Trusteeship of split-interest trusts such as charitable remainder trusts (CRTs) can be complicated due to beneficiaries’ competing interests. The income beneficiary may seek to maximize a stable, tax-efficient income stream during their life, while the charity’s interest is in the long-term growth to maximize the remainder. In our experience managing CRT investments, we’ve identified six investment-related strategies that can help mitigate fiduciary risk:
- Diversify concentrated single stock;
- Bias toward equities early;
- Glide toward bonds late;
- Use taxable bonds instead of municipal bonds;
- Avoid illiquid investments; and
- Write an Investment Policy Statement (IPS) and distribute it to all stakeholders.
Fiduciary Duty
The trustee of a CRT has significant fiduciary responsibilities, outlined in a variety of sources that will apply depending on the specific structure of the CRT and relevant jurisdiction. Many jurisdictions require trustees to conform to the Uniform Prudent Investor Act,1 the Uniform Principal and Income Act2and Uniform Trust Codes relevant to CRTs,3 while other jurisdictions have their own relevant laws that sometime include special reporting requirements.
Trustees have a duty of loyalty to all trust beneficiaries with vested interests, including, in the case of a CRT, both the income beneficiary and the charitable remainder beneficiary. The trustee’s actions (including investment decisions) must take into consideration and balance the interests of both classes of beneficiaries. How do trustees balance this duty to the competing beneficiary interests into actual investment decisions? Once investment decisions are made and implemented, what’s the best way to explain such decisions to the beneficiaries? Is hiring a reputable professional investment manager and attending regular portfolio review meetings enough to satisfy a trustee’s fiduciary duty?
Case Study
To see some common CRT investment decisions and resulting taxable distributions in action, we’ll introduce a brief case study. Our client, Joe, is an inventor who recently sold some surveillance technology for $1 million to publicly traded XYZ Corporation for shares. Joe would like to sell the stock and use the proceeds to support himself in the first 20 years of his retirement and then leave the remaining amount to his favorite charity. He sets up a charitable remainder unitrust (CRUT) that will pay him 5% of the CRUT’s market value annually over a 20-year term and appoints a corporate trustee. See “Case Study Assumptions,” p. 23.
Diversify Concentrated Stock
Joe’s CRUT has been initially funded entirely with XYZ shares, which are regarded as a growth/technology stock. Joe’s XYZ shares held by the CRUT are relatively low basis because the share price has shot up since the sale of Joe’s surveillance technology to XYZ. The XYZ shares have significantly appreciated since the day Joe acquired them in his sale transaction. The trustee of the CRUT hired a registered investment advisor, Acme Money Management, and the trustee believes XYZ has a bright future as a company but also feels continuing to hold the entire CRUT corpus in XYZ shares is high risk, due to the concentration and volatile nature of this particular growth equity security. Thus, even if XYZ’s stock price appreciates wildly in the coming years, the trustee’s choosing now to hold it as the sole CRUT investment won’t meet the trustee’s duty to prudently invest the CRUT’s assets. After receiving additional advice from counsel, the trustee decides to sell all the XYZ shares in Joe’s CRUT account immediately on contribution. This is the prudent approach; the majority of case law surrounding CRUT trustees’ breach of duty involves a failure to diversify the trust’s investments to mitigate risk or even simply a failure to diversify quickly enough before a loss in value.4
It’s a common practice to fund a CRUT with a low basis asset and then immediately sell on receipt into the trust. There’s a significant amount of accumulated long-term capital gains inside the CRUT that will have to be realized by the individual beneficiary incrementally as annual distributions are made, possibly for many years into the term of the CRUT. CRUTs don’t wipe out capital gains on a low basis asset, but rather “stretch out” the realization of long-term capital gains and shift the burden of paying such capital gains taxes to the individual beneficiary.
Bias Towards Equities Early
Joe’s CRUT trustee has chosen to sell the XYZ shares and reinvest the sale proceeds in a diversified portfolio of securities that will produce a 5% annual unitrust distribution to meet Joe’s living expenses while also seeking to protect a remainder amount that will go to Joe’s charity in 20 years.
In “Potential Impact of Equity Choice,” p. 24, we see that there’s a “win/win” from higher equity weights. Both the income beneficiary (orange bar) and the charitable remainder (gray bar) distribution amounts have a higher potential value with higher equity weights in the CRUT portfolio. Because the payout to Joe is 5% of the portfolio’s year-end market value each year, to the extent that the return of the trust’s investment portfolio is above 5%, the annual distribution dollar amount will rise over time, benefiting Joe. Interestingly, at each equity weight, Joe would earn about 40% of the total value of the CRUT’s investment portfolio and the charitable remainder beneficiary gets approximately 60%, so there’s consistent sharing of the investment portfolio’s risk and return.
The downside of choosing a higher equity weight in a CRUT portfolio is that the amount of the annual percentage unitrust distribution to Joe may be more volatile, and should the stock market be down in the last year or two of the CRUT term, the dollar value of the charitable remainder amount would also have a wider range of potential outcomes.
