By Greg Hutto, CFP®, CFA®
In the previous installment of the Perceptive Executive Series, we reviewed a powerful strategy that can allow an investor to achieve diversification, defer capital gains taxes, and basically have their cake (hang onto their stock and hedge downside risk) and eat it too (capture a higher price if the stock appreciates in the future). If you missed this article, no worries: check it out here.
The next strategy in this series is my personal favorite, and it’s likely the most powerful of all advanced planning structures. The article title is no hyperbole, and we’ll review hard figures later that bear out my claim. But despite its effectiveness, the percentage of people who actually implement charitable planning programs remains pitifully low, despite the practically too-good-to-be-true benefits.
This conundrum of why don’t more high-net-worth individuals fund planned giving vehicles (despite their indisputable benefits) is, in my opinion, the most fascinating behavioral finance topic. This quandary gets at the heart of why we invest and, more importantly, what we believe. Buckle your seat belt, because you likely have never thought about money, who benefits from your money, and finally, who owns your money, in the way I’m about to describe.
Why We Invest
There is really not a limitless number of reasons why we invest our money—in terms of who the money is invested for. When we drill it down, we allocate money into various financial instruments and vehicles to benefit either:
- Ourselves: It’s a good thing to embrace personal responsibility and plan for retirement, isn’t it? Unless we plan on working until the day we die, we will all need some form of income in our later years. And even if we plan on working well into retirement, it’s still a good idea to set aside funds and invest some of the money we earn in case we’re unable to work when we’re old.
- Our loved ones: Many people desire to provide for loved ones now or leave some of their wealth to their heirs.
- Causes or organizations that align closely with our belief system: Many people feel strongly about their faith and/or causes they want to benefit.
The planned giving vehicle I’ll outline today can provide for all three beneficiaries of your wealth (yourself, your heirs, and your passions). But in order to do so, you’re going to have to come to grips with realities that few people can overcome. Keep reading if you believe you might be the one in a hundred—or less.
The Scarlet Letter Of Investments
As we approach our 60s, for most of us the transition from our working lives to the rest of our lives begins to take shape. We aim to have X amount of money at retirement and hopefully have begun to work on a retirement plan that will provide enough money to last us for the rest of our lives. This nest egg, combined with Social Security, pensions, and other income sources, needs to be able to generate enough income to at least cover our basic needs, and hopefully our wants and wishes as well.
But several challenges make retirement planning difficult—both for you as a consumer and me as a financial planner. For example, neither one of us knows:
- How long you’ll live, or
- What rate of return your investments will produce, or
- Whether future inflation will cause you to need more income than anticipated, or
- Whether a decline in your health or your spouse’s health will cause you to need more income or a lump sum to pay for future medical expenses.
The uncertainty around these factors causes many retirees and soon-to-be-retirees to seek investment vehicles that can provide an income stream for the rest of their lives. You know the word I’m about to use—it’s the Scarlet A of investments—an ANNUITY. An annuity can come in several forms, but an annuity in its simplest form just means a series of payments. You will receive an annuity from Social Security when you file for benefits, for example. And you don’t have to invest in a commercial annuity in order to receive a series of payments from your portfolio for the rest of your life.
A commercial annuity is an investment vehicle offered by large life insurance companies. This is where many retirees allocate some of their money despite the high expenses and less-than-favorable features found in many contracts. They do this in an attempt to solve the uncertainty of not having answers to the previously mentioned factors. They also do this because often they don’t know of any other way, or any other kind of annuity, to solve their retirement income needs.
But the problem with annuities isn’t the annuity itself, the problem is usually with the providers. Way too many contracts have features, charges, and fees that work against an investor. The good news is that you as a consumer don’t have to invest in a commercial annuity to obtain the benefit that you most likely want in retirement, which is income you won’t outlive.
