Trust-Worthy Decisions A Guide to Managing Trusts

Transcription

1 Global Wealth Management Trust-Worthy Decisions A Guide to Managing Trusts What techniques can stabilize distributions to current beneficiaries? How can remainder beneficiaries be protected against inflation? When might it make sense to distribute assets early from a dynasty trust? July 2014

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3 Table of Contents 1 Introduction 3 New Challenges, New Tools Modest Returns in the Capital Markets A Larger Tax Bite Longer Lives for People (and Trusts) The Expanded Fiduciary Toolbox 6 The Trust Spectrum Trusts Focusing on Current Beneficiaries Trusts Focusing on Current and Remainder Beneficiaries Trusts Focusing on Remainder Beneficiaries The Foresight Saga 8 Trusts Focusing on the Needs of Current Beneficiaries Income Trusts Feature: A Broader Investment Universe Support Trusts 18 Trusts Focusing on the Needs of Remainder Beneficiaries Case 1: Distributing Assets May Increase Family Wealth Case 2: Distributing Assets May Materially Reduce Family Wealth Reaching a Decision 23 Conclusion Feature: Creating a Trust Investment Policy Statement How Bernstein Helps 25 Glossary 26 Notes on Wealth Forecasting System 13 Trusts Focusing on the Needs of Current and Remainder Beneficiaries Share of Wealth Stabilizing the Distributions Maintaining Purchasing Power

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5 Introduction Trustees currently face more challenges than at any point in recent history: They are expected to fulfill their fiduciary duty in an environment where investment returns are projected to be below normal, taxes are substantially higher, and trust beneficiaries are living longer. Trustees now have greater flexibility than in the past and more tools to address these challenges, but more discretion in administering trust assets also brings increased complexity and risk. Acting as a fiduciary and managing trust assets in the current environment call for a sophisticated understanding of the investment markets and thorough knowledge of the legislative landscape, including the tax code. They also call for exceptional foresight the ability to anticipate how decisions made today are likely to affect outcomes years into the future. The fundamental challenge usually comes down to fulfilling the grantor s intent while simultaneously meeting beneficiaries high expectations for the size of the distributions, the stability of the distributions over time, or the longevity of the trust. In some cases, a trustee can use new tools to meet these expectations in full, but when trust goals are not fully compatible with each other, trade-offs are inescapable. As experienced trustees will readily confirm, pressure from beneficiaries may further complicate decision making. Trustees who are relatives or close friends of the grantor often have long-standing relationships with the beneficiaries, and they may find it hard to say no to their requests. The analytic framework presented in this book can help cool the emotional temperature and better prepare trustees to reach reasoned, research-based decisions. It s important to keep in mind that trustees meet their duty as fiduciaries by being guardians of process, not guarantors of success. The capital markets themselves do not offer guarantees of success only probabilities. It s the trustee s job to comprehend these probabilities and choose a likely path to the trust s goals. We recommend that trustees document their actions by keeping written contemporaneous records of the process they follow and the information they rely on in reaching each decision. Trust-Worthy Decisions: A Guide to Managing Trusts 1

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7 New Challenges, New Tools Three primary factors have combined to make financial management of a trust more complex and demanding than in years past: a muted outlook for investment returns, higher tax rates, and the growing longevity of trust beneficiaries. Modest Returns in the Capital Markets Over the next 30 years, returns from stocks and bonds are expected to be below recent history and even further below what we would consider normal. 1 Display 1 shows our median projections for annualized returns for a range of asset allocations. The metric here is total return (the sum of price appreciation, dividends, and interest income), which is the investment standard for most modern trusts. For a diversified intermediateterm municipal bond portfolio, our median annualized total return projection is just 3.3% over the next 30 years well below the 4.9% return we would normally anticipate. Current bond yields, which are close to Display 1 Trusts Are Challenged by Market Conditions Median Return Projections for Next 30 Years* Today vs. Normal 8.1% 8.9% 9.6% Normal 6.1% 4.9% 3.3% 4.5% 6.6% 7.4% 8.1% Today 100% Bonds 20/80 60/40 % Stocks/% Bonds 80/20 100% Stocks *Projected pretax 30-year compound annual growth rate. Stocks are modeled as 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets stocks, and bonds are modeled as intermediate-term diversified municipal bonds. Today reflects Bernstein s estimates and the capital-market conditions as of September 30, Normal assumes all assets are fairly priced; it is Bernstein s estimate of capital-market equilibrium. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein 1 See page 7 for our definition of normal. Trust-Worthy Decisions: A Guide to Managing Trusts 3

