Investment Strategies For Charitable Trusts

Investment Strategies For Charitable Trusts

Article posted in Investing on 1 October 2001| 1 comments
audience: National Publication | last updated: 18 May 2011
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By Neal P. Myerberg

Over the years, planners and their clients have become familiar with the value that various types of charitable trusts can play in philanthropic, financial, tax, and estate planning. Designing charitable remainder or charitable lead trust transactions invariably takes into consideration the nature of the asset to be contributed, the philanthropic goals to be achieved with the charitable interest, the economic circumstances of the contributor relevant to the gift, and the estate and tax planning considerations that impel the size and timing of the donation. Usually, the donor and advisor participate with the trustee and the principal charity (frequently the beneficiary charity is the trustee) in deciding upon the type of charitable trust, the term, and rate of the trust, and the administrative responsibilities of the trustee, extending to accounting, tax compliance, management, and investment of the trust. This puts a considerable burden on the noncorporate trustee, whether the trustee is the beneficiary charity, the grantor, or a third party, and perhaps the grantor's professional advisor.

While the Prudent Investor Act is to be considered in many states with respect to the investment by a fiduciary of the assets of a charitable trust, the theme of this article is the variety of strategies that ought to be taken into account by the trustee when undertaking this investment responsibility.

Charitable Remainder Annuity Trust (CRAT)

This is a fixed rate trust where the periodic payments to income beneficiaries are determined by multiplying the rate set out in the trust by the initial fair market value of the contributed assets. These payments will not vary during the term of the trust (the term is usually measured by the lifetime of named individuals, although it may run instead for a term not to exceed 20 years). The remainder of principal and income will be paid over to the charities named as remainderman at the end of the trust term.

Charitable Remainder Unitrust (CRUT)

This is a fixed rate trust where the periodic payments to income beneficiaries are redetermined annually by multiplying the rate set out in the trust by the value of the trust's assets as determined annually on a calendar year basis. Thus, these payments may vary during the term of the trust, assumably as a hedge against inflation. However, if the value of the trust on a year-by-year basis decreases, the periodic payments year-by-year will decrease when compared with the prior year's payments.

There are three distinct types:

The Standard Unitrust. Payments are made irrespective of the earnings realized by the trust from period to period. Thus, the trust is revalued annually, and the payments due for that year in arrears are paid from either, or both, of the income and principal of the trust as a fixed percentage of the value of the trust.

The Net Income Unitrust. Payments are made only to the extent of the income earned on the trust's assets (as defined in the IRS regulations, the trust agreement, or under state law), which may be more or less than the payments that would be due if it were a "standard" unitrust under annual revaluation.

The Net Income Unitrust With Make-Up Provision (NIMCRUT). Payments made are calculated as the lesser of the unitrust rate (the fixed rate set in the trust), or trust net income as determined annually. Annual revaluations are made (a core element of unitrusts) and the amount due, based upon a multiplication of the annual asset value by the fixed unitrust rate, is paid if it is less than the trust's net income. Net income may be defined under Internal Revenue regulations, the terms of the trust agreement, or state law. To the extent that payments are made to income beneficiaries that are less than the unitrust amount for any period, the difference between the amounts paid, and the amounts that are representative of the unitrust amount are owed to the income beneficiaries. This obligation of the trustee to pay this "make-up" amount extends to any period when the net income (as defined) of the trust exceeds the unitrust amount.

Therefore, the "make-up" amount can be timed for payment by virtue of the trustee's investment strategy, subject to the position of the IRS.1 To the extent that any "make-up" amount remains unpaid at the end of the term of the trust, it is no longer an obligation of the trustee to the income beneficiaries or their executors, personal representatives, successors, or assignees.

Since flip unitrusts were first officially recognized in the proposed regulations under section 664 issued in April 1997, the situation in which this type of trust has most often been employed is the funding of a trust with an illiquid asset. In this situation, the net income limitation is necessary since, without it, the trust would be required to make the formula unitrust distribution without necessarily having the liquidity to do so. The flip provision allows the net income limitation to disappear when the illiquid asset is finally sold and there is adequate liquidity in the trust to make the required distributions.2