A Better Alternative
If a retiree is only interested in providing for their personal income needs (looking after #1, literally, in my list of three beneficiaries), then it’s clear that an annuity can make sense. This knowledge in the world of finance and economics has been around for a long time.
In his groundbreaking work “Uncertain Lifetime, Life Insurance and the Theory of the Consumer,” (1) Israeli economist Menahem Yaari proved in 1965 that an investor who is uninterested in a legacy or bequest motive should allocate all of their money to a life annuity. Said differently, the best way to hedge longevity risk is with the use of a life annuity.
I’m going to concur with Dr. Yaari’s work and tag onto it. The figures are undeniable in that an investor who wants to benefit #1 and #3, or #1, #2, and #3, should allocate a significant portion of their net worth to the best annuity of all time, the charitable remainder unitrust (CRUT). A CRUT is pretty much a life annuity, but depending upon an investor’s goals, it can be even better. It’s basically a life annuity that gives donors a substantial tax deduction when assets are contributed, thus increasing the donors’ after-tax return while also leaving a legacy to charity. And unlike a commercial annuity, which involves an intermediary, a CRUT can be structured with low fees and operating expenses.
Let’s assume you’re nibbling at the bait I’ve thrown in the pond. You like the lifetime income part, the tax deduction sounds good, and you want to avoid capital gains on all that stock you own as well. However, you likely want to benefit your heirs also, and let’s assume you want to benefit your favorite charity or two when you pass away. Can everyone truly win with a charitable remainder trust?
Let’s review a one-page diagram of a CRUT, with an important concept added: wealth replacement.
CRUTs In The Real World
Want to see how it works with some real figures?
Scenario assumptions: John and Jane Donors, a married couple age 65, own $1,000,000 of highly appreciated stock (basis $250,000). They are assumed to be top-bracket income taxpayers.
Let’s walk through the steps:
- One million dollars’ worth of appreciated stock is gifted to the trust.
- Stock is sold and reallocated to a diversified portfolio of dividend-paying stock and other instruments with an average yield of 4%. No capital gains are incurred upon sale. Or the stock can be held in the trust, but if one can diversify away their single stock risk without incurring taxes, then why wouldn’t a prudent investor do this?
- Payments are received from the trust. How much annual income can be generated? It’s a function of the Donors’ age. For an exact answer, please find my contact information at the end of this article. Let’s use a 7% distribution rate, which is around 3% more than would normally be deemed prudent as a retirement withdrawal rate.
- A tax deduction is available in the year the contribution is made. The approximate amount of the deduction is $221,000 (source: Planned Giving Design Center), which can be used to offset up to 50% of one’s ordinary income in a given year. Unused deductions can be carried forward up to five years, under current U.S. laws.*
- The Donors avoid triggering capital gains of $750,000 when selling the stock, which allows the entire value of their stock proceeds ($1,000,000) to produce income. If the stock was sold and reinvested without a CRT in place, the net amount left for investment after taxes are paid would only be $850,000 ($750,000 X (1-20%) + $250,000 basis).
- Let’s assume the Donors were previously receiving a 7% dividend treated at a long-term capital gains rate of 20%. The amount an investor would normally end up keeping without a CRT in place would only be 5.6% (7% X (1-20%)). Now, an investor has an opportunity to receive a 4% dividend taxed at LTCG’s rates, and the other 3% can be treated as a return of premium (not taxed*) if losses are available with some positions in the CRUT, as is usually the case with a portfolio holding some individual stocks. So the Donors’ after-tax income could be 6.2%, not 5.6% (3% return of premium + (4% X (1-20%))).
- What happens at the death of the second spouse? The balance of the trust assets goes to the charity (or charities) named as the beneficiaries of the trust (remember this phrase, Charitable Remainder Trust, the charity (receives) the remainder).
- So the Donors win by receiving lifetime income, by avoiding capital gains taxes on the sale of the appreciated asset, and by receiving a generous tax deduction in the year of the gift. And the charities win by receiving a huge gift at the end of the Donors’ lives. But who’s losing out here?