8 70-year lows, are the primary reason for this subdued outlook. While we expect these yields to rise and approach more normal levels over time, in the near term rising yields will drive bond values lower, which in turn reduces total return in our projections. For globally diversified equities, we project a median annualized total return of 8.1% over the next 30 years. This lags our normal expectation of about 9.6%, but it is still reasonably attractive in absolute terms and very attractive versus the bond market alternative. Our equity forecast is slightly below normal in part because our projections begin at a time when equities appear to be fairly valued. This means that corporate earnings, rather than multiple expansion, will likely be the primary driver of equity gains going forward. Given the outlook for lower returns from both stocks and bonds, total returns from portfolios diversified between these two asset classes are also likely to be below normal, especially allocations skewed toward bonds. These return projections are critically important for fiduciaries trying to set an effective asset allocation, and they are equally important for trust beneficiaries (both current and future) who want to know how much financial support they should expect a trust to provide. Expectations that were shaped by an earlier market environment may now need to be recalibrated. A Larger Tax Bite Even though trusts may be earning less, they re paying more in taxes. At the start of 2013, the passage of the American Taxpayer Relief Act of 2012 (ATRA) and the imposition of the 3.8% surtax on net investment income brought top US income-tax rates to their highest levels in recent history. Today, the top tax rates on ordinary income and long-term capital gains are 43.4% and 23.8%, respectively up from 35.0% and 15.0% in Higher top rates are a particular concern for taxable (or non-grantor) trusts because they cross into the top tax bracket with income of just $12, For individual taxpayers filing jointly, the threshold for the top bracket is $457, Longer Lives for People (and Trusts) Despite the obvious personal benefits, longer life expectancies create another obstacle for trust fiduciaries. The average life expectancy for an individual born in 1970 is 70.8 years, but for someone born in 2010, it s 78.3 years. 3 Today, there s a 25% chance that a 65-year-old woman will reach the age of 94 and that a 65-year-old man will live to Many trusts are established to support one or more beneficiaries throughout their lives, so increasing longevity means that these trusts will have to last longer than ever before. The Expanded Fiduciary Toolbox Thankfully, fiduciaries can meet these more challenging conditions with greater flexibility than they had in the past. Today, trustees typically need to decide what investment strategies will be adopted, how large (and how frequent) the distributions will be, and who will bear the burden of income taxes. In other words, given the intent of the trust s grantor and the needs of the beneficiaries, trustees are responsible for setting investment policy, distribution policy, and tax policy. Investment policy is typically guided by the Uniform Prudent Investor Act (UPIA) [see Glossary, page 25], which generally provides trustees with great flexibility in selecting appropriate investments and considerable latitude regarding the composition of the return (e.g., growth or income). UPIA codifies sensible financial concepts; for example, it requires that each investment be considered in the context of an overall investment strategy that has risk and return objectives reasonably value from Revenue Procedure ; tax rate tables are adjusted for inflation each year. 3 Expectation of Life at Birth, and Projections, 4 Society of Actuaries RP-2000 Mortality Tables 4 Bernstein.com

9 suited to the trust. 5 Furthermore, unless directed otherwise, the trustee must diversify the investments. UPIA also specifies that in the investment and management of trust funds, a trustee should consider a daunting list of factors that may be relevant, including general economic conditions, the possible effects of inflation or deflation, the expected tax consequences of investment decisions, the expected total return, and the beneficiaries other resources and liquidity needs. In practice, trustees must determine an effective asset allocation strategy for the trust and the beneficiaries. Distribution policy is guided by the terms of the trust and by state law. Most trusts drafted today give fiduciaries discretion to distribute income and/or principal to the various beneficiaries. This distribution power may be very broad or may be limited (for example, by an ascertainable standard 6 [Glossary] or by the requirement to take into account a beneficiary s other assets). Many older trusts and certain marital deduction trusts limit distributions to current beneficiaries by the amount of fiduciary accounting income (FAI) [Glossary]. However, with the broad implementation of total return investing, many states have adopted the equitable adjustment power 7 [Glossary] under the Uniform Principal and Income Act (UPAIA) [Glossary]. In cases where trust distributions are limited by the FAI standard, this law allows a trustee to adjust between income and principal to help achieve the goals of the trust, as long as this power is exercised impartially based on what s fair and reasonable to all beneficiaries. 8 A number of states have also adopted unitrust conversion statutes, which provide trustees with a distribution policy that is deemed to be fair and reasonable (see page 14). Like UPIA, UPAIA instructs trustees about exercising the power to adjust and enumerates the important factors to consider: the nature, purpose, and expected duration of the trust; the intent of the grantor; the effect of economic conditions on principal and income; and the anticipated tax consequences of any adjustment. Tax policy is yet another area where trustees now have greater responsibility and more leeway. Today, trustees must consider the tax consequences of any decision they make. Trustees can place the tax burden on current beneficiaries by making distributions that carry out distributable net income (DNI) [Glossary]. In the past, absent certain circumstances, capital gain was typically excluded from DNI and was taxable to the trust (and, ultimately, to the remainder beneficiaries) rather than to the current beneficiaries. However, following the adoption of UPAIA, Treasury regulations now provide that capital gain can be included in DNI if state law and the governing instrument permit it, or if the fiduciary allocates gain to DNI pursuant to a reasonable and impartial exercise of discretion. 9 Thus, fiduciaries now have considerably more power to determine to what extent the trust or the current beneficiaries will be responsible for income-tax payments. 5 UPIA Section 2(b) 6 Internal Revenue Code Section 2041(b)(1)(A) 7 Uniform Principal and Income Act (2008) (UPAIA) Section 104(a) 8 UPAIA Section 103(b) 9 Treasury Regulations Section 1.643(a)-3(a) Trust-Worthy Decisions: A Guide to Managing Trusts 5

