Charitable Strategies
Americans are the wealthiest and most charitably inclined people in the world. During the last quarter of the twentieth century, there was unprecedented growth in the wealth held and controlled by individuals and families in the United States. By the beginning of this century, nearly 5 percent of all American households had a total household net worth of $1 million or more. At a higher asset level, there were approximately ¾ of a million households in the United States with net assets in excess of $5 million. Of these pentamillionaires, 40 percent fall in the 65-years-and-older age range.
The frequency of planned gifts increases among all wealthy people as they age. Wealthy individuals age 65 or older use various planned giving tools at consistently higher rates than individuals in other age groups.
The first step in addressing philanthropy in the process of comprehensive wealth planning is to understand the various tools of charitable giving within the parameters of the traditional planning processes. At a basic level, the objectives of traditional financial and estate planning can be distilled to the following:
• strategies designed to produce income
• strategies designed to reduce or eliminate taxation of income
• strategies designed to position or reposition assets for either growth or income
• strategies designed to reduce or eliminate taxation on the positioning or repositioning of assets
• strategies designed to protect assets from market value decline and from claims of creditors, family members, spouses, litigants, etc.
• strategies designed to protect assets from potential adverse market conditions or claimants while preserving the income production capacity of those assets for personal or family use
• strategies designed to transfer assets to particular individuals (heirs) or classes of individuals in a controlled manner
• strategies designed to reduce or eliminate taxation upon the transfer of assets to others
• strategies designed to use and manage “philanthropic capital” effectively and efficiently
• strategies designed to retain some degree of “control” over assets as those assets are incorporated into strategies with the foregoing purposes
Advisors who engage individuals in planning will necessarily need to identify planning goals from among those goals listed above. All of the above could essentially be reduced to two major issues:
1. I do not want to outlive my assets.
2. I want to pass on as much as possible of what is left.
Perhaps, one of the least utilized planning techniques in Estate and Charitable Planning that perfectly addresses the two above mentioned goals is Actuarial Arbitrage. The following few paragraphs will describe some of the major applications of the concept.
Actuarial Arbitrage as an Income and Estate Planning
Tool for Older Client
Traditional
The traditional actuarial arbitrage is a financial planning tool that creates much greater after tax cash flow and greater transfer to heirs than is otherwise possible with investment assets inside an estate. The traditional straddle, when used, increases after tax cash flow through life expectancy and estate transfers by 100%. It is a combination of two basic financial instruments: life insurance (“LI”), and a single premium immediate annuity (“SPIA”). In its traditional sense, this straddle combines life insurance covering an individual and a SPIA providing guaranteed annual income for that person’s (the annuitant’s) lifetime. The SPIA income can be used for personal expenses, gifting and life insurance premium payments.
The traditional actuarial straddle is able to increase after-tax cash flow for an individual and eliminate certain assets from the individual’s estate, which then results in reduced estate taxes. The asset used to purchase the SPIA is replaced with life insurance outside the estate. The straddle works ideally with older individuals over age 65 who are insurable as a table rating of “B” or better. Obviously, there is a play between the insurance company providing the life insurance and the one providing the SPIA because the actuarial assumptions are different. Life insurance is medically underwritten while annuities are generally not. Additionally, life insurance premiums are generally discounted by Lapse Ratios. Typically, the straddle uses a “life-only” annuity payout option whereby at death, the income stream ceases, and the asset used to purchase the SPIA is eliminated and therefore not subject to estate taxes. But, at the same time, the life insurance owned outside the estate pays an offsetting or greater death benefit.
In the non-charitable environment the Straddle is applicable to both qualified and non-qualified assets, By-pass Trust funding, Private Premium Financing and 1035 exchanges.
There are also several unique application of the concept within the context of Charitable Planning
Charitable Remainder Trusts
A charitable remainder trust makes payments to an individual (or individuals) beneficiary for a term of years or for the lifetime of the beneficiary. At the end of the trust term, the assets of the trust are distributed to a charitable organization. The payments to the beneficiary can be either in the form of an annuity or a unitrust amount. A charitable remainder annuity trust (“CRAT”) pays a fixed dollar amount each year to the beneficiary. A charitable remainder unitrust ("CRUT") pays out a fixed percentage of the value of the trust's assets determined annually to the beneficiary.
The CRAT buy both a SPIA and the Life Insurance policy on the life of the donor. The resulting net cash flow will generally be between 8 to 12 % before tax. At death the remainder (death benefit) is paid to the charity.
Charitable Lead Trusts (CLT) A qualified CLT grants a qualified income interest to one or more charities and provides for the remainder of the trust assets to pass to one or more non-charitable beneficiaries. A qualified income interest is either an annuity or a unitrust interest, payable at least annually.
The idea is the same as in CRATs. The life insurance and SPIA combination produces guaranteed stream of payments for Charity during the lifetime of the donor and GUARANTEES a 100% transfer of assets to non-charitable beneficiaries in the form of a Death Benefit.
The common Gift Annuity is funded either with cash or publicly traded securities. It is established either by a single donor who is also the annuitant, or by a husband and wife who contribute jointly-owned or community property for a joint and survivor annuity. Annuity payments are made until the death of the sole or surviving annuitant, whereupon the residuum is used for charitable purposes. The problem is generally is with the remainder. Gift annuities are priced in such a way as to retain ½ of its original value at life expectancy. Essentially, someone making a $1,000,000 gift to his/her favorite charity in the form of a Gift Annuity, only making a gift of $500,000.
If this person utilizes Actuarial Arbitrage technique, there is a substantial guarantee that the charity will receive a full $1,000,000 without any reduction of income to the annuitant!
Summary
When determining the overall investment policy to implement for a CRAT, CLT, or a Gift Annuity, several assumptions must be made. The first is an assumption as to the rate of appreciation of various types of assets, such as taxable bonds, tax-free bonds, and equities. Equities have historically yielded the highest overall rate of return on investment, but when market conditions are down, bonds are often viewed as a safer investment. Historical data suggest that, over long periods of time, bonds can be expected to yield a return of approximately 5% per year (depending on interest rates), while equities will have an overall rate of return far in excess of 5%. To minimize risk, yet retain the potential for increased returns, most investment advisors recommend an investment strategy that includes both bonds and equities.
By utilizing Actuarial Arbitrage Strategy, planners, Charities and donors virtually eliminate market risk, investment risk and life expectancy risk.
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