Investment Strategies for Fiduciaries of Split-Interest Trusts

Investment Strategies for Fiduciaries of Split-Interest Trusts

Article posted in Investing on 4 December 1998| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In this week's edition of Gift Planner's Digest, philanthropic financial advisor Paul Comstock discusses "Investment Strategies for Fiduciaries of Split-Interest Trusts."

by Paul L. Comstock

Investing the assets within a split-interest charitable trust requires consideration of both beneficiaries. Looking at historical performance returns, it becomes quite apparent that the allocations used for such trusts will not provide the beneficiaries with the benefits they are entitled to receive. Now, under statutory directive in most states, the trustee of such trusts must not only be concerned with the nominal returns achieved, but must look to the inflation adjusted results to determine whether the needs of both the income and remainder beneficiaries have been met.

Statutory Requirements

State statutory requirements dictate the process whereby trust assets are invested. Exhibit A provides an example of the statutes adopted by most states for the management of trust assets. The Uniform Prudent Investor Act, established by the State of California for the management of trust assets, provides an excellent road map for trustees to follow in developing an appropriate investment strategy. Exhibit B is a list of states that have adopted a form of the Uniform Prudent Investor Act.

The requirements to provide donors with disclosure on pooled income funds have always been vague with the emphasis on the sponsoring organization to determine the format. While that is still the same under the Philanthropy Protection Act, the elements required to be disclosed may be more than what most organizations are presently providing to potential donors. For example, if a pooled income fund is being sold as an investment, careful consideration should be given to past performance as well as how that performance compares to the returns achieved under other investment options offered by the nonprofit organization. This is especially true if the sponsoring organization of the pooled income fund also issues charitable gift annuities.

Developing An Asset Allocation Strategy-Modern Portfolio Theory Back Testing

It has generally been viewed that a 100% fixed income allocation for pooled income funds would provide the maximum income benefit. And such is the case over short time periods. However, what if the income beneficiary has a life expectancy of 15 years? Would that same asset class allocation provide the best results for both the donor and the organization? Exhibit C illustrates the impact of the asset allocation of various charitable remainder trusts during the 15-year-periods of highest returns, and worst returns, from 1946 until 1996.

Exhibit D illustrates the performance of various asset allocations during the 15-year-period of lowest inflation, and the 15-year-period of highest inflation. It becomes quite obvious that allocations with higher equity holdings provide a greater level of income over the 15-year-period. However, such a statistic does not bear out the fact that the 100% fixed income return is generally higher in the early years, and lower in the later years.

Illustrating Future Performance of NIMCRUTs, NICRUTs, & Pooled Income Funds Versus CRUTs

Investing the assets of charitable remainder unitrust with net income option (NICRUT), net income unitrusts with makeup provision (NIMCRUT), and pooled income funds present a much more difficult challenge to the trustee than does investing a normal charitable remainder unitrust. The primary reason for this centers on the need to provide maximum income, while keeping that income current with inflation.

Reviewing the chart in Exhibit E provides insight into income returns that a donor might expect to receive over a protracted period of time from each of the various broad asset categories. Included in this information is an historical inflation percentage. These historical numbers can form the basis for asset allocation decisions of a very elementary nature. Having a more elaborate system in place allows the questions posed under the statutory requirements to trustees to be answered in a more precise, and generally acceptable way.

Developing An Investment Policy Statement

Exhibit F offers a checklist of the items that should be covered in writing an investment policy statement. Each entity having investment management responsibility within the portfolio should have its own investment policy. Of course, the critical issue with such a policy is adhering to the established guidelines. Trustees who adopt an investment policy, and subsequently ignore its provisions, create their own breach of responsibility and should do so only with great caution and documented reasoning.

Commingling Trust Assets

Provisions of the Uniform Prudent Investor Act, adopted by California and other states, require the trustee to be sensitive to the cost of managing the trust assets. Commingling trust assets in a commonly managed investment pool will usually always result in lower costs than when management is separately engaged for each individual trust. This is especially true when individual trust asset values do not meet manager minimums. One way to achieve this cost savings is to establish common funds within the endowment. Exhibit G provides an illustration of the concept of commingled investment funds, and how each split-interest trust can participate in them.

Marketing Pooled Income Funds Versus Charitable Gift Annuities

Providing donor/clients with an understanding of how their charitable gift annuity or pooled income fund gift will work for both the donor and the sponsoring organization is critical to a successful long-term relationship between the donor and the institution. You will find that donors appreciate having an opportunity to choose an income gift structure that meets both their personal objectives while also accomplishing goals they have for their gift. Exhibit H provides a sample illustration of how the investment results might be illustrated to a potential donor. In addition, the donor should understand how the income received will be taxed for each presented option, and what the initial year of contribution tax deduction will be in each case.

Conclusion

It is important that donors who are interested in making a gift understand how to structure that gift so that it helps the charitable organization fulfill the objectives to which the donor was first attracted. However, if the gift is recommended solely its merits as an investment, only the gift annuity provides the donor no downside risk of disappointment in his or her decision. Poor investment performance, on the other hand, may affect donors who use pooled income funds and charitable remainder trusts to fund their gift. Providing a benefit to donors that carries no risk of disappointment will reduce the opportunities for challenges by them in the future. It is important to understand that donors whose investment experiences meet, or exceed what they anticipated, gain a new perspective on stewardship, and will generally increase their loyalty to the organization.


