Investment advisors frequently state that the performances of various subsets of investments have met, exceeded or fallen short of their benchmarks. These statements may seem useful to an institutional or individual investor. But, many trustees and beneficiaries may find these statements irrelevant or of little value. Trustees, however, can use appropriate benchmarks in an informed, deliberate manner if they understand their benefits and limitations. Mindful of prudent investor standards, trustees can use benchmarks to select a suitable strategic advisor and individual managers or investments, evaluate asset classes, monitor macro- and micro-trust performance results, increase accountability with advisors and establish a foundation for ongoing decisionmaking. Also, importantly, benchmarks can help manage realistic economic expectations among trustees, grantors and current and remainder beneficiaries to minimize potential conflicts that can arise due to unrealistic expectations.
Prudent investor standards stress process and the duty to conform to fiduciary standards at the time of the investment decision, not in hindsight.1 A trustee’s investment responsibilities are first determined by the duties, authority and powers detailed under the trust document, then by prudent investor standards determined under state law.2 The trustee’s standard of conduct—the duty to exercise reasonable care, skill and caution—is applied to investments in the context of the entire portfolio, not to each separate investment.3 The Restatement (Third) of Trusts “recognizes that investments and courses of action are properly judged, not in isolation but on the basis of the roles they are to play in specific trust portfolios and strategies.”4 So, in that context, how can trustees effectively use benchmarks? First, we’ll give a cursory view of two types of benchmarks (asset class and policy). They can be beneficial in selecting and monitoring a specific trust’s individual investments, as well as the entire portfolio. Then, we’ll discuss a five- step process that may facilitate selecting and monitoring suitable benchmarks in seeking to enhance trust returns and manage risk.
A benchmark is simply one factor to aid in evaluating, planning and implementing an investment policy in a portfolio. When determined in a thoughtful manner, a benchmark becomes the means by which a trustee or any investor can measure the performance of a single investment, asset class, industry, investment manager or overall trust portfolio. The selection of specific benchmarks by an advisor is guided by the trust’s investment strategy as documented in an investment policy statement (IPS), the trust document and state law. A trustee should take care in selecting the appropriate benchmarks, because using an arbitrary or incorrect benchmark can be counterproductive. Two major types of benchmarks—asset class and policy—are particularly relevant in this context.
Asset class benchmarks. These are tools used to monitor portfolio results at multiple levels, highlight areas of focus and provide a mechanism for trustees to build clear levels of accountability into a trust’s investment framework. Asset class benchmarks are subdivided into a broad range of investment opportunities based on clear, objective and common
risk/return characteristics. Generally speaking, asset class benchmarks help identify portfolio diversification. There are many asset classifications used throughout the industry, and a thorough discussion of these is beyond the scope of this article.
Asset class benchmarks generally fall under the following macro-level categories: cash and cash equivalents, fixed income, equities, real estate and other (including commodities, derivatives, personal property and collectibles). They are constructed by grouping investments with common characteristics together into a “basket” or index. Some commonly used subclasses are large-cap, mid-cap and small-cap, as well as value and growth. Each of these subclasses has its own risk/reward profile. Equity characteristics, such as country of origin and industry are also used. Bonds are commonly segregated by issuer, such as corporations, national governments, municipalities and purpose. The issuing entity of a bond is closely tied to its taxability status and credit quality, which plays an important role in asset categorization. Some common examples of indices are the S&P 500, Russell 1000 Index, Barclays U.S. Aggregate Bond Index and MSCI EAFE Index.5
Asset class indices enable the fiduciary to evaluate the past performances of individual asset classes relative to other investment options. The performance of U.S. large-cap equities can be compared to that of other classes, such as U.S. small-cap equities and taxable bonds. Combined with expectations regarding their future performance, the indices may serve as a guide for asset allocation decisions. While past performance is no guarantee of future performance, investment professionals study historical relationships between asset class performance and various capital market conditions. These relationships are used to model a range of probable future index (or asset class) levels to facilitate ongoing allocation discussions.
Investment policy benchmarks. These are the weighted combination of individual asset class benchmarks associated with the trust’s strategic asset allocation that’s recommended by the strategic investment advisor. By properly weighting individual asset class benchmarks, the policy benchmark becomes the single benchmark that’s used to measure the effectiveness of the strategy employed for the trust’s entire portfolio. It’s not uncommon for certain advisors to focus on asset class benchmarks and mistakenly ignore or minimize the policy benchmark’s potential value.
A key requirement of the policy benchmark is that it has a high probability of meeting or exceeding the economic expectations of the trust. These expectations are defined by a minimum acceptable return (MAR) that’s determined by the trustees after considering the trust’s objectives and obligations (distributions, growth, expenses and taxes). From the trustee’s perspective, these factors help determine the trust’s MAR, which is simply the minimum return threshold requirement that’s provided to the strategic advisor as guidance before finalizing the trust’s investment strategy. Once finalized, the strategy is governed by an IPS and is represented by a diversified asset allocation model recommended by the strategic advisor to be most suited to the trust’s objectives. The policy benchmark is the comprehensive top-level view of the asset allocation strategy.