10 The Trust Spectrum Display 2 Where Does Your Trust Lie on This Spectrum? Beneficiaries Current Current and Remainder Remainder Main Concern Current Distributions Sharing of Wealth Maximize Remainder Value Stability of Distributions Division of Assets Purchasing Power Metrics Sustainability of Distributions Purchasing Power Remaining Assets Remaining Assets Example Support Trust Marital Trust Dynasty Trust Investment Policy Preservation Growth Source: AllianceBernstein Trusts are created for myriad reasons, their terms differ widely, and every beneficiary has different needs. Fiduciaries must customize the administration of each trust accordingly. To organize the many decisions and suggest suitable metrics, we ve created an analytical framework that classifies trusts according to their primary purpose (Display 2 ). Trusts Focusing on Current Beneficiaries This group, which includes support trusts, appears at the left side of the spectrum. The main concerns are the stability and sustainability of the distributions to the current beneficiary. The investment policy typically aims for wealth preservation, but some growth may be sought to maintain the desired distributions. Trusts Focusing on Current and Remainder Beneficiaries In the middle of the spectrum lie trusts, such as certain marital trusts, created to share wealth between two kinds of beneficiaries. Current beneficiaries seek stable and sustainable distributions, but remainder beneficiaries focus on the purchasing power and size of the remainder. Both are concerned with the division of trust assets. Because the interests of current and remainder beneficiaries are often divergent and sometimes opposing, this type of trust is inherently more difficult to administer. A trustee will typically choose an investment policy that mixes wealth-preserving assets and growth assets. Trusts Focusing on Remainder Beneficiaries On the far right of the spectrum lie trusts, such as dynasty trusts [Glossary], that focus primarily on the interests of future generations or the remainder beneficiaries. Here, the main concern is to retain purchasing power and maximize remainder value. Fiduciaries of such trusts generally make heavy allocations to growth assets. 6 Bernstein.com

11 Display 3 Bernstein's Wealth Forecasting System SM Is Uniquely Able to Help Trust Profile Scenarios Bernstein Wealth- Forecasting Model Distribution of 10,000 Outcomes Great Market Pattern (10% of probable outcomes are above this result) Type of Trust Grantor s Intent Trust Income-Tax Rate Time Horizon Current Beneficiary Tax/Risk Profile Remainder Beneficiary Tax/Risk Profile Distribution Policy Investment Policy Tax Policy 10,000 Simulated Observations Based on Bernstein s Proprietary Capital Markets Engine Typical Market Pattern (50% of probable outcomes are above this result) Hostile Market Pattern (90% of probable outcomes are above this result) Based on the current capital-market environment Incorporates various account types and planning vehicles Predicts likelihood of meeting long-term goals The Wealth Forecasting System is based upon our proprietary analysis of historical capital-market data over many decades. We looked at variables such as past returns, volatility, valuations, and correlations to forecast a vast range of possible outcomes relating to market asset classes, not Bernstein portfolios. While there is no assurance that any specific outcome suggested by the model will actually come to pass, by quantifying the possibilities of achieving financial goals under changing, and sometimes extreme, capital-market conditions, the tool should help our clients make better choices. See Notes on Wealth Forecasting System at the end of this book for further details. Source: AllianceBernstein The Foresight Saga Trust management decisions can have extremely long-term ramifications. If the beneficiaries are young (or unborn), a trust may survive for three or four decades, or longer. To make prudent decisions, trustees need either a crystal ball or, next best, a research-based system for estimating the long-term impact of alternatives they re considering. Bernstein s Wealth Forecasting System SM (WFS) falls into the latter category a state-of-the-art financial modeling tool (Display 3 ). The WFS is driven by our proprietary Capital Markets Engine, which takes account of the linkages among the capital markets, as well as their unpredictability. We model the drivers of returns, basing our forecasts on economic and accounting principles and asset-specific factors. We also model the impact of inflation, deflation, and taxes. Starting from today s conditions, we simulate 10,000 plausible paths for inflation and a wide range of returns from investment assets. If 9,000 of these 10,000 trials achieve (or exceed) a particular result, it means that the outcome should be attainable even if capital-market returns are poor. We call this the 90% level of confidence. We also focus on the 50% level of confidence the median result, which represents typical capital markets and on the 10% level, which represents very favorable conditions. When we analyze a trust, we consider its type, the grantor s intent, the trust s incometax rate and time horizon, and the tax and risk profiles of all the beneficiaries. Our analysis gives fiduciaries and beneficiaries a reading on whether a given policy decision is likely to achieve the intended result. We also use the WFS to determine the normal levels for asset returns. We define normal as an environment where asset classes are all fairly priced and in equilibrium with one another. Typically, it is close to a very long-term historical average. Normal does not imply a narrow, fixed view of the future; in fact, normal is sure to change over time. Our methodology does not supply answers; it supplies a range of plausible outcomes at varying levels of probability and highlights the trade-offs in various possible scenarios. Trustees have to weigh the likely outcomes and then exercise discretion. In the end, their judgment prevails. Trust-Worthy Decisions: A Guide to Managing Trusts 7