- Yes, the Donors’ heirs have been “disinherited” at this point. If we can solve this problem, could everyone, except the IRS, win in this scenario?
- Everyone can win, except the IRS, with the creative use of life insurance. On average, it will take around 2% of the 7% distribution per year to fund a “second to die” life insurance policy (who said the life insurance industry doesn’t have a gallows sense of humor?), which can replace the assets gifted to the trust.
In this instance, on average, an annual premium of $20,000 will fund a $1,000,000 permanent IUL (indexed universal life) policy on two 65-year-olds with standard non-tobacco (NT) rates. The anticipated life span for both of the Donors is 25 years, with this figure taken from actuarial tables.
It will likely require less premium if one or both spouses are rated preferred NT, and it may take more premium if one or both are rated below standard NT. However, even if the premiums are 3% per year, then the amount of income one can keep with a CRT is still higher than the after-tax distribution of 4% coming from stocks qualifying for LTCG rates. This strategy may not be achievable if one or both spouses are uninsurable.
- With wealth replacement, the three groups that most people want to benefit in retirement can win: ourselves, our heirs, and our charities.
Some factors to consider:
- The annual distribution for a CRUT is normally based upon the previous year’s ending balance, per the language in the trust document.
- If the account balance goes up by 10% at the end of year 1, then the Donors’ income will increase by 10% in year 2. Conversely, if the account balance of the CRUT drops by 10% in year 1, then the Donors’ income will decrease by 10% in year 2 as well. No one wants their total income to drop over time, so for this bucket of the Donors’ retirement assets, it makes sense to allocate most (if not all) of one’s funds in the CRUT to the asset classes with the highest expected return and lowest available risk, as measured by standard deviation.
The financial equation used to measure this ideal combination of high returns and low fluctuation (risk-adjusted returns) is called the Sharpe ratio, named after William Sharpe. It is calculated as follows: (Rp-R(rf))/α(p).
Now in English: R(p) is the return of the portfolio. R(rf) is the assumed return one can receive from a risk-free investment, and α(p) is the standard deviation of the portfolio. So we want a high number for R(p) (portfolio return) and a really low number for α(p) (standard deviation, aka risk), just like any other unreasonable request that is thrust upon us as financial advisors, right? These two desires don’t tend to go together, as we know.
However, there are two investments that can be ideal for CRTs, namely interval funds (which tend to have distributions in the 5.25% range and a historical total return of around 8%), and structured notes (which can be engineered for distributions in the 7 to 8% range with significant downside protection). These yields are much higher than what we normally see with most common stocks, and their downside capture tends to be very low. In other words, although their expected return isn’t quite as high as stocks, the very low standard deviation that interval funds and structured notes possess can allow for much less fluctuation of income in retirement from this bucket.
Turning Our Attention To You
So could a CRT make sense for part of your retirement plans? Maybe, but do you remember my brash comment earlier when I said you would have to be one in a hundred to be a candidate for charitable planning? The reasons why most people won’t contribute to this wonderful vehicle are twofold, in my opinion: fear of the unknown and an ownership mentality.
The first factor is easy to understand. In the back of their minds, many retirees, upon entering retirement, tend to believe they might need more income than their initial budget. And they tend to think that the best way to receive more income later (if it’s needed) is to keep all their options open and not commit to any financial structure or anything that could reduce their ability to move their money, or make changes later.
And occasionally we know of someone who spent down a lot of their retirement portfolio due to health challenges or having an extra-long life. But I’ve found these situations are by far the exception, not the rule. And if the particulars of these situations were known, I believe we would find that these retirees either didn’t take enough risk (by having virtually all of their funds in CDs), or they made poor equity choices by trying to pick stocks or having too much money in one sector (think energy right now).