With charitable remainder annuity trusts, the payment rates for income beneficiaries are fixed. Simply stated, the fixed rate is multiplied by the initial value of the contribution to the trust in order to determine the amount of periodic income that will be paid to the income beneficiaries for the term of the trust. Whatever growth may occur in the value of the principal of the trust throughout its duration is for the ultimate benefit of the remainder charities when distributed. In the case of a charitable remainder unitrust, the revaluation (assuming the new value is greater than the value at close of the prior calendar year) allows the income beneficiaries to share in the growth to the extent of the fixed rate. Thus, if the trust grows in value when compared with the prior year in the amount of $50,000, and the fixed rate was 8%, the income beneficiaries would receive 8% of the new valuation, which includes 8% of the $50,000 of growth (i.e., $4,000). Therefore, the growth in the value of the unitrust is shared between the income beneficiaries, and the charitable remainderman to the extent of their respective participation in 100% of the value of the trust.

Fixed rates set in charitable remainder trusts may not be less than 5%. In the majority of annuity trusts, the rate is set between 5% and 8%, depending upon planning scenarios (e.g., investing in tax-exempt instruments, maximizing the income tax charitable deduction, maximizing income, etc.). However, the rate must be measured against the required test that there be no probability greater than 5% that the trust will have no assets at the end of its actuarial term. Thus, the rate fixed in the annuity trust must be quantified with respect to both the current Applicable Federal Rate (AFR), and the life expectancy of the income beneficiaries (or the alternative term of years set out in the trust). The greater the spread between the fixed rate and the AFR, assuming the same set of actuarial data, the greater the possibility of a violation of the 5% probability test.

Since a unitrust cannot conceptually violate the 5% probability test (i.e., with revaluation, it can never be exhausted), there is no rate mathematically that would, in fact, violate any of the Regulations. However, the matter of charitable intent as evidenced by the present value of the charitable remainder may prove to be a hindrance to the acceptability by the IRS of a high-rate unitrust pursuant to the position of the IRS as enumerated in IRS Notice 94-78.3

Higher fixed rates, however, for either type of charitable remainder trust may also be justified by the advanced age of the annuitants, and by a term of years trust. In the former, elderly annuitants whose life expectancy is assumed to be relatively brief, may establish a higher rate trust where the calculation of the present vale of the remainder proposes a reasonably equal division of the value of the trust between the income and remainder interests. Similarly, where a trust is to run for a limited term of years (the maximum term is 20 years), the calculation of the remainder of a higher rate fixed annuity or unitrust rate may still support a reasonable income interest/remainder division of present value.

Thus, charitable remainder trusts have certain investment planning goals:

  • earn enough net return to pay the annuity without using trust principal--in the case of an annuity trust;
  • grow the capital of the trust in order to at least have the trust's assets keep pace with inflation;
  • maximize the growth of the capital of the trust for the benefit of unitrust beneficiaries; and
  • provide real value for the future charitable remainderman, if possible, in excess of inflation.

The core issue with respect to the investment of charitable trusts is the matter of asset allocation among other resources for consideration because:

  • unitrust donors need growth in asset value to generate growth in income payments year-by-year; and
  • charitable remainder trust donors generally want the charity to have more funds to use for charitable purposes when the trusts end.

In addition, asset allocation is the key to investment performance. It enables the trustee's investment manager to generate a total return from investments in equities and fixed income instruments as opposed to a fixed return of income from a portfolio comprised exclusively of fixed income instruments (e.g., certificates of deposit; Treasury debt instruments; zero coupon bonds; specific issues of taxable and tax-exempt credit instruments). It manages risk and reward in the portfolio, and considers time horizons that reflect the anticipated term of the charitable trust. Therefore, it will make use of stocks as an integral part of the investment strategy.

Why are stocks such an essential ingredient to most asset allocations of charitable trusts? One reason is that stocks historically have superior long-term returns when compared with bonds (e.g., intermediate Treasuries), T-Bills, and inflation. Since stocks generally experience short-term volatility, a longer-term investing horizon is mandated, consistent with the vast majority of terms of charitable trusts.

In a study of the annualized returns of various asset classes by Ibbotson Associates, measured from 1926 through 1996, stocks produced an average annualized return of 10.7%. This return is then compared with the returns for intermediate Treasuries (5.2%), T-Bills (3.7%), and inflation (3.1%) to reflect the significant economic advantage realized in the investment in stocks over time. There have been, however, some substantial periods of stock market risk since 1948. For example, in the 12 major bear markets since 1948, the average length was 10 months, and the average decline (in the S&P 500) was 18.9% (this assumes no reinvestment of dividends). The most devastating and longest bear market (e.g., 21 months) occurred from January 1973 to September 1974. In that bear market, there was a drop in the value of the S&P 500 of 42.5%, the deepest fall of any of the bear markets since 1948. The next deepest bear market was also the shortest in duration. From September 1987 to November 1987, the S&P 500 lost 29.5% in value over a three-month period. The consequences of these bear markets contribute to the concern of some investors that the short-term volatility of the stock market is discomfiting.