12 Trusts Focusing on the Needs of Current Beneficiaries Income Trusts Which assets can be used to safely boost income? What risks must be taken into account? While there is no formal trust with this name, we use the term to designate trusts (whether marital, dynasty, or support) that are permitted to distribute only portfolio income to their beneficiaries. Absent an equitable adjustment power or unitrust conversion power under state law, the trustee cannot alter distribution policy, and the only way to advance trust goals is to adjust the investment policy. Case Study: Initial Assumptions $10 million income trust Beneficiary: age 70 Time horizon: 20 years Over the next 20 years, there s a 28% chance that a 60/40 portfolio will suffer a loss this large almost double the probability we project for normal capital markets. Given this outlook, a trustee s instinct might be to allocate more to bonds. This would make sense in a normal environment, when a 20/80 portfolio would be expected to generate $411,000 of income in year 1, but in today s lower-yield environment, a 20/80 allocation would likely provide just $224,600 even less than the Display 4 Projected Income Is Lower and Investment Risk Higher than Normal Pretax Income in Year 1 $10 Million Trust 60% Stocks/40% Bonds* Probability of 20% Peak-to-Trough Investment Loss Initial investment policy: moderate growth $361,700 Normal 15% (60/40 risk profile) Distribution policy: portfolio income $234,200 Today 28% Objective: to safely boost income In normal markets, the expected income from a $10 million portfolio with a 60% stock/40% bond risk profile would be about $362,000 in year 1, but due to the lower interest rates on bonds, it is just $234,200 today (Display 4 ). And, compounding the problem, we currently anticipate higher-than-normal investment risk even for a balanced portfolio. We represent investment risk as the likelihood of a 20% loss from a market peak to a subsequent trough at any time over the life of the trust [Glossary]. *Stocks are modeled as 21% US value, 21% US growth, 21% US diversified, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets, and bonds are modeled as intermediate-term diversified municipal bonds. Normal is defined on page 7. Today reflects Bernstein s estimates and the capital-market conditions as of September 30, Projections indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 20% over the next 20 years. Because the Wealth Forecasting System uses annual capital-market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein 8 Bernstein.com

13 60/40 mix. This bond-heavy portfolio would also mean that less wealth would remain in the trust. Another instinct might be to stay with the 60/40 portfolio but shift to higher-yielding bonds by going lower on the credit spectrum or further out on the yield curve. And, in fact, by replacing investment-grade intermediate bonds with both high-yield bonds and long-term bonds, a trustee could more than double the expected income in year 1 from $234,200 to $509,700. But this improvement would come at the cost of much greater risk. At this asset allocation, the probability of a 20% loss over the next 20 years would soar to 54% far more risk than most trustees and beneficiaries would willingly accept. A Broader Investment Universe In a period when market returns are muted and often volatile, it s fortunate that the investment universe contains more than just stocks and bonds. Today, investors can own a much broader array of assets, which we categorize as return-seeking, riskmitigating, or diversifying (Display 5 ). Return-seeking assets (such as stocks, taxable high-yield bonds, and municipal high-yield bonds) are engines of growth. Risk-mitigating assets (such as high-quality intermediate-term US bonds, global bonds, and short-duration bonds) can help preserve wealth by offsetting potential investment risk from stocks. Diversifying assets (such as real assets and hedge funds) can steady a portfolio because of their low correlations to other asset classes. Display 5 Investment Markets Have Evolved Diversifying assets may help in several ways. Real assets, which include real estate investment trusts (REITs) and commodities, are investments that tend to rise in value as inflation mounts. They can therefore help protect a portfolio against inflation. Hedge funds may also play an important role. While individual hedge funds can have very idiosyncratic returns, a fund of diversified hedge funds, if properly structured, can provide diversification benefits as well as solid returns. Given the complexity of many hedge fund strategies and the form in which they are often offered (nonpublicly traded shares), trustees need to determine whether hedge funds are suitable (or even permissible) for their trust and beneficiaries, and whether their trust meets the regulatory qualifications. Assets should be categorized by what they do not what they are called Traditional Today Stocks Return- Seeking Stocks: US, International, Emerging, Mid- and Small-Cap, Growth, Value, Stability, Income; High-Yield Bonds: Taxable, Municipal Engines of Growth Diversifying Real Assets; Alternative Investments Low Correlations Bonds Risk- Mitigating Bonds: US and Global Taxable, Municipal, Inflation-Sensitive Preservation of Wealth Source: AllianceBernstein Trust-Worthy Decisions: A Guide to Managing Trusts 9

