When Brian, a successful young North Carolina businessman, notified the planned giving department at a mid-size Southern university that he had irrevocably named them as the remainder beneficiary on his $1 million charitable remainder unitrust, the fundraisers gave each other some high-fives. But the celebration was muted by the fact that the university estimated it would take more than 30 years to
When Brian, a successful young North Carolina businessman, notified the planned giving department at a mid-size Southern university that he had irrevocably named them as the remainder beneficiary on his $1 million charitable remainder unitrust, the fundraisers gave each other some high-fives.
But the celebration was muted by the fact that the university estimated it would take more than 30 years to receive its remainder interest. Thirty years is a long time to wait.
As James Lintott, my Reston, Va.-based colleague at Sterling Foundation Management, puts it: “Illiquid assets, like CRT remainder interests, are nice to have, but they don't pay the rent. Most charities don't like to hold them if they have any choice. It is common for charities to immediately seek to sell illiquid assets they receive as gifts.”
Charities have to value distant gifts correctly before they can make smart decisions about investing and planned-giving fundraising. Although there are several methods for calculating the value of being named as a remainderman on a CRT, the best by far is the discounted-cash-flow approach. Unfortunately, nonprofits often use other, less-favorable, strategies — and suffer unfortunate consequences.
One common mistake is that charities go to extremes when valuing the remainder interest, assessing it at either zero or the full current value of the trust. These crude methods are almost always wrong. The justification for using zero is, “aw-shucks, we'll take it when we get it.” This approach is obviously a mistake, because the value is never just zero. It is also harmful, because such thinking likely will discourage the charity from investing resources in trying to obtain CRT gifts.
The other extreme is just as bad. The remainder could be worth the full current value of the trust only by the sheerest chance; more likely, it won't be worth anywhere near that much. Such overvaluations, if believed, are harmful because they could lead charities to spend too much trying to obtain CRT gifts.
Another typical but problematic approach — I call it the “IRS table” method — involves valuing the interest according to Internal Revenue Service tables and interest rates. One of the advantages of this method is that it attempts to account for the fact that the charity isn't getting the money right away. It's also a vital tool, consistent from donor to donor. But it isn't the most appropriate choice for most charities.
Essentially, the IRS table method involves a complex actuarial calculation that divides the total value of the charitable remainder unitrust (CRUT) assets into two pieces, then assigns one the lead interest and the other the remainder interest. But the problem is that the calculation does not take into account the growth rate of the underlying assets, nor the discount rate for having to wait to get the money. This formula can lead to valuations that most people would consider wrong.
In today's economic environment, the table method probably overvalues the remainder interest compared to the discounted-cash-flow-method value. Consider this example: A healthy 65-year-old man creates a 7 percent CRUT and funds it with $1 million. According to the actuarial tables, he has a life expectancy of about 17 more years. The IRS table valuation of the remainder interest would be about $358,000.
A charity that really believed that the remainder interest was worth $358,000 would be willing to spend nearly that amount to gain such a donation. Alternatively, it would refuse to sell its remainder rights for less than $358,000. But is this smart or reasonable? The answer is, “No.”
It's far better to use the discounted-cash-flow method: First figure out the future value of the remainder interest, then discount it by the appropriate discount rate. How does a charity judge which rate is appropriate? One possibility is to figure out what rate of return it would insist on before tying up its money for 17 years. Even with today's low rates, it's hard to imagine that the return required for such an investment would be less than 12 percent. Yet the required rate of return implied by the IRS table method is less than half of that.
In our example, if the assets in the trust return 7 percent a year, and the donor dies in 17 years, the charity then would receive about $950,000. If $358,000 grows to $950,000 in 17 years, that's a return of about 5.9 percent — which is less than the rate of growth assumed on the underlying assets.
The present value of the right to receive $950,000 in 17 years, calculated with a 12 percent discount rate, is about $138,000. Even an extremely conservative discount rate of 7 percent yields a present value of just $300,000. So, with any reasonable discount rate, the IRS table method significantly overvalues the remainder interest.
So what discount rate is correct? Certainly higher than 7 percent, says Bret Tack, a principal in the main Los Angeles office of the firm Houlihan Valuation Advisors. In fact, Tack says, nonprofits should expect a significantly higher return than they would earn on the underlying assets, because the invested funds are tied up for an uncertain, and often very long, period of time. According to Tack, the charity should ask itself, ”Would we willingly tie up $300,000 for 17 years to earn 7 percent?” Because the charity would expect to earn that anyway by investing in the same assets as the CRT, pretty much everyone would say, “No.” After all, why lock up the assets if you can earn the same return with full liquidity? Therefore, Tack concludes, the discount rate has to be higher than 7 percent — easily an additional 500 basis points or more depending on the circumstances — which would total at least 12 percent.
Another factor, applicable to all but the largest charities, is a pressing need for cash flow. It is fine, in theory, to say that a charity should place assets in illiquid investments for 17 years, or 10 or 30, in order to earn a 12 percent rate of return. But in the real world, very few would intentionally do so. “In the long run,” as economist John Maynard Keynes famously stated, “we are all dead.” There are simply too many pressing needs for cash now to permit long-term, illiquid investments.
Illiquid assets are illiquid for a reason — they have a very limited number of potential buyers. However, with so many charities experiencing a cash crunch these days, Lintott reports, “We're seeing more and more charities looking to turn theoretical future assets into cash today. They want to sell illiquid assets — including remainder interests.”
Why don't more charities use the discounted-cash-flow method? Some are starting to. But many, out of habit or lack of knowledge, continue to use the table method for calculating the charitable deduction value of remainder interests.
For charities that do it right, such as the university that benefited from Brian's largesse, the future gift becomes an important but realistic source of present-day capital. The university to whom Brian donated the CRT wasn't cash-crunched, Lintott reports. But the advisors in the planned giving department did the math and figured that the present value of the university's interest was worth no more than $80,000 — even under the most optimistic assumptions. So they were pleased to find a buyer who paid $80,000. The actual transaction was very simple for the university advisors. They got their cash within about a week of making the decision to sell.
An 18 carat gold and painted-enamel watch stand fitted with a lady's pendant watch, 190 mm by 120 mm, is in the form of a neo-Gothic triptych; made in the 1840s by Fr. Alibert a Paris. It sold at auction in October 2003 by Antiquorum for $26,335.
By Roger D. Silk chief executive officer, Sterling Foundation Management, LLC, Reston, Va.