The duties and responsibilities of a trustee of a charitable remainder trust (CRT) are many and varied, but perhaps the most important one is the investment of the trust’s assets. The investment choices of the trustee directly affect the distributions to the donor (or other income beneficiary) as well as the residual value that goes to the charitable beneficiary.
Being held responsible for the results of trust investments is a natural concern for trustees. This is especially true in situations in which the donor of a CRT is also the trustee. Thus, it’s tempting to look at ways to reduce or eliminate the trustee’s responsibility with trust investment results. Generally, trustees have sought relief in one of two ways; either by finding protection in the trust document or by seeking it within state regulations.
Drafters of CRT documents should take care not to go overboard in protecting the trustee through the trust document provisions. In a private letter ruling, the Internal Revenue Service concluded that a CRT wasn’t qualified because the trust document went too far in delegating investment responsibility to an investment advisor, absolving the trustee of investment responsibility.1
Since state regulations are the most recognized source of trustee law, when crafting a CRT, it’s important to have a solid understanding of the Uniform Prudent Investor Act (UPIA), which is the governing document on this topic in most jurisdictions.
Relief from Responsibility
Generations of trustees, lawyers and others have led the way to a modern understanding of a trustee’s responsibility, and these same individuals have helped define where that responsibility ends. Their influence on the UPIA is extensive and can be found in some of the UPIA’s most important sections. Here’s a brief review of these provisions.
Section 1 covers the Prudent Investor Rule, and Section 1(b) states that a trustee isn’t liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust. Therefore, if the terms of the CRT merely state that the trustee is to invest in a manner in which he sees fit, it could be difficult to challenge the results of the trustee’s choices.
Section 9 reverses the former rule of trust law forbidding the trustee to delegate investment and management functions. On the other hand, this comes at the requirement of certain safeguards (as outlined below). Section 9(c) states:
A trustee who complies with the requirements of subsection (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.
This wording implies that if a trustee delegates investment responsibilities to another, the trustee is free from the consequences of such delegation.
Reinforcement of Responsibility
Here are some of the more important parts of the UPIA regarding specific investment duties:
Section 2(d) notes that a trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets. Consider a situation in which assets are supposedly invested in accordance with the terms of the CRT. To meet the requirement of Section 2(d), the trustee must have some knowledge of the investments within the CRT and do a reasonable amount of due diligence to make sure they’re appropriate.
Additionally, Section 2(f) states that if a trustee holds himself out to have special skills or expertise, that trustee has a duty to use those special skills or expertise. In other words, if the CRT’s trustee claims to have investment management expertise, he is required to use that expertise and can be held to a higher standard than one who makes no such claim.
As mentioned earlier, the relief granted in Section 9(c) comes with strings attached. Specifically, the safeguards in Section 9(a) are: (1) careful selection of the agent, (2) establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust, and (3) periodically reviewing the agent’s performance and compliance with terms of the delegation. Therefore, at a minimum, a trustee is responsible for supervising the actions of any agent he appoints.
General Investment Duties
Given the overall scope of the trustee’s obligations and responsibilities, it’s prudent to review how these play out in the specific scenario of investing the trust’s assets. Here are the more general responsibilities regarding the investment of the CRT’s assets according to the UPIA:
Section 2 provides the overall approach to investing within a trust, including standard of care, portfolio strategy and risk and return objectives. Much of what it covers may seem intuitive. For example, Section 2(a) requires a trustee to invest as a prudent investor would. Section 2(b) goes further and mandates that the assets within the CRT need to be viewed as an individual portfolio, with their interrelationships taken into consideration.
Section 2(c) identifies the investment circumstances that need to be considered: (1) General economic conditions, (2) possible effects of inflation or deflation on the portfolio, (3) possible tax consequences of investment decisions or strategies, (4) the role each investment plays within the overall trust portfolio, (5) the expected total return from income and appreciation of capital, (6) other resources of the beneficiaries, (7) the needs for liquidity, regularity of income and preservation or appreciation of capital, and (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the income or remainder beneficiaries.
Section 2(e) allows the CRT to invest in any kind of property or type of investment consistent with the standards of the UPIA.
Sections 3 and 4 cover diversification and duties at inception of trusteeship. Section 3 requires that a trustee diversify the investments of the CRT unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying. Section 4 requires the trustee to review the assets at the inception of the trusteeship to make sure they’re appropriate for the purposes of the CRT.
Sections 5 and 6 cover loyalty and impartiality. Section 5 requires the trustee’s sole loyalty be to the trust’s beneficiaries. Section 6 considers the split-interest nature of the CRT, and requires the trustee to consider investment decisions and their impact on both income and charitable beneficiaries.
Section 7 covers investment costs and states the trustee must consider all expenses associated with investments made by the trust. Even relatively small costs can have a significant impact on the available distributions to the income and charitable beneficiaries in a charitable remainder unitrust (CRUT). See “Total Distributions to Beneficiaries Over 20 Years,” below.3
Section 8 focuses on reviewing compliance. This section simply states that the trustee’s compliance with the prudent investor rule is determined by the facts and circumstances known at the time of a trustee’s decision. In other words, hindsight is irrelevant.
To determine the appropriateness of an asset for inclusion in a CRT, it’s important to understand the basics of its risk/return profile. Here’s a brief overview of some of the most common assets found inside of a CRT:
Bonds are a common investment purchased for the purpose of generating current income. Generally, municipal bonds are seen as a way to provide tax-free distributions to the income beneficiary. However, because of the ordering of income rules associated with a CRT, tax-free distributions can’t be made until those from every other source are made first. Additionally, if interest rates rise, the principal value of the bond will deteriorate, thereby lowering the valuation of the trust assets.