A review of a log scale of the stock market since 1951, including highlights of eight of the deepest bear markets through 1995, shows that, despite the declines in those eight bear markets, the S&P 500 has progressed steadily upward for that 45-year period.

Interestingly, the first year returns for the S&P 500 after the end of each of the 12 bear markets since 1948 have been indicative of the proposition that "short-term volatility mandates long-term investing." Once through any of the 12 bear markets, the S&P 500 gained, on average, 35.7% in total return the first year after a bear market decline. Thus, an investor who "stayed the course" through any, or all, of the bear markets often realized a post-decline total return greater than the total loss for the entire immediately preceding bear market (see, however, the first year after the 21-month bear market of January 1973 to September 1974, with a total return of 38.1% versus a long bear market decline of 42.5%; and the first year after the three-month bear market of September 1987 to November 1987 with a total return of 23.2% versus a short bear market decline of 29.5%; in the second year after the 1973-74 bear market, the S&P 500 increased by 30.5%; in the second year after the fall 1987 bear market, the S&P 500 increased by 30.8%). It should be noted that, for the calendar year 1987, the S&P 500 was actual1y up by 5.3%. The return of the S&P 500 after each of these bear market periods again supports the theory that investing in stocks requires the tolerance of short-term volatility in order to realize financial rewards over longer-term time horizons. Charitable remainder trusts normally have ascertainable time horizons reflected in the life expectancy tables applicable to the life income beneficiaries, or by virtue of the stated term of years in the trust.

In an article, "Determinants of Portfolio Performance II: An Update,"4 the authors conclude that investment policy, (which includes asset allocation policy) explained, on average, 91.5% of the variation in quarterly total plan returns for a sampling of large pension plans over a 10-year period. U.S. stock market returns when considered over rolling time periods provide even more persuasive evidence of the effectiveness of "staying the course." As annual returns are expanded to rolling multi-year annualized periods, there is less frequency of negative returns. For example, Exhibit A--Equity Market Returns: Annual Returns, shows stock market return data from 1926 through 1996 for a period of annual returns, and rolling periods of five, 10, and 15 years. The frequency of negative returns on the graph of annual returns lessens considerably as longer rolling periods are considered. Specifically, there is only one instance of a negative return, quite minimal in fact, for any rolling 10-year period, that occurring in the late 1920s to late 1930s period. There is no instance of a negative stock market return for any rolling 15-year period from 1926 through 1996. Thus, remaining invested in the stock market throughout annual, more volatile periods is justified when viewing returns over time horizons of 10 years and longer. Charitable remainder trusts will usually fall beyond the threshold 10-year time horizon, absent life expectancy factors, or specific trust terms of years that will fall predictably inside of 10 years, or early termination of the trust due to the premature deaths of income beneficiaries. Nevertheless, the asset allocation in favor of stocks for trusts that end before the expiration of an initial 10-year period may remain intact when the remainder becomes the property of the charitable beneficiary(ies) in order to maximize the expected return for the initial investment plan.

The argument may be made by trustees of charitable remainder trusts that they ought to move in and out of the stock market in order to take advantage of bull market opportunities while avoiding the negative returns of bear markets. It is difficult to presume that a professional investor, not to say a fiduciary of a charitable remainder trust, will be able to time the market so well as to be able to profit from bull markets, while not suffering any losses in bear markets. For example, the period of time from 1926 through 1996 is comprised of 864 months. As is seen in Exhibit B--Danger of Market Timing, the average monthly return for that entire period of 71 years has been approximately 0.9% per month. That average monthly return has been garnered from the best 60 months of that entire period. In that 7% of all months, the average monthly return for the stock market has been 11.7%. In all other months during the 71-year period, comprising 93% of the 864 months, the average monthly return has been 0.1%. Conclusively, if an investor had been in and out of the stock market during that period, and was not invested in S&P 500 stocks during the specific 7% of all months (the noted 60 months), the average monthly return of 0.9% would have been diminished to as low as 0.1%.

