Suppose you’ve been made trustee of a trust. While a formal trust document exists, the indenture contains little detail on investment choice, leaving the Uniform Prudent Investor Act to provide guidance regarding investment specifics. Key to that concept is the preservation of capital, which the Restatement of Trusts defines as:
Safety of capital includes not only the objective of protecting the trust property from the risk of loss of nominal value but, ordinarily, also a goal of preserving its real value--that is, seeking to avoid or reduce loss of the trust estate’s purchasing power as a result of inflation. This objective will also normally tend to protect the purchasing power of the income flow in the future. Reasonable ²return² refers to total return, including capital appreciation and gain as well as trust-accounting income. Thus, return objectives and safety of capital are at least partially interrelated.
The capital-growth element of these return objectives, however, is not necessarily confined to the preservation of purchasing power, but may extend to growth in the real value of principal in appropriate cases. In balancing the return objectives between flow of income and growth of principal, the investment emphasis depends not only on the purposes and distribution requirements of the trust but also on its other circumstances and specific terms, such as the beneficiaries’ tax positions and whether the trustee has power to invade principal.
Here are some brief points to consider based on the above two paragraphs:
1. What is the current inflation rate and what are future projected inflation rates? We can use the BLS’ overall CPI rate for the current level. The St. Louis Fed’s FRED system has 4 different measures of future inflation calculated as the difference between the treasury and tips spread of a certain year’s issue:
All assets with an income component should be selected with an eye toward these benchmarks.
2. Assuming two beneficiaries, what is the present value of the final beneficiaries’ potential payout (including income and final principal payouts) and how does that compare to the annual outflows of payments comprised only of portfolio income paid to the first beneficiary? You’ll need multiple calculations usig reasonable return projections to comply with the trustee's duty of impartialty.
3. The need to preserve capital potentially limits portfolio selection to a conservative set of investments as shown in this graph:
The X-axis plots standard deviation – the standard measure for portfolio risk. Points farther away from the origin represent higher risk. While increased risk leads to higher return it also means a higher probability of increased losses. The downside of higher risk leads to a more conservative investment selection, all things being equal.
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