Statutory Considerations: Section 2(c)(7) of the Uniform Prudent Investor Act directs that, “Among circumstances that a trustee shall consider in investing and managing trust assets are… needs for liquidity, regularity of income, and preservation or appreciation of capital.” A prudent trustee understands that there will be periods when the portfolio does not accomplish the established return objectives, though the distribution requirements must still be met. A prudent trustee will draw up a plan of how they are going to respond to that expected, but unwelcome, event.
Calculating the Income Shortfall: It is assumed that a prudent trustee has established a targeted return for the trust assets so that they can fulfill the trust purposes, terms and distribution requirements. The first source of funds used during such a decline will be the income produced by the investments. Even during periods of dramatic price volatility of the underlying securities, the portfolio is expected to continue to produce some level of income which can be used to meet the trust purposes and administrative expenses.
Projected Distribution – Portfolio Income = Income Shortfall
The “Bond Bunker”: Besides the continued availability of income, most trustees hold some portion of the liquid trust capital in cash, money market funds, and/or short-term bonds which are expected to retain their value during periods of high volatility in the financial markets. By dividing this “Bond Bunker” size by the income shortfall, the trustee can define the contingency reserve as the number of years these stable assets could be “tapped” to cover the income shortfall. This capital held in anticipation of a sustained drop in the equity markets would allow the trustee to continue distributions at the projected level while the equity markets follow their historic path of retraction, stabilization, and recovery.
$40,000 Projected Trust Income from Liquid Assets (2.5% on $2.0m)
$10,000 Income from Illiquid Trust Assets (e.g., net income from rental home)
$20,000 Other income available to the beneficiary (e.g., pension, SS, annuity)
($40,000 + $10,000 + $20,000) = $70,000 Total Projected Income
<$120,000> Projected Expenses
($70,000 – $120,000) = <$50,000> Income Shortfall
$500,000 Bond Bunker (cash+MM+short term invmt grade bonds)
10 years Capital Reserve (Bond Bunker of $500k / Income Shortfall of $50k)
With a 10-year capital reserve ratio, the trustee could continue to make distributions to the beneficiary out of the Bond Bunker for 10 years before this capital reserve was exhausted.
Compliance Library: A prudent trustee will develop a record that demonstrates they have taken seriously their duty to prudently administer the trust, which would include developing a contingency plan so that an established distribution pattern is not interrupted during periods of heightened market volatility.
Give me a call: If you or your clients serve as a trustee and a further discussion would be helpful regarding this duty to create a contingency plan, I am available for a phone call to discuss the facts. Simply click here to book a 20-minute consultation.
Josh Yager, Esq., CFP®, ChFC®
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