Stock Market, Interest Rates Force Nonprofit Groups to Rethink Charitable Trusts

The potential for payout problems with charitable remainder trusts is forcing charitable groups, donors, and financial institutions to rethink their giving approaches, and causing some donors to be more cautious in how they set up charitable gifts that fluctuate with interest rates or the stock market, planned-giving experts say.

In a typical charitable remainder trust, a donor contributes cash, stock, or some other asset to the trust, which makes regular payments to the donor. When the donor dies, any remaining trust assets go to charity. Because such trusts generate money by investing donors’ assets, a declining stock market or falling interest rates can erode the trusts’ principal and make it harder to pay beneficiaries and have money left for charitable uses.

During the late 1990s, charitable remainder trusts grew in popularity, according to the most recently available data from the Internal Revenue Service. In 1999, the revenue service says it received about 100,000 informational tax returns from charitable remainder trusts, up from 85,060 the year before.

But as more donors set up those trusts, some overlooked the possibility that the stock market might fall or that interest rates could plummet, says Doug White, a fund-raising consultant in Washington. “Some people are like dogs — they only think about the here and now,” he says. “But life cycles are longer than economic cycles. When you set up trusts, you have to look down the road.”

Four years ago, Joe Bull, director of planned giving at Ohio State University, got a call from a broker who planned to set up several charitable remainder trusts to benefit the institution that would pay donors 10 percent a year on the value of assets.

“Have you considered a trust that pays out less than 10 percent?” Mr. Bull recalls asking the broker. Paying out less, he says, would have allowed the trust’s assets a better chance to grow over a long period of time, which could have put more money back in the donor’s pocket and left a greater remainder for charity.

“Oh, come on,” said the broker. “We’ll easily make 10 percent in the market, so that trust is going to keep growing.”

While a 10-percent return on investment of assets might have been easy to make during a strong market, many charitable organizations and donors are worried that aggressive payout rates established in the past few years could “cannibalize” charitable remainder trusts now that the economy is sputtering and interest rates have reached 40-year lows, says Mr. Bull. “If you completely erode the principal value of a charitable remainder trust, there is no charitable remainder,” says Mr. Bull. “And if the assets go away, the donor doesn’t have an income stream anymore either.”

Eroding Principal

Merrill Lynch, which manages $4-billion in charitable-remainder-trust assets for private donors, has seen the principal erode in 35 to 45 percent of those trusts, says King McGlaughon, director of Merrill Lynch Center for Philanthropy and Nonprofit Management, in New York. “If you go into a charitable-remainder-trust strategy in an up market, and then the value of the trust goes down for two or three years, as many of these have,” he says, “it becomes very difficult to dig back out of that over time.

“A lot of people we see creating significant charitable remainder trusts who have been successful in their financial lives and fairly sophisticated in their investment strategies haven’t made the leap yet in their charitable giving,” he says. “They’re finally learning that they have to be more sophisticated.”

Donors have become more sophisticated, Mr. McGlaughon says, by diversifying their charitable giving with different kinds of charitable trusts and donations of property, artwork, and other valuable assets and by taking a more conservative, cautious approach to making gifts that fluctuate with interest rates or the stock market. Ten years ago, 75 percent of charitable gifts made by Merrill Lynch clients were established through a charitable remainder unitrust, which fluctuates with the market. Now, Mr. McGlaughon says, only about half of the firm’s charitable gifts come in that form.

Donors are still setting up planned gifts in large numbers, though not necessarily using approaches that are vulnerable to falling interest rates.

For donors on fixed incomes, gift annuities are among the more appealing options, says Shari Fox, president of Beech Acres Foundation, an organization in Cincinnati that teaches child-rearing skills. Gift annuities allow donors to contribute assets to a charity in exchange for fixed annual payments. The percentage of a gift that a charity pays to a donor varies with the donor’s age. Younger donors receive smaller payments because they are expected to live longer than older ones.

“Gift-annuity rates are quite attractive when compared with other fixed-income rates,” says Ms. Fox. “We’ve seen several people who have CDs maturing inquire about gift annuities.”

The yield on a one-year certificate of deposit is currently between 2 percent and 3 percent, and the yield on a five-year CD is about 4 percent, according to Bankrate.com, a Web site that tracks interest rates. By comparison, the gift-annuity rate for a 70-year-old donor is 6.7 percent, according to the American Council on Gift Annuities.

Gifts of appreciated real estate also have grown in favor, especially among wealthy donors in some large cities, planned-giving experts say.

The California Community Foundation, in Los Angeles, received several real-estate gifts valued at more than $8-million last year, says Peter Dunn, director of gift planning. “Real estate is a conversation that has picked up a lot and we anticipate will keep going,” he says.

Trusts ‘On Sale’

In addition to gift annuities and real-estate donations, charitable lead trusts are gaining in popularity, planned-giving experts say. In a charitable lead trust, a donor makes a large gift to a charitable organization, with the money distributed to the charity in annual fixed payments over a specified period. Whatever money is left at the end of that time is passed along to the donor’s beneficiaries, in some cases tax-free.

With low interest rates and a low IRS discount rate — the rate used to calculate the tax deductibility of most planned gifts — the lead trust is “basically on sale right now,” says Robert F. Sharpe Jr., a planned-giving consultant in Memphis. “The lower the interest rate,” says Mr. Sharpe, “the greater the gift the charity receives, and the less the gift is taxable to heirs.”

If a donor set up a charitable lead trust in July 2001 with a 7-percent annual payout rate to charity, Mr. Sharpe says, it would take 40 years for the beneficiaries to receive a tax-free distribution. If a donor set up a 7-percent lead trust today, it would take just 20 years for beneficiaries to receive a tax-free distribution, he says.

Although most planned-giving experts say that charitable lead trusts are infrequently established because donors must give up a large asset without being able to earn interest on it, organizations that have large numbers of wealthy donors are encouraging them, says Mike Goodwin, vice president for alumni and university relations at Georgetown University, in Washington.

During the past few years, Georgetown has attracted three or four lead trusts in the $1-million range. The university is trying to publicize lead trusts by sending letters about them to its board of regents and by having its major-gift staff interject the concept into conversations with donors. “Not every donor can do a lead trust,” says Mr. Goodwin, “but we like them because we get cash flow right away.”