For portfolios weighted at 100% equities, while the long-term growth of the principal is likely, there have been years when the stock market fell as much as 48% from peak to trough. Such volatility in any particular year’s annual returns may not be appropriate, given that Joe has a need for the income distribution amount, and the charitable remainder beneficiary typically wants to protect the value of its remainder interest. For this reason, we typically see trustees choose an initial 60%-70% equity weight to balance the desire for higher long-term returns for both the income and charitable remainder beneficiaries with the risk level that can negatively impact both classes of beneficiaries.
Glide Toward Bonds Late
Instead of committing to one fixed asset allocation (such as 70% equity and 30% fixed income) for the entire lifetime of the CRUT, trustees may want to agree in advance on a pre-agreed schedule to gradually reduce the equity allocation as the CRUT’s time horizon gets shorter. A regular adjustment of the asset allocation over a number of years, outlined in the IPS and communicated to all beneficiaries, should manage expectations and secure beneficiaries’ confidence in the trust administration. This approach also helps the trustee avoid the temptation to make one-off reactionary investment decisions in response to real-time market changes, which will almost inevitably appear (at least in the eyes of beneficiaries) to prioritize one class of beneficiary over the other.
In Joe’s CRUT, we model a 70% allocation to equities over the full 20-year time horizon of the CRUT. However, the trustee may decide at the outset of the 20-year term that during the last five years, it will be more appropriate to dial down the CRUT’s asset allocation to equities on a set schedule, arriving at an allocation of 20%-30% to equities by the end of the CRUT’s term.
This approach has been commonly used for retirement target date funds, which will have high equity weights early in an investor’s career and then shift toward bonds as the investor approaches retirement.
Taxable vs. Municipal Bonds
Understanding the tax character of a CRUT’s distributions to individual beneficiaries is critical to a thoughtful approach to the CRUT’s investment policy. CRUTs themselves are tax-exempt, and thus no tax is due for realizing capital gains or from receiving dividends or income interest. However, the annual distributions to Joe are taxed to Joe personally based on an accumulated income basis in a “worst out first” framework:
- First, the distribution is taxed as ordinary income to the extent of any current ordinary income and any undistributed ordinary income from prior years.
- Second, if ordinary income has been exhausted, the distribution is treated as capital gains incurred that year and any undistributed capital gains from prior years.
- Third, if capital gains have been exhausted, the distribution is treated as other income to the extent generated for that year and any undistributed other income from prior years.
- Finally, any distribution amounts in excess of the above items of income are treated as non-taxable return of principal.
To the extent taxable bonds are used in the CRUT’s asset allocation, due to the “worst out first” tax treatment of distributions, the ordinary income from the taxable bonds will come out first before any capital gains, increasing the taxes due to Joe. Because municipal bonds are federally tax-exempt, they go to the bottom of the “worst out first” stack, and their federally tax-exempt income will only be distributed to the extent that all accumulated ordinary and capital gains income have already been distributed. If the CRUT were funded with a low basis asset such as Joe’s XYZ shares, it may take years before annual distributions to Joe “use up” all existing capital gains sitting inside the CRUT from the sale of the shares and shift to distributing other income or principal.
Using taxable bonds in a CRUT allocation typically creates a higher potential remainder value, because taxable bonds tend to have higher interest rates. However, investing only in taxable bonds (versus municipal bonds) may result in less after-tax distribution amounts to Joe. So Joe may request that the trustee weight the CRUT’s fixed income investments toward tax-exempt municipal bonds.
We see in “Potential Impact of Bond Choice,” this page, that over the 20-year life of Joe’s CRUT, using taxable bonds (and not tax-exempt municipal bonds) maximizes the expected remainder value to the charity by a lot—the remainder charity is about $100,000 better off—at only a small cost to Joe’s individual income stream. Joe is projected to be about $10,000 worse off as far as total after-tax distributions received if the CRUT invests solely in taxable bonds, and this downside for Joe is spread over his 20-year term. The downside difference to Joe is surprisingly small, in part because over time, the higher potential return from the taxable bonds, which maximizes total return and overall growth of the CRUT’s market value, results in a higher unitrust payment amount to Joe. This higher overall distribution amount to Joe can offset much of the increased personal income tax drag.
We tested the question of investing in taxable bonds versus tax-exempt bonds for shorter and longer CRUT time horizons and for individual beneficiary payout rates ranging from the minimum 5% up to as high as 11%. The conclusion was the same: Investing in taxable bonds tends to significantly benefit the charitable remainder beneficiary while generating only a minor downside to the individual beneficiary. The conclusion to generally prefer taxable bonds in CRUTs is also robust with respect to varying overall income levels and corresponding tax bracket of the individual beneficiary, as the incremental tax rate for taxable bonds relative to municipal bonds is fairly consistent across income levels.
