As a trustee, you are legally obligated to act in the interest of your beneficiary, and one day you may be called to prove the decisions you made were the right ones. So how should a trustee approach the investment and distribution decisions for the trust assets? This is where using a bucket strategy can provide an attractive structure in demonstrating a sound approach. It is also the simplest way to manage the distributions from the trust for the beneficiary.
If you’re a trustee and have been selected to manage a trust perhaps you may feel a bit overwhelmed by the responsibility. Managing your own financial life can often feel like a daunting task, now you’ve been asked to manage the assets of another person while somehow ensuring those assets last as long as the beneficiary needs them. As a trustee, you are legally obligated to act in the interest of your beneficiary, and one day you may be called to prove the decisions you made were the right ones. So how should a trustee approach the investment and distribution decisions for the trust assets? This is where using a bucket strategy can provide an attractive structure in demonstrating a sound approach. It is also the simplest way to manage the distributions from the trust for the beneficiary.
So what is a bucket strategy and why is it the right approach for many trustees?
A bucket strategy is simply another way to allocate the assets in the trust. Trustees are obligated to follow The Uniform Prudent Investor Act (UPIA). The UPIA is a statute that provides guidelines for trustees when investing the trust’s assets. The UPIA uses modern portfolio theory when determining if the trustee is allocating resources appropriately. The trust’s entire portfolio is taken into consideration, rather than just the individual assets. Diversification is explicitly required, and asset allocation is the tool.
Asset allocation is simply a strategy that aims to balance risk and reward through the proper apportionment of assets based on risk and investment horizon. Typically, these assets are allocated across 3 classes; equities/stocks, fixed income/bonds, and cash/cash equivalents. Each of these classes has different levels of risk and return and behaves differently over time. Stocks and bonds are thought to be generally negatively correlated, meaning that when stocks go up, bonds go down, and vice versa. Although this relationship does not hold in every scenario, as demonstrated by the latest coronavirus crisis. But, as a general rule, we assume bonds and stock will act in concert. As such, an appropriate mix of stocks bonds, and cash provide a diverse portfolio that responds to market drawdowns better than a single asset class.
So what might this look like? A common asset allocation is a 60/40 portfolio. This means that 60% of the portfolio’s assets are allocated to stocks, stock mutual funds, or Exchange Traded Funds. The remaining 40% of the portfolio is allocated to bonds and other fixed-income assets as well as a little bit of cash. This type of portfolio is easy to understand and implement during the accrual phase during a person’s working years, such as when they may be actively funding the trust. However, it is less intuitive during the drawdown phase when assets such as stocks and bonds must be converted into cash so that the trust can fund the daily expenses of the beneficiary. This is where the bucket strategy comes into play. The bucket strategy is a simple to understand withdrawal strategy.
WHY THE BUCKET STRATEGY WORKS
The trust should dictate strategies and limitations for investing and distributing trust assets. However, many trusts give broad discretion to the trustee to determine what is in the best interest of the beneficiary. The bucket approach allows a trustee to develop a purposeful spending strategy, while still growing the remaining assets so the trust can continue to provide needed resources well into the future. The trustee can separate, track, and progress each bucket independently. The bucket approach lets the trustee feel confident that they are balancing the required expenditures, while simultaneously still growing the principal.
The Fundamental Flaw of Any Withdrawal Strategy; Sequence of Return Risk
I’m writing this article while we are still in the throes of a massive selloff from the coronavirus. Many people’s portfolios have drawn down well over 30% during this time and are especially scary for those that rely on these portfolios to fund retirement or the expenses needed to provide care for the beneficiary of a trust.
Withdrawing assets from a portfolio during a down market has a name. It’s called Sequence of Returns Risk. Sequence risk is the danger of poor timing when withdrawing from an account. This risk can have a significant impact when implementing a withdrawal strategy because you are no longer contributing money to the portfolio regularly and instead are only making withdrawals from the portfolio. When selling assets at a depressed price to fund the required expenses of the beneficiary, the overall size of the portfolio is adversely impacted during a down market and will deplete at a much faster rate.