In 1991, the year of the Gulf War (January/February), the S&P 500 appreciated at a rate of 26.3%. Yet it was during 28 trading days in that year that the entire previous annual performance was, in fact, exceeded. During the initial stages of the Gulf War (January 16 to February 13), corresponding to 21 market trading days, the S&P 500 appreciated by 17.6%. For the last seven trading days of the year, the market appreciated by 9.0%. Had an investor been fortuitous enough to have been able to time the market, and been invested for only those 28 trading days, his or her stocks would have grown by 26.6%. For the remaining 225 trading days of 1991, the S&P 500 lost 1.5% of value; therefore, a fully invested 1991 would have had a stock market performance of 26.3%. However, had an investor attempted to time the market in 1991, and missed all or a portion of the 28 successful trading days while remaining invested in stocks throughout the balance of the year, stock account returns for the year could have been negative.

It may seem that an investment wholly in U.S. stocks will achieve the goals of the trustees of a charitable remainder trust considering the growth rate of stocks over the last 70 years, and the distinction that this is the only asset class that has exceeded inflation over time. However, charitable remainder trusts involve an obligation of the trustees to make current and/or deferred payouts that directly affect the compounding of returns, mandating implicitly that an investment exclusively in U.S. stocks should not be maintained by the fiduciary. The payouts by definition will exacerbate any down market returns by the rate of the payout, making it that much more difficult for the trust to speedily regain its value in a subsequent market.

Understanding the short-term volatility inherent in investing exclusively in U.S. stocks, considering the time-horizon performance of stocks, and recognizing the volatility inherent in short-term investing enables trustees of charitable remainder trusts to meet the challenge of achieving stock-like performance over time, while maintaining an acceptable level of risk within the trust's portfolio. Understandably, an investment of trust assets exclusively in short-term, highly-rated (therefore, low-risk) fixed income instruments will not enable the value of the trust to keep pace with inflation after paying out the annuity or unitrust amounts to income beneficiaries, and the costs of the trust. The goal of the trustee, therefore, is to establish an investment mix that will enable the trust to:

  • achieve enough growth to beat inflation after payouts;
  • generate enough income (and/or total return) to meet current and future needs of the trust; and
  • provide for some level of portfolio predictability.

Thus, it is a balanced portfolio, with a mix of equities, and fixed income instruments that can best achieve the goals of the trustee while providing more predictability than stocks or bonds alone. Beating inflation over time is a challenge for trustees. For the period 1926 to 1996, stocks, T-Bills, and long bonds were fairly close in the percentage of time each asset class beat inflation. As holding periods are lengthened, stocks measurably outperform T-Bills and long bonds when compared with inflation. Only U.S. stocks have beaten inflation in 100% of rolling 20-year periods since 1926.

Over a more recent period of time (1951 to 1995), a comparison of various asset allocations, and their respective real (above-inflation) returns shows that, for investments that require an approximate 6% annual payout (e.g., charitable remainder annuity or unitrusts at fixed rates at, or in excess of, 6%), only an all-stock allocation (7.7% real return) would have provided enough income and growth to pay the trustees' income obligations, while enabling the value of the charitable remainder to beat inflation.

Nevertheless, a charitable remainder trust with a fixed rate of 6% would perform at, or very close to, inflation (after payment of income to beneficiaries) with an asset allocation of 60% stocks/40% bonds at considerably lower volatility when compared with an all stock portfolio. If it were a unitrust and grew at the rate of inflation after payouts, the income payments to beneficiaries would, by definition, be inclusive of inflation as well. Interestingly, a charitable remainder trust with a fixed rate of 8%, (which is certainly not atypical in the present philanthropic environment) would have under performed inflation even with an all stock portfolio.

Exhibit C--Probability Range of Asset Values, shows a simplified asset allocation with various asset mixes of stocks and bonds (assuming a bond yield of 6%) and what the total return on the portfolio would be at various stock market total return scenarios. In the +20% equity market, the mix that contains the larger percentage of stocks (e.g., 90/10) would realize the greatest total return (e.g., 18.6%). The next largest mix of stocks (e.g., 70/30), and the evenly allocated mix (e.g., 50/50) measurably under performed the 90/10-asset mix. However, when the asset mixes are viewed against negative equity market returns, the mixes with the greater proportion of bonds suffered appreciably lower levels of negative total returns than the 90/10 allocation heavily favoring stocks. Thus, if short-term volatility is a key issue, a mix with a more even balance between stocks and bonds will cushion the ride.

