life insurance is “sold not bought,” and in many ways that’s true. If I hope to accomplish anything with this book it is to help readers take better control of many of the decisions in their lives and to “buy” rather than “be sold,” particularly when it comes to those decisions with consequences far in the future.

Right now, I am not going to tell you how to buy life insurance, but I do want to talk about a kind of decision and an opportunity that I believe more of us as individuals should consider and those of us who work at not-for-profit organizations should be attentive to. It’s the kind of decision where Present Value is front and center and where an individual can potentially impact the world in a positive way. It is also an area where a not-for-profit organization needs to consider Present Value very carefully. Specifically, I want to talk about the decisions we will all have to make eventually about where the assets we accumulate over our lifetimes will go when we are gone.

In 2001, my partner and I sold our little consulting firm to a big insurance brokerage firm, and I was given a relatively large lump sum of money. It was not so large as to radically change my life, but it was enough so that I needed to find a long-term investment for it and ideally do so in a way that would enable me to avoid paying a lot of up-front taxes. By now, it should be no surprise that I went through our 5-step process to evaluate the various alternatives I had with respect to using (or investing) the money. After going through the process, I decided to look for some kind of guaranteed lifetime annuity that would begin paying me when I retired. Unfortunately I was only forty-five years old, and far too young for an insurance company to be willing to make the kind of long-term investment guarantees that would be required to sell me such a product. As luck would have it, my old school heard about my windfall, and I got a call from Sam (the Planned Giving Officer) who, after hearing the details of my situation, presented me with the opportunity of obtaining a Charitable Gift Annuity (CGA) from the school.

The annuity I was offered was similar in structure to that of a traditional annuity purchased from an insurance company.⁵³ In this case, however, I would be able to combine my retirement planning objectives with the ability to benefit my alma mater. Specifically, I would make a large lump sum contribution to the school, and in return the school would promise to provide a guaranteed stream of payments to me that would begin when I turned sixty-five and continue for the rest of my life. The only difference between this and an annuity purchased from an insurance company was that my contribution would be considered a gift to the school because, upon my death any funds remaining after all annuity payments had been made would revert to the school’s endowment. As a result, in addition to receiving the guaranteed lifetime income, I would also receive an immediate tax deduction for the Present Value of what the school expected to recover from my contribution (and all the investment income they were able to earn on the funds) after I died.

Essentially, obtaining the CGA was like buying an annuity from an insurance company except that instead of profiting the insurance company, I would be making a deferred gift to an organization that I cared about. Surprisingly, however, the terms of my annuity (guaranteed income beginning twenty years after the purchase) were better than I could get from any insurance company then in the market. This seemed too good to be true. While Sam was an attorney and clearly knowledgeable about the mechanics of how CGAs (as well as all the other more esoteric Planned Giving products) operated, he was not an actuary and seemed unaware of how financially attractive to me (and risky to the school) this arrangement was. After checking the numbers and the documents to make sure I wasn’t missing anything, I signed up and purchased my CGA, feeling satisfied with my investment but just a little embarrassed (and concerned) by how grateful Sam seemed at the “extremely generous” gift to my alma mater.

The experience sent me scurrying to find out more about Planned Giving in general and the CGA market specifically. What I found was a world full of opportunity and risk that is operating, in my view, without adequate actuarial guidance. It turns out that when charities and other not-for-profit organizations (e.g., universities and hospitals) offer CGAs (as well as other “legacy” gift opportunities) to potential donors, IRS rules provide that such donors can get an immediate tax deduction for their deferred gifts. That is why I was able to get an immediate tax deduction for my purchase even though the school wouldn’t get full access to my contribution until (hopefully) many years from now. But the flip side of this is that—theoretically at least—charities are supposed to structure these arrangements in such a way so that a large portion of the initial amount contributed reverts to the charity when the donor dies. In fact the American Council on Gift Annuities (ACGA) does provide CGA rate guidelines to charities,⁵⁴ but because the charities are often short on internal expertise, these guidelines are often misinterpreted or misapplied. You are not supposed to get an annuity that provides more retirement income from your alma mater than from a company like Prudential Life Insurance.

After this discovery, I started talking to my not-for-profit clients about their Planned Giving programs and attending Planned Giving conferences to hear what the professionals had to say about how these programs are structured and what issues are current. Everyone seemed unfailingly excited about the future of Planned Giving and most of the talk centered around “marketing” and how charities could all get their fair share of this growing and potentially enormous market. And enormous it is. The estimates I’ve seen suggest that when the Baby Boomers eventually die they will leave behind about $41 trillion.⁵⁵ To me, the question of where that money goes and how it is managed is one of the important Present Value questions facing society today. Clearly, insurance companies and the financial services industry in general have their eyes on this pot of money. But, in a perfect world, charities and other not-for-profit organizations that benefit society should get a lot of it as well. In fact, the system is designed for that to happen because of the tax breaks donors receive and people’s inherent desire to benefit organizations that are trying to make the world a better place. Unfortunately, right now charities are losing the battle due to the public’s lack of awareness of these Planned Giving opportunities and the fact that for-profit companies (like insurance companies) have an overwhelming advantage when it comes to resources and expertise, particularly in the area of product development and sales.