Do these broad conclusions mean that a CRUT trustee should always invest the CRUT portfolio’s equity allocation at 70% or more and always invest its fixed income allocation entirely in taxable bonds paying no heed to whatever relatively minor downside may be produced for the individual beneficiary? Certainly not. CRUT investment decisions should always be discussed among the trustee, its advisors and the trust beneficiaries, considering the full context of balancing all fiduciary duties and risks unique to each trust’s circumstances.
Avoid Illiquid Investments
CRT trustees may feel that an allocation to more illiquid investments such as private equity or hedge funds should be considered in addition to publicly traded securities, in the name of added return and/or diversification. An investment that can’t be liquidated until a future date will still need to be valued annually for purposes of calculating a unitrust distribution amount, and its end-of-year market value will contribute to the dollar amount of the unitrust percentage distribution, even though it may not offer any liquidity towards the distribution amount. Over time and particularly if the value of an illiquid investment grows dramatically, this dynamic has the potential to skew the CRT portfolio’s weighting further towards such illiquid investment, as more liquid assets within the portfolio are tapped to make up the annual distribution to Joe. Further, in the case of a CRT tied to an individual beneficiary’s lifetime, an unexpected death of the individual beneficiary may put the trustee in the position of either distributing the illiquid investment in-kind or waiting until the end of the illiquid investment’s lockup period before being able to distribute the full remainder to the charity. Depending on the charitable beneficiary’s level of sophistication, time horizon and need for the remainder funds, neither option may be suitable to the charity.
Write an IPS
How can a CRT trustee mitigate the risk that the income or remainder beneficiary objects to its investment decisions? As is often the case in trust administration, transparency and communication among all parties is key. For trustees, it’s about disclosure. While not required in every jurisdiction, the trustee should generally plan to send regular statements to all vested beneficiaries of the trust, including all individual and designated charitable remainder beneficiaries.
Further, a CRT should have a written IPS that clearly states the trust’s objectives, articulates the approach to investing the assets and explains how it meets the trust’s objectives. The IPS may be thought of in three sections:
- How will the trustee handle the asset initially contributed to the trust? Sell it or hold it, over what timeline and terms?
- On sale, what should the asset allocation be between equities and fixed income for the sale proceeds, and why?
- Once the asset allocation is decided, how will it be implemented? How should the portfolio use equities? Should fixed income be weighted to corporate taxable bonds or tax-exempt municipal bonds? Should alternative investments play a role?
The trust’s investment advisor, legal and tax advisors can help with crafting an IPS. The process of the team working together on the IPS provides an opportunity to uncover any potential needs and identify concerns or tensions before they become problematic.
The identity of the trustee itself may further affect the IPS process. If the donor is serving as trustee but isn’t a beneficiary of the CRT, the donor’s approach to the IPS and subsequent investing decisions might be presumed to reflect the donor’s intent (though still subject to trustee fiduciary duties). When a CRT beneficiary is also serving as the CRT trustee, whether individual or charity, even closer attention should be paid in the IPS and subsequent investment decisions to avoid any favoritism.
Fiduciary Fitness
A trustee’s robust and thoughtful approach to the duty to invest CRT assets prudently and satisfy its fiduciary obligations to all vested beneficiaries requires thoughtful and detailed analysis. CRT trustees will usually prefer higher equity weights that may decrease on set schedules as the trust term draws nearer, use taxable bonds more than tax-exempt bonds and avoid illiquid investments to balance the different interests of the individual and charitable beneficiaries. Advisors emphasize to trustees that while they can’t guarantee investment results, the consideration, documentation, communication and consistent implementation of an investment process through an IPS is just as important as the end result in showing the good faith fulfillment of trustee duties. The hope is the trustee six-pack will enhance your fiduciary fitness!
— This article represents the opinions of the authorsas of the date published and does not necessarily reflect the opinions of Capital Group or its affiliates.Endnotes
Endnotes
1. Uniform Prudent Investor Act (1994); Restatement (Third) of Trusts; Prudent Investor Rule (1992).
2. Uniform Principal and Income Act (2000).
3. Uniform Trust Code (2000).
4. See, for example,Museum Associates v. Schiff, 2011 Cal. App. Unpub. LEXIS 1752 (March 10, 2011) and In re Rosenfeld Found. Tr., No. 16641V2022, 2006 WL 3040020 at *2 (Pa. Com. Pl. July 31, 2006) (surcharging trustees who failed to diversify out of the initially gifted concentrated stock); Wood v. U.S. Bank N.A., 828 N.E.2d 1072 (Ohio App. 2005), in which a trust document’s clause allowing a trustee to hold stock in its own company, and the trust document’s silence on the duty to diversify, together weren’t sufficient to exonerate the trustee’s retaining a concentrated stock position in its own stock that plunged in value; Fifth Third Bank v. Firstar Bank N.A., 2006 Ohio 4506 (Ct. App. 2006), inwhich a charitable remainder unitrust trustee was found to have failed to diversify quickly enough.