A trust is typically funded by a single event, such as through the transfer of an estate, or the payout from a life insurance death benefit. Unlike our personal retirement accounts, the trust typically isn’t generating more income. It’s not like the trust can choose to go back to work to make up the shortfalls generate by a market crash! Further compounding the issue, is that a beneficiary’s expenses may be fixed. If the trust is providing for the expenses of a disabled child, those expenses are likely supplementing quality of life and medical needs. The beneficiary isn’t simply choosing to forgo some extraneous lifestyle expense. Therefore, the trustee must make the best use of the finite assets the trust has been given. The bucket knowingly strategy gives up some performance, in exchange for limiting the impact of a sequence of returns risk.
BUCKET 1: LONG-TERM GROWTH
The first bucket we will call the Long-Term Growth Bucket, or Bucket 1. This bucket holds riskier assets such as stocks, stock Mutual Funds, and Exchange Traded Funds that generally have greater expected returns. This bucket is the growth engine of the trust portfolio and where most market gains will come from. Because the assets held in this bucket have the highest expected returns, they are also the riskiest and are subject to greater volatility over time. This volatility is what makes withdrawing assets from a heavily weighted stock portfolio troublesome. If the market is down, selling stock positions has a greater adverse effect on the portfolio than selling when the market is up. Waiting for the market to return to its previous highs can take quite some time.
BUCKET 2: INTERMEDIATE-TERM INCOME
The second bucket is the Intermediate-Term Income Bucket, or Bucket 2. This bucket will provide steady income generated by fixed-income assets such as bonds and inflation-protected securities. As previously mentioned, these assets are generally thought to be negatively correlated to the assets in bucket 1 and are expected to provide moderate growth even when the market is down. These assets have less volatility and can be sold and turned into cash more easily, however, they will not match the growth potential of bucket 1 over the long-term.
BUCKET 3: NEAR-TERM SPENDING
The third bucket is the Near-Term Spending Bucket or Bucket 3. This bucket holds cash, cash equivalents, and short-term treasuries. This is the bucket that funds the daily expense of the beneficiary because the assets are the most liquid and easily accessible.
Step 1: Get a Handle on the Budget
The bucket strategy only works if the trustee has a good handle on the budget. The trustee needs to understand how many fixed expenses are required and develop an estimate for reoccurring variable expenses. The trustee will likely need to do a Lifetime Financial Needs Analysis (LFNA) for the beneficiary to identify the gap between those services covered by government benefits and social services and those services and expenses the trust will need to pay for. This gap is what must be filled by bucket 3, the cash bucket.
A note of caution: for a portfolio to be sustainable for the long term, the withdrawal rate must be carefully balanced with the expected growth rate of the portfolio, taking into consideration the different expected growth rates of each type of asset held across the three buckets. A quick back of the envelop way to check this is to use the “four percent rule” to determine how much can be withdrawn in any given year. This rule has generally held over many different types of market conditions and is a good way to quickly determine if the portfolio can support the desired level of expense for a 30-year time horizon.
To do this, multiply the total amount of assets held in the trust by four percent. This number is how much can be withdrawn each year for the next 30 years. If the trust’s expenses are less than this number, the trustee can feel confident the assets will last for at least 30 years and likely continue to grow over time. If the expenses are greater, or the trust must last longer than 30 years, the trustee should use a smaller percent (eg: 3% or 2.5%). It is recommended the trustee perform a more detailed analysis of how long the portfolio would be expected to last and find necessary cost savings to reduce expenses using expected growth and future value of the portfolio.