The MAR reflects potential total return, which incorporates expectations of future income and capital appreciation. Importantly for trusts, cash flow is a major factor in determining the MAR. Trust duration, mandatory and discretionary distributions, expenses and beneficiaries’ needs can change the cash flow model and, ultimately, the MAR or investment policy benchmark. The closer the trust’s performance is to the MAR, the more likely the performance will achieve the trust’s overall economic objectives. However, while meeting the MAR may indicate that the trust’s objectives are being met, the policy benchmark helps a trustee determine whether the investment strategy being employed is effective.
Commonly known industry best practices suggest that the potential value of using an asset class or policy benchmark may be diminished or nullified if it lacks any one of the following characteristics:
• Investible: The option should be available to invest in the individual components of the benchmark as an alternative to the portfolio under consideration.
• Measurable: The benchmark’s performance results are calculable on a frequent basis and readily available.
• Appropriate: The benchmark’s main characteristics (risk and return) are consistent with those of the portfolio under consideration.
• Unambiguous: The components of a benchmark and their weightings are understandable and known.
• Specified in advance: The benchmark is determined prior to execution of the investment program (usually part of an IPS) to facilitate effective performance comparisons at all applicable levels.
Trusts are often created and funded for non-tax reasons or with specific sums or assets to meet transfer-tax planning goals within the confines of exclusion amounts or charitable tax deductions. Consequently, there can be a disconnect among the amounts and types of assets used to fund the trust, trust distribution provisions, beneficiaries’ expectations and the short- or long-term investment policy.
For example, a client creates a non-grantor dynastic trust and funds it with an amount equal to the available generation-skipping transfer (GST) tax exemption. The trust is intended to provide for successive generations’ needs. The current beneficiaries receive a 4 percent annual unitrust distribution payable monthly. Over the trust’s term, the trust’s purchasing power will likely diminish due to inflation and an overweight allocation to cash to meet monthly distributions, expenses charged to income and principal and tax payments on undistributed realized gains.
The trust’s investment policy is subject to the prudent investor standard, typically requiring asset allocation with adequate diversification and investments with suitable risk-adjusted returns. The current and remainder beneficiaries expect total return on investments, which, presumably, would then increase income and principal during the trust term for each generation.
Do the grantor and drafting attorneys (at the creation and funding of the trust), trustees, current beneficiaries and remainder beneficiaries have realistic economic expectations? Can benchmarks help manage and meet these expectations and objectives? These questions may be answered by using a well-conceived IPS with appropriate asset class benchmarks and an investment policy benchmark for the specific trust and not necessarily with an individual investor’s mindset. The grantor and a strategic investment advisor (responsible for designing the IPS and selecting and monitoring the overall portfolio) can consider the analysis in five broad steps. (See “Benchmark Review in a Trust Portfolio,” p. 43.)
Step 1: The grantor should draft (or modify) the trust and fund it, initially or subsequently, considering the trust’s objectives, trust term, long- or short-term investment horizons, taxes (grantor or non-grantor trust status, estate tax includible in the grantor’s or
beneficiary’s estate, GST-exempt or non-GST-exempt or split-interest charitable trust), inflation, trust expenses, current or future mandatory or discretionary income or principal distributions, competing and conflicting interests among current and remainder beneficiaries, risk tolerance of trustees and beneficiaries and accredited investor and qualified purchaser rules for alternative investments, if any.
For existing irrevocable trusts, modifying the trust with the beneficiaries’ or interested parties’ consent or court approval or decanting an existing trust to a replacement trust may make sense to substitute outdated or inflexible investment or administrative provisions that hinder meeting economic objectives. Modifying or decanting a trust to provide unitrust or power to adjust capability may allow the trustees to invest for total return, meet economic expectations and mitigate the beneficiaries competing interests.
Step 2: The trustee should estimate the MAR needed to accomplish the trust’s objectives, taking into account the factors mentioned in Step 1. Using the non-grantor dynastic trust example, the trust’s overall return should provide for the 4 percent unitrust payout, approximately 1 percent annual expenses, minimum 2 percent per annum inflation and estimated taxes on undistributed realized capital gains to maintain purchasing power for current and remainder beneficiaries. The trust will most likely require a minimum 9 percent annual total return on its investments to maintain its asset base and purchasing power. Therefore, the MAR would be 9 percent per year, which may not be realistic.
The trustee determines a realistic MAR and policy benchmark to meet the current and remainder beneficiaries’ expectations and needs. If the MAR is attainable, based on the parameters of the trust document, state law and the investment strategy, then the policy benchmark should be designed to meet or exceed the MAR. If meeting the MAR is unlikely, due to a realistic view of market conditions, then the MAR should be reduced. Steps 3 and 4 will help determine the probability of meeting the desired MAR.
Step 3: The trust’s strategic advisor should consider preparing an IPS, taking into account capital market assumptions and historical data. He may develop the asset allocation model using a Monte Carlo simulation, which generally considers two investment cycles
(15 years) in determining returns based on the asset class and policy benchmarks for the particular trust. These capital market assumptions review various asset classes’ historic returns and the benchmarks for each particular asset class. The Monte Carlo simulation considers the correlation between the various asset classes’ benchmarks and their historical performance. These projections are based on probabilities, which may be realized in the ordinary course of investing and will be revised during the trust term.