Translating this into a time horizon range of returns for the period 1950 to 1995, recognizing that the trustees of charitable remainder trusts have fixed obligations to meet to income beneficiaries, the shift in asset allocations becomes persuasive. As the 50/50 mix extends gradually to a 60/40 mix and 70/30 mix, performance in highest and average markets increases. Conversely, under performance in lowest markets increases as the stock portion of each mix is greater. Yet, a comparison of each of the three asset mixes shows that the frequency of three-year losses is identical for the 50/50 mix and 60/40 mix (it is twice as great for the 70/30 mix). And, in none of the proposed asset allocation alternatives is there any frequency of five-year losses. That being the case, it could well be the trustees' choice to allocate the assets of a typical charitable remainder trust at a minimum level of 60/40, and more probably at 70/30 for performance expectations in average markets with no greater probability of losses over five years, or greater horizons than more conservative 60/40 and 50/50 asset allocations. Note that the 60/40 and 70/30 alternatives invest equities globally, beginning in 1970 (with 25% of the stock portion in developed foreign markets beginning in 1970, and an additional 5% of the stock portion in emerging markets beginning in 1985).

An application of these mixes to a 5% fixed payout rate for a charitable remainder annuity trust, with an initial contributed corpus of $500,000 for the period 1950 to 1996, provides an analysis of inflation adjusted payouts to beneficiary charities assuming that the trust terminated in 1996. Although the value of the trust in 1996 would have grown at 50/50 to $3.0 million, the inflation-adjusted payout to the remainderman would have been worth less than the initial contributed corpus (e.g., $469,000). At 60/40, the corpus of the trust would have grown to $4.8 million by 1996 and been worth, in inflation adjusted terms, $744,000, nearly 50% more than the value of the contributed comus. Finally, at 70/30, the trust would have grown to $6.3 million by 1996, with an inflation-adjusted payout to the remainderman. Again, the stocks had a global mix beginning in 1970, and the portfolio was modified to include emerging market stocks beginning in 1985. These inflation-adjusted payouts to the charitable remainderman are also after the 5% per annum payout to the trust's income beneficiaries.

Assume that the trustee chose an asset allocation of 50% stock, 25% bonds, and 25% money funds, and that the mix would have an expected return over time of 8% per annum. Assume further, that the trustee had the obligation to pay 5% per annum to income beneficiaries during the term of the trust--the net return to the trust would be 3% (without regard to the trust's investment, administration, and compliance costs) before inflation. If inflation were calculated at 3.5%, the trust would experience a negative inflation adjusted per annum return of -0.5%, much to the detriment of the charitable remainderman. Thus, it is incumbent upon the trustee to select an asset allocation weighting both stocks and bonds that will enable the trust, over time, to realize positive inflation adjusted returns in order to carry out fiduciary responsibilities to both the income beneficiaries and the ultimate beneficiary--charities.

To maximize the performance of the investments in a given portfolio, particularly with respect to the stock portion of a balanced account, the trustees should allocate a portion of the account to international stocks (i.e., securities of companies in developed foreign markets). This is a way for the trustees to reduce the volatility of the stock portion of the account without moving further into bonds. Therefore, the trustees can achieve stock-like performance at lower risk. Since there is low correlation between U.S. stocks and the stocks of developed foreign markets, there is opportunity for returns in both markets, while lowering the volatility of the portfolio and smoothing the ride.

The larger universe of opportunity through global diversification is reflected by the considerable change in worldwide market capitalization from 1970 to 1996. In 1970, nearly two-thirds of the market value of stocks was based in U.S. corporations; by 1996, it was nearly the mirror image, with 60% in non-U.S. corporations. In the years around 1970, banking and real estate, for example, were significantly based in U.S. corporations. By 1996, the U.S. share of several major industries was reduced to well under 50%, with automobiles, and banking at 37%, and real estate at 27%. In addition to the opportunities abroad occasioned by the switch in market values to a more global emphasis, there is low correlation of U.S. stocks, developed foreign markets, and emerging markets.

