The Art and Science of Investing Trust Assets

Investing trust assets requires a trustee to consider and balance several factors to carry out the trust purpose in the best interests of its beneficiaries. There are also a number of legal principles that affect how the assets are to be managed in the absence of specific guidance in the trust documents.

It’s critical that a trustee understand what these various factors are and how they interrelate. Interestingly, these considerations are fairly wide open and don’t provide clear bright line rules to guide trustees.

Successful fiduciary investing is as much an art as a science, as it requires a careful and objective weighing of several factors, which themselves may conflict with one another. With experience comes the expertise to strike the right balance that preserves the trust assets for the family while also providing a meaningful benefit to those who are receiving current distributions.

The Trust Purpose and Beneficiaries

If you step back, it’s obvious that a trustee must know for whom they’re investing and the overall purpose of having a fund available for one or more beneficiaries. Newly minted trustees will often find that the trust document doesn’t specify whether the child is to be the primary beneficiary so that the grandchildren’s interests are secondary while the child is alive. Interestingly, it’s not uncommon for a trust for a spouse to state that the spouse’s interests come first so that distributions may favor the spouse and the time horizon of the trust is oriented around the spouse’s lifetime.  

Without guidance, and if no extraordinary distributions are needed for medical or other needs, a trustee may find that he’s to pay the trust’s “income” to one or more eligible beneficiaries and that the goal is to have the trust “principal” keep its purchasing power over time, taking into account inflation, costs (trustee and investment advisory fees), taxes and, of course, the income distributions.

Understanding the purpose and needs of the trust is equally important for charitable trusts, as there’s often a 5 percent payout that’s required under the tax laws that needs to be factored into the investment strategy, especially for a long-term charitable trust. Here’s just a sample of the considerations in looking at the trust’s purpose and how to invest in response:

• Who are the beneficiaries?
• What’s the purpose of the trust? (Who’s it for? Is one individual or generation to be favored?)
• Does one or more beneficiary’s interest have priority over another?
• What’s the projected term (lifespan) of the trust?
• What’s the amount of anticipated distributions to beneficiaries?

The Primacy of Asset Allocation

The asset allocation set by the trustee is the most important investment decision. The asset allocation should consider all the factors noted above and provide for an expected return that meets the trust’s purpose and requirements for distributions. Equally important, the anticipated returns from the asset allocation mix should be pursued with a level of risk appropriate for that particular trust. Risk is measured by volatility of returns (standard deviation) for each asset class. A greater standard deviation indicates a wider variance between each price and the mean: the higher the potential returns, the higher the risk. 

For example, on average over the past 20 years, the S&P returned 7.0 percent with a standard deviation of 14.9 percent vs. the Bloomberg Barclays U.S. Aggregate Bond Index, which returned 5.1 percent on average with a standard deviation of 3.4 percent. 

As the risk tolerance of the trust beneficiaries changes, the asset allocation should reflect their evolving circumstances. For example, younger beneficiaries may take more risk in their portfolio because they have a longer time horizon to ride out the down years. When beneficiaries get closer to retirement, they may focus more on capital preservation to ensure their wealth is sustainable not only for them but also future generations.

The Emergence of “Total Return” Investing

Trustees have typically labored to balance the interests of the current beneficiaries (often the beneficiaries receiving income) with the interests of the younger generations who stand to benefit in the future. In today’s low rate environment, a trustee would sometimes skew the asset allocation toward more fixed income assets to increase income to satisfy the needs of the current beneficiaries. However, the effects of inflation on the bond portfolio coupled with the long-term outperformance of the equity markets versus the fixed income markets often meant that such a strategy wouldn’t enhance family wealth over the long run.

Trustees are now permitted to invest for the appropriate “total return” given that changes in the law allow them to adjust the income received in the form of interest and dividends by adding a portion of the gains from the overall portfolio. This is authorized by the more modern Uniform Principal and Income Act available to most trustees.

This way, a trustee can invest the portfolio more heavily weighted toward equities that offer higher principal returns with often lower, if any, income in the form of dividends, assuming the approach meets the proper risk/return criteria. The trustee then would allocate an appropriate portion of the total return to income, which would in almost all cases be distributed to the current beneficiaries.

Total Return Investing and Taxes

Minimizing taxes is another key duty for trustee investments. After all, it’s the amount net of taxes distributed or retained by the trust that matters versus the pre-tax returns. Given the duty to factor in taxes, one can see how useful it is to invest more of the trust in equities that are taxed at lower capital gains rates. Experienced trustees will also take care to typically avoid triggering short-term gains, which are taxed at the higher ordinary tax rates, as well as “harvesting” losses by selling positions with losses and offseting them against embedded gains within the portfolio so that there’s no net taxable gain to be recognized. Taken individually, each transaction may not have a substantial effect, but the long-term aggregate effect could be to greatly increase the net after-tax returns of the trust.

Investment Policy Statement

The output of applying our decades of fiduciary experience to these criteria is often an investment policy statement that frames the purpose of the trust, the current circumstances of the family, our outlook for the economy and expected market returns, as well as the future needs of the beneficiaries under the trust document. The IPS will also analyze which asset allocation is appropriate for the trust and the beneficiaries. It will also set forth targets for the various assets classes as well as the reporting that will be made to co-trustees and the beneficiaries. It sets forth the trustee’s practices regarding:

• Diversification
• Conflicts of interest (e.g., can a trustee invest in an affiliate’s funds?)
• Portfolio rebalancing
• Investment restrictions such as ethical, environmental, social or other factors
• Other significant assets held by the beneficiaries or their families

A major consideration, and often the one with the greatest impact, is the aggregate level of distributions required for the beneficiaries. The higher the amount becomes, the more unlikely it is that prudent market returns will be able meet these needs. In addition, making frequent sales to raise cash to meet needs is disruptive as the trustee as an investor would ideally time these sales when market prices are most favorable, for example, avoiding selling stocks in a down market to raise cash.

Is the Trustee a Prudent Investor?

The acid test to evaluate the trustee’s approach is simple: Did the trustee understand the trust’s purpose and did he invest in a manner that makes sense in light of all the circumstances for the various beneficiaries and the economy as a whole? If a trustee succeeds in doing this, then the trustee will be a “prudent investor,” which is the standard by which trustees are judged regarding their investment decisions.