14 Is There a Better Way? Using the asset allocation framework presented on page 9, a trustee can boost income without increasing portfolio risk. In this particular situation, we found that tilting the equities in the return-seeking portion of the portfolio toward high-dividend-paying stocks could increase income from $234,200 to roughly $253,000, while allocating 10% of the portfolio to high-yield bonds, sourced from stocks, could boost income to just under $278,000 (Display 6 ). Adding both of these asset types could be expected to raise income to $293,400 almost 25% more than a traditional 60/40 mix would be likely to generate. The shift would not raise the level of investment risk in fact, it would reduce the probability of a 20% peak-to-trough loss from 28% to 19%. By taking these steps, the fiduciary can, without sacrificing safety, meet the primary goal of providing the trust s current beneficiary with greater income. There is, however, a possible downside: High-dividend-paying stocks and high-yield bonds generally don t appreciate in price to the same extent that traditional stocks do. Shifting the allocation in this way will likely reduce the growth of trust principal, which means that the increase in income for the current beneficiary would come at the expense of the remainder beneficiary. In some trusts, this could have little consequence, but in others it would be a serious consideration. Lessons from Income Trusts In a period when the capital markets are not delivering a great deal of income, thoughtful changes in asset allocation clearly can help. But all risks need to be taken into account, and whatever changes a trustee implements need to be monitored over time as the capital markets evolve. Display 6 Boosting Income While Reducing Risk $234,200 * 60/40 assumes 60% invested in global stocks and 40% invested in intermediate-term diversified municipal bonds. High-Dividend Stock Tilt assumes 37.8% US value, 4.2% US small-/mid-cap, 13.5% developed international, 4.5% emerging markets, and 40% intermediate-term diversified municipal bonds. 10% HY (High-Yield) Bonds Sourced from Stocks assumes 50% global stocks, 10% high-yield bonds, and 40% intermediateterm diversified municipal bonds. Both Strategies Combined assumes 31.5% US value, 3.5% US small-/mid-cap, 11.25% developed international, 3.75% emerging markets, 10% high-yield bonds, and 40% intermediate-term diversified municipal bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Remainder value in real dollars. Projections indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 20% over the next 20 years. Because the Wealth Forecasting System uses annual capital-market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein Support Trusts Pretax Income in Year 1 Initial Assets: $10 Million* $252,900 60/40 High- Dividend Stock Tilt $277,800 10% HY Bonds Sourced from Stocks $293,400 Both Strategies Combined Remainder Value: Year 20 (USD Millions) $9.7 $9.5 $8.2 $8.1 Probability of 20% Peak-to- Trough Loss 28% 25% 22% 19% 25% More Income What are the advantages and disadvantages of a more return-oriented asset allocation? How can a trustee reduce depletion risk without increasing investment risk? Support trusts are also established to meet the financial needs of a current beneficiary, but unlike portfolio income-only trusts, the trustee has the flexibility to distribute both income and principal. 10 Bernstein.com

15 Display 7 Greater Equity Allocation Improves Likelihood of Meeting Goals Projected Trust Values Initial Assets: $10 Million, USD Millions, Nominal Probability 5% 10% 50% Traditional 20/80 Allocation* Traditional 60/40 Allocation* $ % 95% $17.3 $11.2 $11.7 $9.5 $11.4 $11.7 $13.1 $13.5 $7.6 $8.0 $4.5 $7.7 $5.8 $3.0 $0.0 $ Years 20 Years 30 Years 10 Years 20 Years 30 Years $25.2 Probability of Depletion 2% 2% 31% 2% 2% 11% *Spending $370,000, adjusted for inflation. Traditional 20/80 Allocation assumes 20% global stocks and 80% intermediate-term diversified municipal bonds. Traditional 60/40 Allocation assumes 60% global stocks and 40% intermediate-term diversified municipal bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Probability of Depletion represents probability of trust assets less than $100 in given years. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein Case Study: Initial Assumptions $10 million support trust Beneficiary: age 60, with few personal assets Time horizon: 30 years Investment policy: conservative (20/80 risk profile) Distribution policy: $370,000 annually, adjusted for inflation Not Quite There Starting from these initial assumptions, we projected the value of the trust over the next 30 years. The left side of Display 7 indicates the results. The blue bar shows an array of outcomes in market conditions ranging from hostile at the bottom of the bar (the 90th percentile) to great at the top of the bar (the 10th percentile). The lines extend these projections to the 95th percentile at the bottom of the bar and the fifth percentile at the top. The middle of the bar, indicated by the aubergine diamond (the 50th percentile), represents typical market conditions. The left side of the chart shows that with a 20/80 risk profile, the trust will still have assets after 30 years in typical markets, but if market returns are poor, the trust will likely run out of money by year 30. In fact, as indicated in the table below the graph, it has a nearly one-in-three chance of depletion. Although it looks quite sustainable over 10 years and 20 years, the $370,000 annual drawdown from the portfolio is clearly not sustainable over 30 years under hostile market conditions assuming, of course, a 20/80 asset allocation. If 20% is too small an allocation to stocks, what asset mix would solve the sustainability problem? We tested various scenarios and found, as shown on the right side of Display 7, that success required a 60% allocation to stocks. With a 60/40 portfolio, the trust should be able to distribute $370,000 a year for 30 years with just an 11% risk of depletion. Trust-Worthy Decisions: A Guide to Managing Trusts 11

