Donors Dreams, Investment Realities

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1 By Sally Rubin, CFA Director of Investments Crystal Thompkins, CAP, CSPG CM Director of Relationship Management Donors Dreams, Investment Realities Charitable donors are increasingly interested in how their gifts are invested but too often their perception of what constitutes an appropriate investment strategy may be more a dream than reality. For example, a donor may believe that the investment strategy in his or her own portfolio should also be used for his or her charitable remainder trust. However, this fails to consider the importance of the characteristics of the trust, as well as the risk tolerance of the income and remainder beneficiaries. When a donor s ideas about investing turn out to be incorrect, it can lead him or her to feel confused, disappointed or even angry. It may cause the donor to mistrust the advice that he or she has been given. The fallout is a much-lessthan-ideal gift. To avoid this, it s important for everyone with an interest in the management of a trust the donor, the investment manager and the charitable organization to understand the root of these misconceptions so they can be better prepared to face the realities before them. The seven misconceptions detailed here can be hard to dispel, as they often appeal directly to a donor s emotions. Believing some of these misconceptions might make investing seem less daunting. To avoid disappointment during the life of the gift, it is crucial to convey the reality of each situation to the donor in a clear, straightforward manner. Misconception 1: Trust Investments Will Always Appreciate Reality: In order to attain greater returns in the long run, donors must be willing to tolerate short-term losses. There is always a trade-off between risk and returns. Riskier assets have the potential to deliver greater returns over time, but investors should anticipate choppier, more volatile returns in the short run. Donors need to be prepared to weather those fluctuations and to keep their eye on their long-term goals. Misconception 2: Recent Market Trends Will Continue Indefinitely Reality: Past or current performance does not guarantee future results. It s rare that a particular asset class would ever be the top performer for two years in a row. Assuming that recent trends will continue without looking closely at the details is a recipe for disaster. For example, the length and magnitude of a bull market in equities is unpredictable. 1 Donors Dreams, Investment Realities August 217

2 The current bull market in bonds is another good example. As we see in Figure 1, interest rates have been steadily declining for over 3 years. It s easy to understand why someone might assume that this trend would continue, especially given the current upheaval in global markets. Figure 1: Interest Rates Lower for Longer 1-Year Constant Maturity Note Yields PERCENT As of 8/5/16. Source: Federal Reserve Bank But with interest rates so close to zero, they essentially cannot go any lower. History and the principles of economics strongly suggest that rates will eventually rise at some point in the future, and when they do, bond returns will be challenged. Figure 2 shows the impact of a 1% increase in interest rates on the one-year total return of various government bonds. Figure 2: Risk of Rising Interest Rates 1-Year Total Return with a 1% Rise in Interest Rates PERCENT % -2.3% -5.9% -5.2% % Year 5-Year 1-Year 1-Year TIPS* 3-Year Assumes current breakeven inflation of +1.44%. Breakeven inflation impacts the total return of TIPS. As of 6/3/216. For illustrative purposes only. Source: Bloomberg L.P. 2 Donors Dreams, Investment Realities August 217