Exhibits

The following Exhibits are in Microsoft Excel, Microsoft Power Point, and Plain text. You must have the appropriate software on your machine to view the .xls and .ppt. Click on the Exhibit you are wanting to view, when prompted to "save as" or "open" choose open. It may ask you to pick an application to open it. Browse your drive for Microsoft Excel or Power Point ( it should be located under your C:program files/MSOffice ).


Exhibit A: California Uniform Prudent Investor Act

PROBATE CODE
SECTION 16045-16054

16045

This article, together with subdivision (a) of Section 16002 and Section 16003, constitutes the prudent investor rule and may be cited as the Uniform Prudent Investor Act.

16046

(a) Except as provided in subdivision (b), a trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule.

(b) The senior may expand or restrict the prudent investor rule by express provisions in the trust instrument. A trustee is not liable to a beneficiary for the trustee's good faith reliance on these express provisions.

16047

(a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard. the trustee shall exercise reasonable care, skill, and caution.

(b) A trustee's investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.

(c) Among circumstances that are appropriate to consider in investing and managing trust assets are the following, to the extent relevant to the trust or its beneficiaries:

General economic conditions.

The possible effect of inflation or deflation.

The expected tax consequences of investment decisions or strategies.

The role that each investment or course of action plays within the overall trust portfolio.

The expected total return from income and the appreciation of capital.

Other resources of the beneficiaries known to the trustee as determined from information provided by the beneficiaries.

Needs for liquidity, regularity of income, and preservation or appreciation of capital.

An asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.

(d) A trustee shall make a reasonable effort to ascertain facts relevant to the investment and management of trust assets.

(e) A trustee may invest in any kind of property or type of investment or engage in any course of action or investment strategy consistent with the standards of this chapter.

16048

In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so.

16049

Within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee shall review the trust assets and make and implement decisions concerning the retention and disposition of assets, in order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust, and with the requirements of this chapter.

16050

In investing and managing trust assets, a trustee may only incur costs that are appropriate and reasonable in relation to the assets, overall investment strategy, purposes, and other circumstances of the trust.

16051

Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of a trustee's decision or action and not by hindsight.

16052

(a) A trustee may delegate investment and management functions as prudent under the circumstances. The trustee shall exercise prudence in the following:

Selecting an agent.

Establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust.

Periodically reviewing the agent's overall performance and compliance with the terms of the delegation.

(b) In performing a delegated function, an agent has a duty to exercise reasonable care to comply with the terms of the delegation.

(c) Except as otherwise provided in Section 16401, a trustee who complies with the requirements of subdivision (a) is not liable to the beneficiaries or to the trust for the decisions or actions of the agent to whom the function was delegated.

(d) By accepting the delegation of a trust function from the trustee of a trust that is subject to the law of this state, an agent submits to the jurisdiction of the courts of this state.

16053

The following terms or comparable language in the provisions of a trust, unless otherwise limited or modified, authorizes any investment or strategy permitted under this chapter: "investments permissible by law for investment of trust funds," "legal investments," "authorized investments," "using the judgment and care under the circumstances then prevailing that persons of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of their capital," "prudent man rule," "prudent trustee rule," "prudent person rule," and "prudent investor rule."

16054

This article applies to trusts existing on and created after its effective date. As applied to trusts existing on its effective date, this article governs only decisions or actions occurring after that date.

Information provided by Swerdlin White Huber, Swerdlin, Hallie, October 1998. For more information, contact Swerdlin White Huber at 800-557-9373 or www.swerdlin-white-huber.com


Exhibit B: Prudent Investor Rule

The Prudent Investor Rule has been adopted (or a version thereof) in each of the following states:

  • Alabama
  • Alaska
  • Arkansas
  • California
  • Colorado
  • Connecticut
  • Delaware
  • Florida
  • Georgia
  • Hawaii
  • Idaho
  • Illinois
  • Indiana
  • Iowa
  • Kansas
  • Kentucky
  • Maine
  • Maryland
  • Massachusetts
  • Michigan
  • Minnesota
  • Mississippi
  • Missouri
  • Montana
  • Nebraska
  • New Hampshire
  • New Jersey
  • New Mexico
  • New York
  • North Carolina
  • North Dakota
  • Ohio
  • Oklahoma
  • Oregon
  • Pennsylvania
  • Rhode Island
  • South Carolina
  • South Dakota
  • Tennessee
  • Texas
  • Utah
  • Vermont
  • Virginia
  • Washington
  • West Virginia
  • Wisconsin
  • Wyoming

Information provided by Swerdlin White Huber, Swerdlin, Hallie, October 1998. For more information, contact Swerdlin White Huber at 800-557-9373 or www.swerdlin-white-huber.com


Exhibit C: Impact of Allocation on Charitable Remainder Trusts During the 15 Year