16 Why Investment Risk Matters The larger allocation to stocks helps reduce depletion risk, but there s also a second key risk that a fiduciary needs to consider: investment risk. As Display 8 makes clear, these two risks run counter to one another: the smaller the investment risk, the greater the depletion risk, and vice versa. With the bond-heavy 20/80 portfolio, investment risk is insignificant, but depletion risk is nearly one in three. Shifting from a 20/80 to a traditional 10 60/40 asset allocation reduces depletion risk but increases the probability of a 20% peak-totrough loss to 45%. Trustees need to consider both risks when choosing an asset allocation strategy. High investment risk is worrisome largely because of its potential impact on trustees. When the market drops, many investors find the pain intolerable and sell some or all of their holdings. Selling at a market low can cause long-term (and sometimes permanent) damage to a portfolio s principal value. Although trustees are managing assets for others rather than for themselves, they may be susceptible to this same behavioral bias. Any reduction in investment risk helps diminish the chances that panic selling will be triggered. In this particular case, diversifying assets (see page 9) can help. Shifting the 60/40 allocation to include inflation-sensitive bonds and diversified hedge funds can lower the odds of a large decline from 45% to 39% while also slightly reducing the risk of depletion. Including these assets clearly doesn t eliminate investment risk, but it can provide a modicum of stability during market downturns. Lessons from Support Trusts Whenever you set a distribution policy and an investment policy for a support trust, you expose the portfolio to two kinds of risk: on the one hand, the risk that the Display 8 Two Types of Risk to Balance 31% Depletion Risk* 11% 10% Investment Risk (Probability of 20% Peak-to-Trough Decline) Traditional 20/80 Traditional 60/40 <2% 45% Diversified 60/40 39% *Determined by the inverse of the probability of assets greater than nominal $100 in 30 years. Traditional 20/80 allocation assumes 20% global stocks and 80% intermediate-term diversified municipal bonds. Traditional 60/40 allocation assumes 60% global stocks and 40% intermediate-term diversified municipal bonds. Diversified 60/40 allocation assumes 52% global stocks, 14% diversified hedge funds, 26% intermediate-term diversified municipal bonds, and 9% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/ mid-cap, 22.5% developed international, and 7.5% emerging markets. Numbers may not sum due to rounding. Data indicate the probability of a peak-to-trough decline in pretax, pre-cashflow cumulative returns of 20% over the next 30 years. Because the Wealth Forecasting System uses annual capital-market returns, the probability of peakto-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein burden of distributions will deplete trust principal, and on the other hand, investment risk. Trying to avoid investment risk is not a good strategy if it increases depletion risk too much. A 20% loss is certainly painful, but it doesn t hurt the beneficiary as much as depletion of all trust assets would. There is no risk-free option here, but after reviewing the probabilities, a trustee will have a basis for striking a responsible balance between these risks. 10 Consisting solely of conventional stocks and bonds 12 Bernstein.com

17 Trusts Focusing on the Needs of Current and Remainder Beneficiaries What tools can a trustee employ to fulfill the grantor s goals? What kinds of trade-offs may be necessary? In the middle part of the trust spectrum lie trusts where the needs of both current and remainder beneficiaries must be considered a classic example being a trust for the current benefit of a spouse and the long-term benefit of remainder beneficiaries who are the decedent s children from a previous marriage. Here, a fiduciary is responsible for ensuring that both sets of beneficiaries are treated fairly and equitably. The metrics here are more complicated than they were for the support trust. For the current beneficiary, the important standards are: The level of the distributions The stability of the distributions The sharing of trust wealth For the remainder beneficiaries, the important metrics are: The size of the trust remainder The purchasing power of the trust s principal The sharing of trust wealth Case Study: Initial Assumptions $10 million testamentary trust Current beneficiary: decedent s 50-year-old second spouse Remainder beneficiaries: decedent s grown children from an earlier marriage Surviving spouse spends $400,000 a year Time horizon: years Distribution policy: trust document specifies that all income is to be paid out, but the trustee has the power to adjust [Glossary], as well as discretion over distributions Long-term goal: equitable distribution of the trust assets, with approximately 50% going to the spouse and 50% to the children Trustee is considering: y An investment policy with a growth-oriented 80/20 risk profile y An annual distribution policy of the greater of $400,000 (inflation-adjusted) or all trust income Share of Wealth We used our Wealth Forecasting System to examine whether the trustee s initial concepts for investment and distribution policies would be likely to result in equal sharing of the wealth. We found that they would not. Trust-Worthy Decisions: A Guide to Managing Trusts 13