3 Misconception 3: It s Better to Take a Higher Payout Rate From a Charitable Remainder Unitrust Reality: A lower payout rate may better serve the needs of both the donor and the charitable remainder beneficiary. As the income beneficiary of a unitrust, a donor may believe that a higher payout rate offers the best deal. What the donor may not realize, however, is that drawing higher payouts from the principal value of the trust could undermine the value of all income he or she receives over the life of the trust. Choosing a lower payout rate would leave more assets in the trust to appreciate over time. Because unitrusts pay out a fixed percentage of the principal value, allowing the principal to grow could be more lucrative for the donor over the long run. As Figure 3 shows, a lower percentage payout on a larger principal amount is often better for the income beneficiary than a higher percentage payout on an ever-diminishing principal amount. Figure 3: Spending Opportunity vs. Risk Impact of Spending Rate on Portfolio Value Probability of Assets Greater than Half Original Value After 3 Years PROBABILITY (%) % 3% 4% 5% 6% SPENDING RATE 8% Equity/2% Fixed Income 1 6% Equity/4% Fixed Income 2 3% Equity/7% Fixed Income 3 Spending rate equals stated percentage of inception market value and increases at an assumed inflation rate of 2.5% per annum. Asset allocations are constructed based on current BNY Mellon Wealth Management strategy recommendations: 1 Comprised of: 29.8% large cap equity, 3.7% mid cap equity, 2.3% small cap equity, 12.% developed international equity, 12.3% emerging markets equity, 1.2% taxable fixed income,.9% high yield fixed income, 2.2% absolute return strategies, 11.7% long/short strategies, 1.% private equity, 1.6% commodities and 3.3% managed futures. 2 Comprised of: 22.4% large cap equity, 3.1% mid cap equity, 2.% small cap equity, 9.% developed international equity, 1.% emerging markets equity, 28.8% taxable fixed income, 1.9% high yield fixed income, 3.1% absolute return strategies, 7.3% long/short strategies, 7.5% private equity, 1.2% commodities and 3.7 managed futures. 3 Comprised of: 13.4% large cap equity, 3.2% mid cap equity, 2.1% small cap equity, 4.5% developed international equity, 4.4% emerging markets equity, 6.2% taxable fixed income, 2.% high yield fixed income, 4.4% absolute return strategies, 2.6% long/short strategies, and 3.2 managed futures. Return assumptions: 8.% large cap equity; 8.75% mid cap equity; 9.5% small cap equity; 7.8% developed international equity; 1.% emerging markets equity; 4.% taxable fixed income; 7.% high yield fixed income, 6.% absolute return strategies, 7.5% long/short strategies, 12.% private equity, 7.% commodities and 6.% managed futures Donors Dreams, Investment Realities August 217

4 Misconception 4: Investors Should Get Out of Financial Markets When Markets are Declining, and Try to Get Back in When Markets Are Poised to Rise Reality: As we see in Figure 4, it is impossible to always time the market profitably, and being out of the market for even a few days can dramatically impact investment performance. Figure 4: The Danger of Market Timing Growth of $1 Invested in S&P 5 at Period Inception, as of 12/215 DOLLARS 1,2 1, 8 1, Years 1 Years 25 Years Entire Period Less Best 3, 1 and 25 Days* Source: Morningstar Direct Intended for illustrative purposes only, furnished without responsibility for completeness or accuracy. Past performance is no guarantee of future results. * Return represents entire period return less best 3, 1, and 25 days in respective 3, 1, and 25 year time periods. It s natural for investors to have an emotional reaction to a decline in the markets, especially when their portfolios have absorbed losses. But in order to succeed with a market-timing strategy, an investor needs to make two correct decisions each time: when to get out of the market, and when to get back in. No one has been able to do this consistently. Misconception 5: Don t Sell the Stock That Was Used to Establish the Charitable Remainder Trust Reality: Diversification is the best way to reduce the risk exposure of a portfolio. Donors often have an emotional attachment to the trust s funding gift. It may be stock in a company that is responsible for the donor s wealth, or even a company that the donor helped to found. Nevertheless, portfolios that are too concentrated in a particular asset are exposed to more risk than those that are more broadly invested. By holding a variety of assets that are affected differently by changes in the market, it s possible to diminish the amount of volatility the portfolio may experience. This is why, for example, we include bonds in our clients portfolios even when there is a poor outlook for fixed income returns their inclusion in the portfolio helps to reduce risk. Additionally, not selling a concentrated stock position means failing to take advantage of one of the opportunities offered by a charitable remainder trust: putting an appreciated asset into a charitable remainder trust allows for the asset to be sold, in the trust, without the need to pay capital gains tax on the appreciation. 4 Donors Dreams, Investment Realities August 217

