Asset allocation is an important decision in the investment of any pool of assets, and charitable remainder trusts can have unique characteristics that affect the asset allocation discussion. While every portfolio is customized to meet the particular needs of the client/trust, we use a common framework to determine the appropriate strategic asset allocation. Generally, time horizon, return, risk tolerance, liquidity, taxes, and distributions are key components in the asset allocation decision.
The goal of a charitable remainder trust is to provide the agreed-upon payments to the donors during their lifetime (or defined term) while preserving as much of the original value as possible. The remainder will ultimately go to the charity upon the trust’s termination, which is either at the death of the underlying noncharitable beneficiaries or upon expiration of a specified term of years.
Charitable Remainder Trusts: the Basics
There are two types of charitable remainder trusts: charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs).
A CRAT establishes a fixed income distribution percentage, with the annual distribution amount determined at the onset based upon the initial fair market value of the trust. For example, if a $1 million CRAT is established with a 7% payout, the annual distribution will be $70,000.
While a CRUT also has a fixed income distribution percentage, the actual distribution amount will fluctuate based upon an annual valuation of the trust. For most CRUTs, the valuation is conducted on the “first business day of the new taxable year.” Chart 1, page 2 shows the potential variability of the annual distribution for a CRUT, using two years with positive market returns and a year with a negative market return. Currently, there are four versions of the charitable remainder unitrust:
- fixed percentage or standard charitable remainder unitrust;
- net income, which distributes the lesser of a fixed percentage amount or trust income;
- net income with make-up, which distributes the lesser of a fixed percentage amount or trust income with the ability to distribute more, to “make up” for years that distributed less; and
- flip trust, a net income trust that contains a provision that allows the trust to become a standard charitable remainder unitrust.
In the rest of this paper, we focus on the CRAT and the standard CRUT, as those are the most common types.
Managing Investment Policy: Some Factors to Consider
When managing any individual investment program, there are certain factors that we believe are highly important to proper portfolio positioning. In this section we highlight the factors we believe are important for the asset allocation discussion. It is our opinion that these factors should be explicitly included in investment policy statements (IPS), as we wrote about in our white paper guide to nonprofit IPS, The Discipline to Succeed. There are six factors, among others, that we believe are high priority to address for asset allocation discussions:
It is important to take into consideration the risk tolerance of both the remainder and income beneficiaries. The charity’s (the remainder beneficiary) objective is to grow or maintain the amount of the trust, as these assets are intended to support the mission of the organization in the future, while the income beneficiary’s objective is for the trust to make the agreed-upon payments. As charitable remainder trusts can make distributions as often as monthly, minimizing short-term volatility is a key concern for income beneficiaries, particularly those of CRUTs where the distributions are recalculated annually. If the trust suffers negative returns during a given year, the amount of the distribution will be reduced.
The time horizon for a CRT is typically defined by the life expectancy(ies) of the underlying beneficiaries. In certain cases, CRTs can have pre-defined terms, typically not to exceed 20 years. All things being equal, the longer the time horizon, the greater the ability to take on risk. This is because the longer time horizon allows the assets to “ride out” short-term volatility, allowing for a higher equity allocation.
The life expectancy of the trust is a key determinant in the asset allocation decision. It is a given that, as the income beneficiary ages, the life expectancy of the trust decreases. As the time horizon changes over the life cycle of the trust, the asset allocation should be reviewed to help make sure the asset allocation is still appropriate. For example, the life expectancy of the trust can dramatically change if the death of one of multiple beneficiaries significantly changes the remaining average life expectancy. Time horizon is only one of several factors that should be considered when determining asset allocation. For example, a trust’s payout may be so high that the goal of trying to earn enough return to cover the payout outweighs the potential for volatility over the short term.
Another key determinant of the asset allocation of a charitable remainder trust is the distribution rate. The management of a charitable remainder trust is meant to balance the need to meet the agreed upon distribution to the underlying income beneficiary(ies) with the target remainder objective of the remainder beneficiary. Distribution rates can vary, ranging from 5% to 10% across the PNC Planned Giving client base. It is important to note that, generally, the higher distribution rates are associated with trusts established in the late 1990s/ early 2000s. Currently, a charitable remainder trust, at its establishment, must have at least a 5% distribution rate (but no greater than 50%). The distribution percentage is subject to “Probability Testing” imposed by the IRS. These tests establish the likelihood that the CRT will perform as expected and will result in a distribution at least 10% of the original gift value to the named charity. All else being equal, the higher the distribution, the higher the equity allocation needed to support the distributions.
While both CRATs and CRUTs are based on fixed percentage distributions, the difference in the calculation of the dollar amount can significantly impact the characteristics of the trust. For CRUTs, the dollar amount of the distribution is recalculated annually and will vary year to year, but will always be based on the same percentage at the initiation of the trust (albeit recalculated annually).
For CRATs, the dollar distribution is calculated at the beginning of the trust’s life and remains constant. It is worth noting that during the life of the trust this dollar amount can become a significant distribution on a percentage basis. As the corpus of the trust is distributed, the dollar payout becomes a larger percentage of the current market value. For example, a CRAT established with $1 million with a 5% payout will distribute $50,000 on an annual basis. If the current market value of the trust is now $560,000, the $50,000 now represents an 8.9% effective payout rate and should be considered within the asset allocation decision.
Liquidity is an important consideration with the investment of CRTs as distributions can occur monthly, quarterly, semi-annually or annually. Given the frequency of distributions, CRTs should only be invested in liquid, readily marketable securities. Specifics around distribution needs should factor into decisions such as fixed income duration positioning and public versus private security positioning. Any decisions that are made on liquidity should be incorporated and well documented in the investment policy statement.
Distributions from charitable remainder trusts are taxable to the income beneficiary. Understanding the beneficiary’s expectations with respect to taxes is important; however it is worth noting that the prioritization of taxation can impact the asset allocation decision and subsequent investment returns. For details regarding the taxation of charitable remainder trusts in specific situations, consultation with a tax professional is highly recommended.
We would like to make a special note here of leaving a space in investment policy statements for “Unique Circumstances.” The purpose of this section is to document any unique features or objectives of the arrangement that are relevant to the investment management, security selection, risk tolerance, or liquidity of the portfolio.
As an example, for non-standard CRUTs such as a net income trust or FLIP trust, the additional characteristics of the trust must also be taken into consideration. FLIP trusts involve a triggering event that will convert the trust from a net income trust to a standard payout trust. The nature of the FLIP event and when the event may occur should be considered in the asset allocation decision. For example, if a trust is established when a beneficiary is 55 years old with the aim of converting to a standard trust when he reaches the retirement age of 65 years old, the stage of the trust can potentially change the appropriate asset allocation. Even after the trigger event in this example, the time horizon, while ten years shorter, will still be relatively long given the life expectancy of a 65 year old. In this case, the payout rate would be a key determinant of asset allocation.
The ultimate asset allocation decision takes into consideration a variety of factors and is not a “one size fits all” decision. We believe the investment objective of the trust needs to balance the needs of the income beneficiary and making the agreed upon distribution with preserving as much of the original value for the charity. The life expectancy of the income beneficiary, payout rate and type of CRT are primary drivers of the asset allocation decision but risk tolerance and liquidity should also be considered. As with any type of account, the asset allocation decision should not be a “set it and forget it” strategy; we recommend formally reviewing the asset allocation as part of the annual investment policy statement review and as market conditions warrant.
Accessible Version of Chart
Chart One: CRUT Distribution Variability