Any trust constraints and prudent investor standards must be considered in the selection of the asset class benchmarks. For instance, if the trust document precludes a particular asset class, then benchmarks for that asset class should be excluded from the model. To be relevant, the asset class benchmarks should reflect the actual investment opportunities available to the trust. Since benchmarks also are evaluated relative to their historical risk levels, trustees should exclude those investments that exceed a given risk appetite.
Step 4: The trustee reviews the various asset class benchmarks and blends a portfolio that will increase the likelihood of achieving the MAR based on suitable risk for the trust. The trustee considers which weighted blend of asset class benchmarks typically meet or exceed that return. Depending on existing and anticipated economic conditions, a traditional blend of 55 percent public equities, 40 percent fixed income and 5 percent cash may achieve the MAR. The MAR and policy benchmark may have to be reduced. In that case, the trustee may modify the distribution plan, if permissible, to be consistent with a realistic MAR and policy benchmark or advise the beneficiaries to expect a probable diminution of the trust’s asset base.
Step 5: The trustees have a duty to monitor the investments and determine whether the investment strategy through the review of asset class benchmarks and the investment policy benchmark is still appropriate or should change. Investing is dynamic, not static. A decision should be made as to the frequency of benchmark rebalancing. Without rebalancing, the individual constituents will cause the policy benchmark to drift away from an appropriate asset allocation. The same rebalancing frequency should apply to both the MAR and portfolio. If the actual portfolio’s holdings are rebalanced quarterly, but the MAR is only rebalanced annually, the comparison between the two is less meaningful. The frequency, in large part, depends on the factors listed in Step 1 and the economic markets. Return and risk will vary over periods of time for the various asset class benchmarks, which may necessitate a change to the investment policy and strategy. This aspect of the process is important to continually manage the interested parties’ expectations and, hopefully, avoid conflict.
Using asset class benchmarks and model trust portfolios during the monitoring phase to predict probabilities of return for investments has distinct limitations. Under the prudent investor standards or trust document, a trustee may be precluded from a certain investment strategy, which attempts to attain an unrealistically high MAR. For instance, it’s not uncommon for the asset base in certain charitable remainder trusts or charitable lead trusts to decrease substantially because the annuity or unitrust payout rates are too high to sustain a portfolio with suitable risk-adjusted returns over the trust term. This can be particularly evident if there’s a down market early in the trust administration and if additional funds can’t be or aren’t contributed to the trust.
Using an index fund as an asset class benchmark for a trust may provide overly optimistic expected returns. Unlike trust assets, an index fund’s value isn’t diminished by taxes, internal trading costs or inopportune timing of withdrawals. For instance, distributions at inopportune times sometimes require liquidation of trust assets during a downturn in the market. An index fund has the advantage of increased returns (undiminished by untimely withdrawals) when the market has an upturn. Also, there’s performance drag on the entire portfolio due to a large allocation to cash in a trust portfolio to meet distribution requirements and trust expenses. The more frequent the distributions, the greater the challenge. Additionally, some index funds have a high concentration in one or two holdings, which would be inappropriate for a trust portfolio and can skew the fund’s performance either up or down.
These issues may compel a trustee to incorporate active managers for some or all of the asset classes to help meet a higher MAR. The trustees must determine if the performance and possible mitigation of risk justifies the additional fees typically associated with active managers, in contrast to index funds or passive investments.
In the final analysis, a particular asset class benchmark, MAR or policy benchmark may be realistic based on the economic environment, the trust’s objectives and the beneficiaries’ expectations. Recognizing the dictates of prudent investor standards, a trustee’s sound use of benchmarks—acknowledging their benefits and limitations—can be another arrow (but not the sole arrow) in his quiver when implementing an investment strategy.
—This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.
This content represents thoughts of the authors and does not necessarily represent the position of Bank of America.
All asset classes and asset allocations are not suitable for all investors. Each investor should select the asset classes and asset allocations for them based upon their goals, time horizon and risk tolerance. Not all recommendations will be suitable for all investors.
U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.
1. Restatement (Third) of Trusts, Section 227, General Comment, para. (g).
2. Ibid., Sections 227(d) and 228: “The terms of trust may and often do broaden, guide, or restrict the trustee’s statutory or common-law authority and responsibilities in investment matters, in either general or specific ways.” Section 228, General Comment, para. a.
3. Ibid., Section 227(a).
4. Ibid., Ch. 7, Intro., Principles of Prudence.
5. S&P 500 Composite Stock Index tracks the performance of 500 widely held, large-capitalization U.S. stocks; Russell 1000 Index tracks the performance of 1000 of the largest companies, based on market capitalization; U.S. aggregate bond index is a market value-weighted index that tracks the daily price, coupon, pay-downs and total return performance of certain fixed rate issues with at least one year to final maturity; and MSCI FAFE is a capitalization-weighted index that tracks the total return of common stocks in 21 developed market countries within Europe, Australia and the Far East.