5 Misconception 6: You Can t Lose Money Investing in Bonds Especially U.S. Government Bonds Reality: All fixed income securities have the potential to lose value, as they are exposed to both interest rate risk and credit risk. Credit risk is the risk that the issuer of the bond won t be able to repay the amount it has borrowed when the debt comes due. Though this isn t much of a concern when it comes to U.S. government bonds, private companies can and do default on their bonds. Rising interest rates can cause the value of bonds from companies with low credit ratings to decrease, as the increased cost of borrowing makes it less likely that they will be able to service their existing debt. All bonds, including U.S. government bonds, can be affected by interest rate risk. When interest rates rise, the present value of the future interest and principal payments associated with any existing debt immediately decreases. Diversifying holdings within the fixed income asset class is useful, because it reduces the concentration of exposure to the different types of risk whether credit quality risk, duration risk, or industry-sector risk. Misconception 7: Changes to Asset Allocation Should Be Based on Gut Instincts, or What Commentators Are Saying in Response to Recent Events Reality: Experienced investors understand that a successful investment strategy relies on discipline, maintaining a long-term perspective, and often involves sticking to principles even when doing so may feel uncomfortable in the short run. At BNY Mellon Wealth Management, we do not adjust long-term asset allocation in response to market events, media reaction or commentary, or in an attempt to time the market. We will adjust the long-term asset allocation in a portfolio in response to a considered change in risk tolerance. The worst time to change an asset allocation away from risky assets is just after those assets have sold off. In that case, the change in risk tolerance would have been dictated by the markets, and the portfolio would risk selling low and locking in the losses it has just suffered. 5 Donors Dreams, Investment Realities August 217

6 Organizations Can Help Their Donors Come to Terms with These Investment Realities Identifying and understanding the reality behind these misconceptions is just the tip of the iceberg when working with trust donors. The key to truly enhancing the donor s understanding of the investment process is to have proactive and engaging conversations. Here are a few tactics that can help: 1. Initiate the Investment Conversation Early Timing is key to getting off to a good start with a charitable gift. It is important to talk with the donor about the concept of trust investing when establishing the gift structure. Payout rate, time horizon and trust type all have an impact on the investment strategy. 2. Don t Assume the Donor s Level of Interest in Trust Investing Although the donor may not have given any indication that he or she is interested in knowing about the trust s investment strategy, that apparent lack of interest often changes quickly when beneficiary payments decline. Even a very high-level conversation about how the value of the trust can change in different market environments or about how time in the market can offset short-term losses will go a long way towards mitigating donor disappointment. 3. Stay in Touch The importance of staying connected with donors is well-established. Regular reviews of a donor s trust portfolio can uncover changes in investment goals and risk tolerance, and help set realistic expectations for the future. 4. Leave the How to the Experts Donors should rely on investment advisors for the details about asset allocation, stock picks and implementation. The development officer s role in the investment discussion should be to focus on the why of trust investing and to address any misconceptions. 5. It s About Trust At the end of the day, the donor s philanthropic goal is what matters most. The investment strategy is simply the means to accomplish that goal. Any discussion about trust investing should be framed in a way that highlights both the ultimate benefit to the charity and the fulfillment of the donor s wishes. Conclusion Both charitable giving and following one s investments can be emotional and highly personal experiences. It is important to communicate with donors and income beneficiaries about the investment of a gift at the beginning of the relationship. If donors enter into a planned gift with reasonable expectations about how investments work relative to their payout expectations, there are less likely to be misunderstandings or difficult conversations down the road. 6 Donors Dreams, Investment Realities August 217

7 About Us For over 2 years, BNY Mellon Wealth Management s dedicated Planned Giving team has focused on providing nonprofit organizations with comprehensive, expert gift management, tailored investment management solutions, and donor and organizational support. To learn more about how we can help, please us at pgrelationshipmgmt@bnymellon.com and visit bnymellonwealth.com This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. 217 The Bank of New York Mellon Corporation. All rights reserved Donors Dreams, Investment Realities August 217