I spoke earlier about how Planned Giving represents great risk and opportunity for charities. The opportunities are easily understood and fairly well known to the executive directors and management of most large not-for-profits. Being able to grow their endowment by having donors contribute lump sums now in return for making payments in the future is a benefit that you don’t have to be an actuary to appreciate, but even in the basic transfer of funds there are nuances that many organizations fail to pick up on. For example, because a CGA is a legally binding contract that a charity enters into, there are potentially better ways to structure a deferred gift by using what are known as Charitable Remainder Trusts (CRTs)⁵⁶ that essentially provide the same benefit (and more flexibility) to donors without the same legal restrictions inherent in a CGA. Beyond that, a direct bequest (i.e., writing the charity into your will) can provide a Present Value benefit to a charity that is often undervalued by the Planned Giving community.

As important as Planned Giving opportunities are for both individuals and the organizations that provide them, it is a shared responsibility between donor and charity to ensure a win-win result. The donor should be willing to take a modest reduction in the Present Value of their own retirement income in return for being able to direct some of his or her ultimate legacy to a worthy cause (thus maximizing the Present Value of the financial plus non-financial impact of their accumulated assets). At the same time, the charity needs to be able to provide the opportunity to do so with knowledge and attention to the financial risks inherent in CGAs and other Planned Giving vehicles.

There is a good reason why the deferred annuity I purchased was not available in the general market, and that is because the CGA I got contained interest rate guarantees that extended far beyond the duration of any existing corporate or government bond. This is important, because any organization that guarantees a future payment stream needs to find a way to invest the money received in a way to have reasonable assurance of being able to meet those guarantees. Insurance companies do this by setting up sophisticated bond portfolios whose income stream will match the annuity payment obligations they take on. From what I’ve seen among the charities and other nonprofits I’ve talked to, the most common investment approach taken is for the charity to simply invest the funds received in the same way as the rest of their endowment is invested. To me this is a very risky approach, as stock market crashes and/or significant reductions in interest rates can suddenly create situations where the charity will actually lose money on the CGAs they issue.

In addition to the investment/interest rate risk, there is longevity risk that charities take on when they issue CGAs that should not be underestimated. In addition to the fact that most donors who obtain CGAs are both financially secure (though often not rich) and healthy, there is “anti-selection” risk where individuals who, for one reason or another (perhaps based on family history), know they are more likely than most to live a long time are therefore more inclined than the general public to buy an annuity. By now, you should recognize these concerns as those associated with steps 2 and 3 of our Present Value process and therefore won’t be surprised to learn that insurance companies and their actuaries are very attentive to this risk and build in significant margins to their pricing to accommodate it. Beyond that, there are other more technical aspects to managing the risks of a Planned Giving program (e.g., concentration of risk in large contracts and fiduciary risk) where actuarial advice could provide a great deal of value.

As more and more Baby Boomers retire and consider their options for providing themselves with income to live on and think about the legacy they want to leave behind, I see a great need and an opportunity for society to benefit, but all concerned need to keep the principles of Present Value and the 5-step process front and center in their thinking. An opportunity like this is unique in history. Charities and other “mission driven” organizations are well positioned to address society’s most pressing needs (from healthcare to education, to poverty, deprivation, and beyond) while at the same time there is a whole generation of Baby Boomers who want to provide their support but are largely unaware of how Planned Giving can provide the means to do so.

To their credit, the nonprofit world has so far taken the “high road” and has not competed directly with the financial services industry, relying instead on speaking only to their donors’ philanthropic motivations, though as noted they often seem unaware of the risks they are taking on. While I don’t think it will ever be appropriate for charities to “compete” with insurance companies, my opinion is that as the stakes get higher, they will need to change their message to the coming generation of potential donors and obtain more help from the actuarial profession in all aspects of this field. That support will include setting payout rates on CGAs and CRTs as well as managing the underwriting risks and advising charities on investing their assets and hedging their liabilities. Actuaries could even be valuable in engaging with Congress and the IRS to protect the tax advantages that charitable contributions for CGAs and CRTs deservedly enjoy and may come under attack when the rest of the financial services industry realizes the extent to which Planned Gifts could eat into their future profits.

It’s a battle well worth winning, Present Value is the weapon of choice, and all of us can join the fight.