The U.S. stock market, of all equity markets, shows the lowest volatility over the past 12 years. Nevertheless, this volatility is significantly greater when compared with other nonequity asset classes (e.g., bonds). By diversifying equities in the portfolio to include foreign stocks in developed and emerging markets, the trustee of a charitable remainder trust will be able to take advantage of the performance in a particular market to produce a total return that may be superior to an all U.S. stock position. Of course, there may be times when having investments in stocks outside of the U.S. may drag down performance and affect the total return of the portfolio; but, with low correlation between these equity markets, there ought to be times when foreign stocks raise performance of the portfolio when the U.S. stock market under performs. As a consequence, the trustee will have prudently allowed the trust to avoid a loss in value that might have resulted if the portfolio were only invested in U.S. stocks in a down market year. Thus, by combining several highly volatile equity classes in a single portfolio, the volatility of the portfolio is actually reduced even where the volatility of each individual class of equities remains high.

As an example (Exhibit D--Year by Year Breakdown of Trust Payouts and Growth), let us assume that three charitable remainder unitrusts are established and funded each with $1,000,000 in appreciated securities. The trustee of each CRUT sells the contributed securities, and invests the proceeds in an investment portfolio with an asset allocation unlike the other two trusts. In trust A, the asset allocation is 100% intermediate term Treasuries; in trust B, 50% U.S. stocks and 50% intermediate term Treasuries; and, in trust C, 80% global stocks (U.S. and developed foreign markets) and 20% intermediate term Treasuries. We will assume an inflation rate of 3% per annum, and a fixed unitrust rate of 7% in each trust. Performance of the U.S. stocks will be pegged to the S&P 500 index; intermediate term Treasuries will be pegged to the Lehman Brothers Aggregate Index. The goals to be achieved by each trust are: 1) to emulate, or exceed inflation in the value of the principal passing to the charitable remainderman at the end of the trust; and 2) to keep the income payments at pace with inflation on an annual basis. It is also assumed that, based on the life expectancies of the income beneficiaries, the trusts will run for 20 years.

In average markets over the 20-year term, Trust A (intermediate term Treasuries) will return $900,000 to the charitable remainderman at the end of the term of the trust. Trust B (50% U.S. stocks and 50% intermediate term Treasuries) will return $1.3 million. And Trust C (80% global stocks/20% intermediate term Treasuries) will return $1.6 million. Inflation, compounded at 3% per annum, translates into a valuation of the original $1.0 million to approximately $1.8 million at the end of the 20-year term. Thus, only Trust C comes near enough to the inflationary value of the original contribution (89%) to provide a remainder to the charity, deferred 20 years from the original contribution, which is increased to reflect the impact of inflation. The donor's desire to have the value of contributed funds provide for the programs and services of the charity will not be measurably diminished as a consequence of the investment strategy implemented in Trust C.

Trust A, with an approximately $900,000 remainder, under performs inflation by 50%. Trust B, with an approximately $1.3 million remainder, results in a reduction of the value of the remainder due to inflation by approximately 28%. Any asset allocation that is established between the parameters of Trust B and Trust C, under which a global stock allocation is greater than Trust B's 50% U.S. stock position (the balance being invested in intermediate term Treasuries) but less than Trust C's 80% global stock allocation, will in average markets, raise the value of the remainder interest, and bring it closer in line with the inflationary value of the original contribution. Thus, the asset allocation in a Trust C type formula might be 70% global stocks/30% intermediate term Treasuries, resulting in slightly greater reduction against inflation but with somewhat lower portfolio volatility.

The income payments made to the donor over the 20-year term in Trusts A, B, and C are reflective of investment performance because the unitrust must be revalued annually to determine payments to the income beneficiary for the next calendar year. In these examples of a "straight" unitrust, payments are made to the income beneficiary out of income (and principal to the extent needed) at the rate of 7% per annum. If the trust under performs the 7% bogey, the valuation at the close of the calendar year will be lower than at the commencement of that year. Thus, the income payments for the next year will be lower than those paid for the prior year. The converse is also true. If the performance exceeds 7%, the valuation will be increased, and the income payments for the next year will be greater than those for the prior year.

In Alternative A (Trust A), the payouts (to income beneficiaries) diminish year by year since the return on the portfolio (100% intermediate term Treasuries) is, on average, less than the 7% unitrust rate. At the end of 20 years, the trust will pay over to the remainder charity $886,600. In Alternative B (Trust B), income beneficiaries will receive increasing payments year by year since the expected return from the trust's asset allocation exceeds the 7% unitrust rate annually on average. It is in Alternative C (Trust C) that the payments to income beneficiaries keep reasonably at pace with the assumed 3% rate of inflation, while enabling the remainder charity to receive nearly $1.6 million (or 89% of the inflationary value of the original contribution) at the end of the 20-year term.

