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Uniform Prudent Investment Standards
By Dr. David Edward Marcinko; MBA, CMP™
By Tom Muldowney; MSFS, CFP®, AIF®, CMP™
By Hope Rachel Hetico; RN, MHA, CPHQ™, CMP™
The physician-investor dichotomy, income now versus growth for later, is not unique. Trusts; that have the potential to span decades, usually place the interests of the income beneficiary at odds with the remaindermen.
Conflicting Goals
Historically, trustees invested these irrevocable trust assets in bonds so as to generate the necessary income for the income beneficiary. But this led to conflicts…investing in bonds provides little growth of either the investment asset base or the income generated thereon. Interestingly, this has also placed the interests of the remaindermen at odds not only with the income beneficiary but with the trustees who have been charged with the duty of stewarding these assets for the benefit of both generations. This conflict of the generations has led to some surprising results both in practice and in the courts.
“Total Return Trust”
Income beneficiaries want current cash flow, remaindermen want growth and trustees want to minimize the exposure to liability. Notice the subtle difference … rather than “income” (dividends and interest) income beneficiaries want cash flow. They generally do not care about the source from which the cash flow was generated. Recognition of this subtle but important difference has led to the development of Uniform Prudent Investment Standards and the introduction of the “Total Return Trust.”
Uniform Prudent Investment Standards
The Uniform Prudent Investment Standards (agreed upon by legislatures of all 50 states) identify that for a trustee to be a “prudent investor”, investments that are allocated across a broad spectrum of investment asset classes, provides the greatest protection from investment risk. But; because this allocation across a broad spectrum must – by definition – include stocks, the potential for income in its technical sense (interest and dividends) must be reduced. The use of a “Total Return Trust” addresses and solves this problem.
Combination of Assets
A total return trust thus allows a trustee to manage a portfolio of assets commensurate only with the volatility risk that the trustee identifies is appropriate for the trust. This gives the trustee the ability to invest in a combination of assets that include stocks, bonds and other investment assets. The purpose of the total return trust includes safety and protection of the assets with a reasonable growth rate, from which a periodic ‘unitrust’ cash flow may be withdrawn for the income beneficiary. Unitrust cash flow is based on the recognition that a stated percentage withdrawal from trust corpus, each year, may be made to the income beneficiary without regards to the source of that cash flow, whether it be from income, or from corpus. The Unitrust cash flow recognizes that from time to time volatility in the equity marketplace will cause the trust corpus to fluctuate, sometime below that amount that was originally invested.
Cash Flows
Using this technique, as long as assets of the trust portfolio grow and the long term cash flow withdrawal rate is less than the long term growth rate, several benefits to all of the parties will inure: Cash flow to the income beneficiary will be maintained; cash flow to the income beneficiary will increase as the asset base increases; asset growth will satisfy the needs of the remaindermen; the trustee will be secure in knowing that he has satisfied his fiduciary duty to serve both the income beneficiary and the remaindermen. A substantial side benefit for the income beneficiary is that the cash flow will include not only income (dividends and interest) but will also include distributions of long term capital gains (which enjoy a lower annual tax rate.)
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Filed under: Estate Planning, Insurance Matters, Investing, Retirement and Benefits, Risk Management | Tagged: Estate Planning, trusts |
With the recent downturn and turbulence in the stock market, questions arise regarding the wisdom of maintaining a diversified portfolio which includes stocks in a trust whose primary purpose is to provide income.
After all, the crash of 2008 to 2009 was the worst decline since the 1930’s. The last decade has been called the “lost decade” for investors, as the S&P 500 was actually down 9.1% for the period – the worst market since at least the 1830’s. So what is an investor – or a trustee – to do? A common reaction is that a “less risky” strategy using income-producing bonds is more prudent. But there are important facts to consider:
A well-balanced portfolio including 60% to 70% equities provided an annualized return of 5 to 6% for this “lost decade”.
Broad global diversification greatly enhanced returns. Although the S&P 500 was under water for the decade, other asset classes such as international stocks, emerging markets, and even real estate had positive returns.
Diversifying with both bonds and stocks gives the investor opportunities to rebalance (buy low and sell high) when there is turbulence in the market. Studies show that a disciplined rebalancing strategy adds 0.5% to 0.9% extra annualized return over an extended period of time.
Income from bonds is currently very low – in the range of 2 to 3%. Moreover, there is a risk that the value of the bonds will decline in the future as interest rates inevitably rise.
Stocks are cheap. PE ratios and other measures show that the prices are low by historical standards. Moreover, decades with below-average stock returns are most often followed by decades of above-average returns. Stocks may be less risky as an asset class than bonds at this point in time!
Allocating too much of a portfolio to fixed income investments trades one type of risk for another. The volatility may be less, but inflation risk is higher. With current patterns of government spending and borrowing, inflation is likely to arise at some point in the next few years.
A total return trust with a balanced approach, broad global diversification, and disciplined rebalancing still offers the best opportunity for both the beneficiary and the remaindermen to meet their goals.
Brian J. Knabe, MD
Savant Capital Management, Inc®.
190 Buckley Drive
Rockford, IL 61107
Tel 815-227-0300
Fax 815-226-2195
bknabe@savantcapital.com
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Dr. Knabe
Fine and well but are we heading toward a double-dip recession?
Nancy RN
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