Split Interest Exhibit C (Microsoft Excel)


Exhibit D: Performance of Various Asset Allocations During Fifteen Year

Split Interest Exhibit D (Microsoft Excel)


Exhibit E: Protracted period of time from each of the various broad asset categories

Split Interest Exhibit E (Microsoft Excel)


Exhibit F: Items to Cover in Investment Policy

  • Risk and return objectives
  • Distribution objectives
  • Time horizon of the investment
  • Liquidity requirements
  • Tax considerations
  • Legal considerations
  • Outline of duties of each party participating in the
  • investment process
  • Asset classes to be used
  • Restrictions to be placed on delegated management
  • Benchmarks for performance measurement
  • Reporting requirements

Exhibit G: Power Point Spreadsheet

Split Interest Exhibit G (Microsoft Power Point)


Exhibit H: Creation of a Charitable Remainder Trust

Mr. & Mrs. B. A. Donor
1234 Happy Blvd.
Hometown, USA 12345

Dear Mr. & Mrs. Donor:

Thank you for considering the creation of a Charitable Remainder Trust (CRT) for the benefit of the Worthy Institution. Your gift will provide many generations the joy and benefits of our programs.

In our previous conversations and correspondence, we have reviewed the concept of funding your gift through a Charitable Remainder Trust and have identified the appreciated asset you will be contributing to it. The asset is to be sold by the trustee and the proceeds of the sale invested in a more diversified portfolio.

I would now like to review the plans for implementing the investment structure of your Charitable Remainder Trust as discussed in general during our last visit. In addition, I will review the subsequent negotiations on your behalf that took place with each manager and the custodian.

To best illustrate the results of our efforts, the following chart is provided:

MR. & MRS. DONOR CHARITABLE REMAINDER TRUST

Asset Allocation Implementation & Cost Structure

               
 Manager Investment Style Investment Amount Standard Cost Negotiated Cost Weighted Standard Cost Weighted Negotiated Cost
Mgr. A LC/Grwth $2,000,000 1.25% 0.75% 0.25% 0.15%
Mgr. B SC/Grwth $1,000,000 1.25% 1.00% 0.13% 0.10%
Mgr. C SC/Value $1,000,000 1.00% 0.75% 0.10% 0.08%
Mgr. D Foreign $1,000,000 1.30% 0.90% 0.13% 0.09%
Mgr. E Equity/FI $5,000,000 0.28% 0.28% 0.14% 0.14%
Total Management   $10,000,000     0.75% 0.56%
Custodian Custody $5,000,000 0.12% 0.08% 0.06% 0.04%
Total Fee         0.81% 0.60%


You will note that the fees being charged by Mgr. E are well below standard market levels. Your long-term relationship with Mgr. E has been well justified. I am particularly impressed with the equity rate of 0.28%. This low fee coupled with their tax efficiency makes Mgr. E very attractive for participating, where appropriate, in meeting their style allocation of the portfolio.

The negotiations with Mgr. A on your behalf were very successful. Mgr. A allowed our larger institutional rate of 0.75% to apply to your account. We were also successful in getting Mgr. B to come down to 1% from their standard fee of 1.25%. Regarding Mgr. C & D, we were able to secure management structured on a tax efficient and concentrated basis at levels normally reserved for much larger accounts. Both managers are providing services well below that which would be paid to access them through their mutual fund. Mgr. D, for example, is allowing us to participate in their institutional partnership wherein they pay all of the custody fees (approximately 0.30%) external to the partnership expenses.

We recommend that the trustee pay all management expenses from income actually received by the trust during the year. Income payments to the beneficiaries will be made out of any remaining income not used to meet expenses as well as the liquidation of assets sufficient to make the total 6% required distribution.

The following chart illustrates the impact of utilizing the ordinary income and realized short term gains to pay all expenses of the trust thereby requiring the trustee to make the bulk of the distribution payment from realized long term capital gains (18 months or longer holding periods).

CRT Income Analysis

           
Manager Investment Style Investment Amount Anticipated Income Weighted Income
Mgr. A LC/Grwth $2,000,000 1.80% 0.36%
Mgr. B SC/Grwth $1,000,000 1.00% 0.10%
Mgr. C SC/Value $1,000,000 2.00% 0.20%
Mgr. D Foreign $1,000,000 0.00% 0.00%
Mgr. E Equity/FI $5,000,000 4.00% 2.00%
Total   $10,000,000   2.66%
Total Fees       1.05%
Gross Distribution @ 39.6%       1.61%
Net A/T Distribution       0.97%
Gross Distribution @ 20%       4.39%
Net A/T Distribution       3.51%
Total Net A/T Distribution       4.48%
         
Blended Tax Rate       25.26%


To implement the recommendations on the CRT as outlined in this correspondence we will need to have your authorization given to the custodian. As custodian of the assets, he can implement the necessary accounts for each of the managers to utilize.

I am pleased with how the investments of the CRUT have been organized and look forward to visiting with you soon to firm up the balance of the allocation. If you have any questions concerning this material please do not hesitate to give me a call.

With warmest regards,

Paul L. Comstock
Chairman


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