The second factor is more problematic. When working with anyone who has a desire to benefit all three groups (themselves, their loved ones, and their passions), I get a lot of long looks and silence when I bring up this next concept of ownership of one’s money. “Well of course I ‘own’ my money!” Wouldn’t that likely be your reply if I asked you, “Who owns your money?”
Well, the question of who owns your money really comes down to two factors: what do you believe, and how strongly do you believe in what you believe? The following statement isn’t an attempt to convert you to my beliefs—but I’ll engage you in an email dialogue later if you’re interested!
And please don’t worry if you’re an atheist, folks; I’m not writing this to condemn you. Depending upon whose statistics you use, your level of benevolent giving is (sadly for me) likely better than that of Christians.
All of the major religions have, as a part of their core tenets, that their Supreme Being is the owner of all. In the case of Christianity, this theme is all over the Bible—you can’t miss it. The most well-known verse on this subject is probably Psalm 50:10, the “cattle on a thousand hills” verse.
Unfortunately, I’ve found that most Christians believe that God is the owner of all but at an intellectual level only. We tend to believe that God owns our money in a way that is similar to how we believe that speeding is wrong or not coming to a complete stop at a stop sign is wrong. Most people believe it’s a good idea to not speed down the freeway, or that to come to a complete stop at a stop sign is a good habit to have, buuuuut…we end up speeding, don’t we? (I do—guilty as charged!) And does anyone really come to a weight-shifting stop behind the stop sign, except on their driving test?
If we believe God owns our money, but only at an intellectual level, then the overwhelming tendency will be for you and I to put it off, to wait, when we hear of this wonderful structure, and other planned gifts like it. You and I will want to find any reason we can to not follow through when someone like me challenges you to put actions to your beliefs. When the incredible attributes of this structure (or other planned gifts) are presented to us, we will tend to say, “Well, I just need to think about that….”
I’d like for you to do that, to think about this. And at the same time, think of the amazing life that you’ve had a chance to live. While you’re at it, think of the wonderful people who have helped you along the way. And think about the causes and charitable organizations that you love, these causes that really need your time…and desperately need your money.
I’ve selected this structure (a charitable remainder unitrust) because it’s one that can accept multiple contributions over time. I would be asking a lot of you to follow up on your belief with an action by contributing a huge portion of your net worth to a planned gift. Basically, I know you won’t do this. It’s too uncomfortable for you right now.
So instead, I’ll ask you to do this. Do yourself (and others) a favor. Get educated about this structure, and then make a contribution at a level that you’re comfortable with. Your financial situation should improve, and there’s nothing like following up your beliefs with actions. Have questions? Concerns? Give us a call at 817.503.0100 or email email@example.com to schedule a free introductory meeting.
Greg Hutto, president and CEO of Heritage Retirement Advisors, comes from a family of educators, so it’s no wonder he holds a bachelor’s degree in business from Texas A&M University, and a master’s degree in education from Tarleton State University. He spent years as a teacher and coach before entering financial services in 1996. After 14 years in the industry working for such powerhouses as UBS Paine Webber and Raymond James, Greg founded Hutto Retirement Advisors LLC in 2010, now Heritage Retirement Advisors. He holds both the Certified Financial Planner® (CFP®) and Chartered Financial Analyst (CFA®) designations. Additionally, he is the founder of Heritage Tax Advisors LLC. Greg and his wife, Angie, have three children. He likes to cycle, play golf, travel with his family, and he’s still trying to convince Angie of his dream of being husband-and-wife truck drivers, or at least working and living on the road in an RV! To learn more about Greg, connect with him on LinkedIn.
* Neither Heritage Retirement Advisor or their advisors provide tax or legal advice. Please consult your tax or legal advisors regarding the concepts and investments mentioned in this article before investing.
(1) Yaari, Menahem E. Uncertain Lifetime, Life Insurance, and the Theory of the Consumer. Review of Economic Studies, 1965, vol. 32, issue 2, 137-150.