It is with the NIMCRUT that special caution must be taken when designing an investment strategy for the trust. In this "lesser of/make-up" scenario, the trustee pays to the income beneficiary a sum that is either an amount equal to the unitrust amount or the income earned on trust investments, whichever is the lesser. With some planners, the amount of income is kept purposely low in the early years of the trust when the income beneficiaries are not in need of the cash flow in order to maximize payments in subsequent years, when both the unitrust amount, and the deferred payments (make-up) can be paid from the trust. The trustee anticipates that income will exceed the unitrust amount (say 7%) in subsequent years due to a change in the trust's investment mix; and, as a consequence, the trustee will first pay out the unitrust amount for that year (assumed to be lesser than income), and then pay out the excess of income over the unitrust amount in order to retire all or a portion of the make-up.

The execution of this plan may be significantly dependent on the definition of "income" set out in the unitrust agreement. If income is defined by reference to Section 643(b) of the Internal Revenue Code, it is limited to interest and ordinary dividends. Thus, if the unitrust rate is 7%, and there is a "make-up" to pay, the return of interest and ordinary dividends from the trust's investments must exceed 7% in order to provide any make-up payments to the income beneficiaries. A state's prudent investor rule may limit the trustee from investing in high-yield instruments to produce income in excess of 7%. Thus, it is conceivable that the payment of the make-up under this definition of income would not be made; and the make-up is not a liability of the trustee for payment to the estate of an income beneficiary.

The unitrust agreement may, subject to state law, redefine income to include realized capital gains, extraordinary dividends, and stock dividends. Under this definition of income, the trustee will invariably be able to pay the make-up under an asset allocation that would include at least a 50% weighting in stocks (U.S. or global) over time by realizing capital gains (in addition to interest and dividends) in order to make the payments. The asset allocation would require a mix that would have an expected return of greater than 7%, on average, annually in order to pay the make-up (where the unitrust rate is fixed at 7%) from year to year. In order, however, to keep the income, as redefined in this example, at a low amount in the early years of the trust, the trustee might choose to invest in a portfolio that produced a low level of income (interest, dividends, and realized capital gain); and, in a subsequent year, reallocate the investment of trust assets to a portfolio that may produce a higher level of income, particularly realized capital gain, to have adequate funds from investments to pay the unitrust amount, and retire the make-up.

Some planners define income under IRC ยง 643(b) and fix a unitrust rate at 5%, anticipating that a strategy of investment to produce interest and ordinary dividends will, on average, exceed 5% per annum, enabling the trustee to have excess income from which to pay any make-up amounts.

Conclusion

There is a real challenge for trustees who take on the fiduciary responsibility for investment and management of charitable remainder trusts. To attempt to have the annual payments to income beneficiaries keep pace with, or exceed inflation (one of the principal reasons behind a donor's decision to make use of the unitrust form of a charitable remainder trust), the trustee must choose an asset allocation that will enable the assets of the trust to grow annually after payouts. By doing so, the trustee will not only be able to increase annual payments to the income beneficiaries, but also preserve a substantial portion of the inflationary value of the remainder interest passing to charity in the future.

Endnotes


  1. See IRS Exempt Organization Continuing Professional Education Technical Instruction Program Textbook where the IRS calls in question certain NIMCRUTs used to defer the receipt of income.back

  2. For a more detailed explanation of flip trust provisions and advanced NIMCRUT design, see David Newman's article, "Advanced NIMCRUT Design" in the PGDC Gift Planner's Digest.back

  3. 1994-2 C.B. 555.back

  4. "Determinants of Portfolio Performance II: An Update," Brinson, et al., Financial Analysts Journal, May/June, 1991, p. 40.back


    Neal P. Myerberg is vice president of Sanford C. Bernstein & Co., Inc. in New York, a firm that provides investment research and money management to institutional and individual clients. Previously, he was the chief executive officer of the department of planned giving and endowments at UJA-Federation of New York. Myerberg is an author and lecturer on various planned giving topics, and was the creator and editor of Estate & Tax Planning with Charitable Gifts, a quarterly planning newsletter. He is a graduate of the University of Baltimore School of Law, and the New York University Graduate School of Public Administration.

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Inv. Strategies for Charitable Trusts

Great article...would be nice to have an updated version(i.e. 2004).

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