18 As the left side of Display 9 shows, the proposed inflation-adjusted distributions would likely provide the spouse with a very narrow range of outcomes, all of which are favorable. 11 But in more trials than not, the $400,000 minimum payment forces the trustee to dip into principal. If future markets are hostile, the trust could be depleted by year 30, leaving nothing at all for the children. Even in the typical case, the trust principal would dwindle to $5.6 million (inflation-adjusted) in 30 years time, at which point, 65% of the total inflation-adjusted wealth created by the trust would have gone to the spouse and just 35% would remain for the children. And if the spouse should live to year 40, which is a distinct possibility, 12 depletion risk would be greater still. This investment policy and distribution policy largely meet the spouse s needs, but the children hold all the investment risk. Thanks to the broad powers granted under the trust instrument, the trustee can, as an alternative, institute a unitrust-based distribution policy one that pays out a fixed percentage of the trust assets each year. Switching to a 4% unitrust would eliminate depletion risk for the children (Display 9, right side ). In addition, the children s share of wealth would increase meaningfully from 35% to 45% in the typical case. Each year, the payout would fluctuate directly with the value of the trust, so the spouse would now share the investment risk, as evidenced by the larger range of the accumulated distributions. And the spouse s longevity would be less of a concern. Thanks to the percentageof-assets-based policy, the trust would not come close to depletion in 40 years. But the stated goal of the trust is equal sharing of trust wealth, and the 4% unitrust-based distribution policy Display 9 Unitrust Improves Sharing of Wealth and Investment Risk Inflation-Adjusted Wealth* $400,000, 80/20 Risk Profile, After-Tax, Year 30 USD Millions Inflation-Adjusted Wealth 4% Unitrust, 80/20 Risk Profile, After-Tax, Year 30 USD Millions Probability 5% 10% 50% 90% 95% Spouse s Accumulated Distributions $11.7 $10.8 $10.0 $17.9 $5.6 $0.0 Children s Remainder Value Spouse s Accumulated Distributions $14.1 $9.5 $6.6 Children s Remainder Value $15.5 $7.6 $3.7 *Distribution is the greater of income or $400,000 grown with inflation. 80/20 risk profile assumes 63% global stocks, 21% diversified hedge funds, 12% intermediateterm diversified municipal bonds, and 4% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein 11 Because the remainder beneficiaries care, above all, about the long-term purchasing power of the trust s principal, we focus here on the inflation-adjusted values of distributions and principal rather than on the nominal values, which are a more appropriate standard for analyzing income and support trusts. 12 At age 50, the chance of living to age 90 is 31% for a male spouse and 42% for a female spouse (Society of Actuaries RP-2000 Mortality Tables). 14 Bernstein.com

19 is not likely to achieve it. According to our calculations (Display 10), to improve the odds of equal sharing of trust wealth, the unitrust distribution rate would have to be lowered to 3.6% a 10% cut in the annual payout to the spouse. In the typical case, the spouse s accumulated distributions and the children s remainder value would then converge in year 30. Stabilizing the Distributions Setting the distribution rate at 3.6% could help achieve the grantor s objective, but it would not be the final step for the trustee. If trust distributions are the major (or sole) source of income for the spouse, their stability will be extremely important. In this respect, a unitrust can leave a lot to be desired. Because unitrust payouts are based on the value of the portfolio, which is variable, they can fluctuate widely from year to year. Stocks can be volatile, so the larger their allocation in a portfolio, the greater these fluctuations are likely to be. One possible way to make the distributions more stable would be to shift to a more moderate asset mix: a 60/40 risk profile rather than an 80/20. Assuming a 3.6% unitrust distribution rate, by year 30 an 80/20 portfolio would result in a typical inflation-adjusted distribution of $309,000, pretax. However, in hostile markets the payout could fall to $150,000, and in great markets it could rise to $620,000. With the 60/40 portfolio, the range is much narrower. The spouse could expect annual pretax distributions of about $267,000 in typical markets, about $144,000 in hostile markets, and over $487,000 in great markets. While shifting to a 60/40 risk profile would help stabilize the payouts, it would also reduce the probable wealth for both the spouse and, especially, the children. As Display 11 (next page) indicates, the 80/20 portfolio would be better for the children in all market environments and better for the spouse in both typical and great markets, although slightly worse in hostile markets. It s up to the trustee to weigh the resulting Display 10 Adjusting the Unitrust Percentage Can Equalize Wealth Unitrust 80/20 Risk Profile,* Year 30 USD Millions Spouse s Accumulated Distributions Children s Remainder Value 4.0% $9.5 $ *Inflation-adjusted, after-tax. 80/20 risk profile assumes 63% global stocks, 21% diversified hedge funds, 12% intermediate-term diversified municipal bonds, and 4% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/ mid-cap, 22.5% developed international, and 7.5% emerging markets. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein trade-off between greater potential stability and lower potential total wealth. There are other strategies to consider for stabilizing the payouts. A smoothing rule, which has been adopted in many states that have unitrust conversion statutes, might help. A three-year smoothing rule, for example, bases each year s payout on the average of the portfolio s value in the current year and its value in each of the two prior years. Smoothing would make the annual payouts more predictable and reduce the probability of a 10% year-over-year decline in the payout from 13% to just 3%. But smoothing does have limitations: It helps on a year-to-year basis, but it cannot minimize the effect of multiyear market cycles. In an extended bear market, the current beneficiary s support would be likely to slide, and in an extended bull market, high current distributions would be likely to erode the remainder Trust-Worthy Decisions: A Guide to Managing Trusts 15