Individual stocks can be held to generate various sources of income, including capital gains (long and short-term) and dividends. Stocks are usually held because of their ability to provide growth to a portfolio, but do so at the price of high volatility. A typical approach to taming portfolio volatility is to have a blend of stocks and bonds, which have historically moved in opposite directions. As stated in UPIA Section 2(b), what matters is how the investments within the CRT work in relationship to each other, and if the overall volatility of the portfolio is reduced by having a blend of stocks and bonds, then it matters less that an individual stock is highly volatile.
Mutual funds are managed pools of investments, and by their definition are well diversified according to the objectives of the fund. Mutual funds can be invested in stocks, bonds or a combination of both. Mutual funds will mimic the income, growth and volatility of their underlying portfolios. A new type of mutual fund type is a target volatility fund. The main purpose of this type of fund is to professionally manage the assets within the fund to provide growth within a specific volatility range.
Variable annuities have been popular investment vehicles for net income makeup charitable remainder unitrusts (NIMCRUTs) for a long time. This is largely due to their ability to let trustees limit income by allowing them to choose the level of withdrawals to take when the contract is at a gain. Additionally, they may provide good diversification since most variable annuities allow for investing in a large number of asset classes.
If a trustee wishes to purchase an annuity for a CRT and the trust terminates at the end of two lives, it’s advisable to purchase one that allows for joint annuitants, assuming it doesn’t terminate at the first annuitant’s death. Otherwise, at that time, all of the accrued gains in the annuity will be realized by the trust. This could create an extraordinarily large distribution (and a painful tax situation) to the surviving income beneficiary. Ironically, this also could reduce future distributions available to both the surviving income and charitable beneficiaries.
The introduction of optional guarantees has given variable annuity owners additional ways (beyond diversification) to reduce risk while still being fully invested. To know if a variable annuity’s optional guarantee makes sense within a CRT, it’s important to understand what the guarantee provides, and then decide if it’s of any value to the trust beneficiaries.
There are three types of optional guarantees that may be available on variable annuities: (1) income, (2) accumulation, and (3) death benefit. Each optional guarantee carries an additional cost, so a decision to purchase one must be carefully considered.
An income guarantee protects the ability of the annuity owner to receive income, even when the assets within the annuity have been exhausted. This guarantee may make sense for a portion of the funds in a charitable remainder annuity trust (CRAT), since the CRAT is at risk of running out of funds to make distributions to the income beneficiary. It will have little or no effect on distributable income from a CRUT, since distributions from a CRUT are ruled by the trust’s provisions, valuation of assets and income.
On the other hand, an accumulation guarantee may be useful in creating distributable income from a CRUT. This type of guarantee protects against a decline in the value of the variable annuity (which may include gains in addition to principal) over a specified period. In return for this guarantee, the upside potential of these contracts is limited. If the account value is less than that of the guarantee, the account value is brought up to the guaranteed amount on the appropriate time interval (usually on a specified contract anniversary).
The purpose of a death benefit guarantee is to pay an amount of money in excess of the value of the annuity upon the death of its measuring life. A death benefit guarantee won’t help the income beneficiary (assuming the annuitant is the income beneficiary,) nor will it have any impact on the tax deduction available to the donor. But, it may help the CRT fulfill its obligation to provide a benefit to the charitable beneficiary.
Proper Investing Approach
A good investment design process for a CRT involves many of the same steps used in a comprehensive investment planning exercise for an individual. The trustee needs to take three steps: (1) profile the parties to the trust arrangement (the donor, income beneficiary if other than the donor) and the charitable institution, (2) identify each party’s investment and/or other long-term objectives, and (3) draft a plan that balances potentially competing objectives within the context of the current economic, investment and fiduciary environments. The key outputs of this process are an asset allocation decision appropriate for the trust and a documented investment policy to guide the management and monitoring of the investments.
The trustee must understand the personal and financial characteristics of the income beneficiary the trust is designed to benefit. For CRUT beneficiaries who need more stability and predictability of income, higher fixed-income allocations might make sense. For CRUT beneficiaries who want their income stream to grow over time as well as increase the remainder value, higher allocations to equities might be appropriate. If the donor isn’t the income beneficiary, the donor’s objectives in creating the trust must also be understood. For example, perhaps the donor’s primary goal is to provide a growing income stream for the named income beneficiary or conversely, to preserve the trust principal for the charitable beneficiary.
Ultimately, the investment planning process should enable the trustee to achieve three goals: (1) identify the asset classes that should be considered as options for the trust investment portfolio, (2) identify the risk and return (income and appreciation) expectations of each asset class, and (3) understand the benefits of combining these asset classes in order to achieve an attractive risk-adjusted rate of return. The return and risk attributes of different investment combinations will have a significant impact on the construction of the CRT’s portfolio.
1. Private Letter Ruling 8041100.
2. The four-tier rules establish a “worst-in, first out” framework of taxation, in which income flows to the income beneficiary first as ordinary income, then as capital gain (short-term followed by long-term), then as tax-free income and lastly as return of capital. See Internal Revenue Service Section 664(b). Strategies to minimize taxes shouldn’t conflict with the diversification requirement in Section 3.
3. Chart assumes no investment volatility and is for illustrative purposes only. Charitable remainder unitrust distributions made mid-year.