STEP 2: FILL UP THE BUCKET 3 WITH CASH
The bucket strategy knowingly gives up overall performance by holding a large amount of cash in the portfolio. The overweighting of cash will reduce the amount of expected return those assets could have generated if invested more aggressively. But that is not the point. The trustee is not trying to have the most efficient portfolio or design a portfolio to have the highest returns. Rather, they are purposefully structuring the portfolio to meet the needs of their beneficiary by carefully balancing risk with return. To this end, the trustee should purposefully set aside enough cash in bucket 3 to weather the inevitable market downturn or bear market. How much is enough? This is the fundamental question that must be answered but is subjective to the individual. However, a good place to start is by ensuring there is enough cash set aside for at least 2 years’ worth of expenses. Why this amount? Because the average market drawdown lasts 22 months.
STEP 3: SPEND
The entire purpose of bucket 3 is to provide income for necessary expenditures. This bucket is meant to be spent down. How you do this is up to the trustee. The trustee can cut a check directly to the beneficiary or move money from the trust account to the beneficiary checking account at the beginning of each year, quarterly, or monthly. It is up to the conditions of the trust, or the judgment of the trustee to determine how they want to spend.
However, if the beneficiary is reliant on government resources for much of their support, such as in a Third-Party Special Needs Trust, the trustee must be very careful to never transfer more than $2000 into the beneficiary’s account. Doing so will likely cause the beneficiary to lose those benefits until their assets are spent down under the $2000 limit. A more appropriate approach is for the trustee to move money into a liquid cash account such as a money market fund or checking account that the trust owns. The trustee then pays expenses directly from the trust-owned checking account without any money being given directly to the beneficiary.
STEP 4: REFILL THE BUCKETS BY REBALANCING
The fundamental purpose of a strategy like this is to keep from selling stocks during a down market. This is why the trustee has set aside such a large amount of the portfolio in cash knowing the cash will drag on the overall returns for the portfolio. Each year as money is moved from bucket 3 to an expense account/checking account that withdrawal must be replaced.
Using the traditional bucket strategy approach, the trustee would refill bucket 3 by selling bonds from bucket 2 and earmark those proceeds into bucket 3. The trustee then sells stocks from bucket 1 to refill the bonds redeemed in bucket 2; essentially each bucket refilling the next subsequent bucket, with bucket 1 refilling over time from the growth in the underlying stock portfolio.
However, this traditional approach may exacerbate the issue in a down market by selling both stocks and bonds to refill the cash bucket at an inopportune time. A modified approach, more in line with typical portfolio rebalancing may be more appropriate. After moving the annual expense into the trust’s checking account, the refill strategy should look like this:
- When stocks are up, sell stocks;
- and when stocks are down, sell bonds;
- and when both stocks and bonds are down, such as in a prolonged bear market, continue using funds identified for year 2 expenses from bucket 3 until you get to the other side of the market drop, then rebalance accordingly.
This is what traditional rebalancing looks like in a portfolio. The only difference between this example and a trust bucket strategy is the trustee has purposefully set aside deeper cash reserves in bucket 3 so they are not having to sell assets when the entire market is depressed. The importance of regularly rebalancing can’t be overstated. This article by Michael Kitces does a more thorough job explaining the issue, however, let me refer to his chart to make my point; rebalancing between buckets is the key to the longevity of the entire portfolio.
Watch out for Taxes!
Trusts are taxed at a much higher rate than most individuals. Dividends typically reinvested inside the trust can quickly become a large taxable event for the trust as a trust reaches the maximum marginal tax rate much quicker than an individual. The trustee should be cognizant of the effect of taxes on a portfolio when deciding what types of asset classes to invest in. For example, a trustee will likely want to limit the taxable gains generated from dividends by using tax-aware assets such as tax-free municipal bonds or low turnover stock mutual funds and ETFs rather than their traditional counterparts.
Is the Bucket Strategy Right For You?
Maybe, maybe not. There are plenty of reasons to forgo using a bucket strategy; namely the possibility of lower overall returns. If you are using a trust to protect assets in an estate and transfer those assets to the following generation, the trustee may not need to focus on making the assets last for a specified period of time. However, if the beneficiary is disabled, or the trust is needed to fund a set amount of expenses, the bucket strategy is worth exploring.