20 Display 11 Lower Equity Allocation Creates Greater Certainty but Less Wealth for All 3.6% Unitrust Total Wealth* Inflation-Adjusted, Year 30 Probability 5% 10% 50% 90% 95% Spouse s Accumulated Distributions USD Millions $13.3 $8.9 $6.1 $11.8 $8.5 $6.2 Children s Remainder Value USD Millions $17.4 $8.5 $4.1 $13.5 $7.3 $3.9 80/20 60/40 80/20 60/40 *After-tax. 80/20 risk profile assumes 63% global stocks, 21% diversified hedge funds, 12% intermediate-term diversified municipal bonds, and 4% intermediate-term inflation-sensitive bonds. 60/40 risk profile assumes 52% global stocks, 14% diversified hedge funds, 26% intermediate-term diversified municipal bonds, and 9% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Numbers may not sum due to rounding. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein beneficiaries wealth. As a result, smoothing alone does not fully meet the needs of beneficiaries of either type. To mitigate the effect of market cycles on smoothing, the trustee could add a floor and ceiling to the size of the annual payout, provided that either state law or the trust document grants this power. With an 80/20 risk profile and a three-year smoothing rule, the probability of a 30% peak-to-trough decline in distributions is 51% over the next 40 years. The left side of Display 12 shows how a floor and ceiling could limit the extreme troughs and peaks. In fact, they could lower the odds of such a large peak-to-trough decline to just 16%. The right size for a floor and ceiling depends on the unitrust percentage, the asset allocation, and the expected term, among other factors. For this particular trust, our tests indicated that a floor of 80% of the initial distribution, inflation-adjusted, and a ceiling of 120% would be highly effective in stabilizing distributions for the spouse through market cycles. How would the children be affected? The floor puts more strain on the trust in down markets, but the ceiling can offset that effect by capping the distributions in spectacular markets. As the right side of Display 12 shows, the addition of a floor and ceiling would extend the range of outcomes for the children at both the high and low ends, and create a relatively modest reduction in the typical outcome. The floor and ceiling appear to be fair and reasonable for the children. Maintaining Purchasing Power Both UPIA and UPAIA require fiduciaries to take the impact of inflation into account as they administer trust assets. Over the last 60 years, inflation averaged about 3.7%, but it spiked into double digits in the 1970s and early 1980s. Since forecasters have shown little ability to predict increases in inflation, some protection may be in order. The truth is, it will be very difficult for this trustee to maintain purchasing power in the future. We examined a 16 Bernstein.com

21 Display 12 Floor and Ceiling Provide Smoother Payouts at Little Cost to Children Distribution to Spouse 80/20, 3.6% Unitrust with 80% Floor and 120% Ceiling* Inflation-Adjusted Remainder* Year 30, 80/20 USD Millions Probability 5% 10% 50% 90% 95% Display 13 Lower Distribution Rate Better Protects Purchasing Power Median Wealth* Year 30, 80/20 Inflation-Adjusted, USD Millions $17.4 $17.9 Probability of 30% Peak-to-Trough Decline: 16% Years $18.1 $8.7 $4.1 $20.6 $8.4 $ % Unitrust 3.6% Unitrust with Three-Year with 80% Floor/ Smoothing 120% Ceiling $10.0 Current Remainder $8.9 $7.9 $8.5 $ % Chance of Maintaining Purchasing Power *Assumes three-year smoothing and, where noted, an 80% floor and 120% ceiling, grown with inflation, on year 1 distribution of $360,000. Year 1 floor is $288,000 and ceiling is $432, /20 risk profile assumes 63% global stocks, 21% diversified hedge funds, 12% intermediate-term diversified municipal bonds, and 4% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Pretax, nominal. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein range of asset allocations to ascertain whether the portfolio s purchasing power could be sustained for 30 years. Even with inflation-sensitive bonds in the portfolio and a large allocation to stocks (an 80/20 risk profile), the odds are just four in 10 that the portfolio s principal would retain its initial purchasing power. With a 3.6% distribution rate, no asset allocation would be very likely to counteract the impact of inflation. According to our modeling, distributions would have to be reduced from 3.6% to 3.0% to protect trust principal against inflation. This rate, coupled with an 80/20 portfolio, would give the remainder beneficiaries a 50% chance that the trust principal would be worth $10 million, adjusted for inflation, at the end of 30 years (Display 13 ). For the current beneficiary, this change would mean about $1 million less in cumulative distributions over the course of three decades. Initial Assets 3.6% Distribution *Current beneficiary s wealth consists of after-tax accumulated distribution, inflation-adjusted. Remainder beneficiary s wealth consists of remaining trust portfolio value, inflation-adjusted. 80/20 risk profile comprises 63% global stocks, 21% diversified hedge funds, 12% intermediate-term diversified municipal bonds, and 4% intermediate-term inflation-sensitive bonds. Global stocks comprise 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging markets. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on Wealth Forecasting System at the end of this book for further details. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AllianceBernstein In this instance, the trustee is unlikely to satisfy everyone. Absent any guidance from the trust document, the trustee has to weigh the potential cost for the current beneficiary against the potential benefit for the remainder beneficiaries and make the judgment call. Lessons from Marital Trusts 3.0% Distribution Fiduciaries of marital trusts generally have several tools to employ: In addition to adjusting the investment policy and distribution policy, they can consider unitrust conversion, smoothing rules, and floors and ceilings. These tools may enable a trustee to achieve the grantor s goals for both kinds of beneficiaries, but where trade-offs are unavoidable, a trustee can make them with open eyes and explain them clearly to the beneficiaries. Trust-Worthy Decisions: A Guide to Managing Trusts 17