Outside of the academic debate, practitioners often recommend the approach that best meets the requirements of their agency. In simple terms, if they are primarily a mortgage banker, then a reverse mortgage makes the most sense. A realtor will surely want you to downsize. According to an insurance agent, annuities are the best. A financial planner with a bank of computers will verify that a fixed distribution rate based on probabilities is the appropriate approach. Admirers of Jack Bogel and Vanguard will follow Bogel’s lead and age-weight money between stocks and bonds. Many individuals still hold on to the age old idea of separation of principal and interest.
Not to be left out, investment counselors like ourselves are subject to this same problem. Each counseling firm believes they have an investment philosophy that is far superior to all others, whether they actually do or do not.
The benefit to those who are near retirement or currently in retirement is that the debate itself will generate new ideas, new products, and new approaches towards solving the needs of retirees, and there will probably be reduced cost due to a highly competitive marketplace. But until these benefits are fully realized, individuals will have to make decisions today given today’s choices.
I have worked with retirees for over three decades, and I know that there is no universal solution to this problem. The solution is different for each individual. The only guarantee I can give our clients is that their financial needs will change with time, and that they will eventually breathe their last breath. Any investment approach that does not consider both of these facts, death and change, will not suffice. As the goals of retirees usually consist of both creating income now and of not running out of money before death, we don’t need to look very hard to find guidance for this. These goals are similar to the goals of the vast majority of trust accounts with a life income beneficiary and a remainder beneficiary. Granted, some retirees are only concerned with their current needs and have no intent or need to pass on assets to another person or party. However, my experience has been that the vast majority of people do have a desire to spend some of their money and upon death, pass an estate on to a surviving spouse, children, relatives, or a charity.
Trusts have been used by individuals for centuries to preserve and grow wealth in order to provide a livable income to current family members without destroying the capital that produces the income. This is the same goal of many of today’s retirees. Because the goals are so similar, it seems logical to manage the financial assets of retirees in the same manner that trustees manage the financial assets of a trust. The duties of trustees have been set by law, tested in court proceedings, and modified by the courts over time as needed in order to meet the ongoing needs of both income beneficiaries and remainder beneficiaries. Because the trustee of every trust has a fiduciary duty to the beneficiaries of the trust, and can be held personally liable for mismanagement of trust assets, a prudent approach is mandatory and enforced by the law. This approach, then, is a great guide for managing the assets of retirees.
Current trustees in the state of South Carolina are bound by the South Carolina Uniform Prudent Investor Act when exercising their discretion over the investment of trust assets. South Carolina’s Act is based on the Uniform Prudent Investor Act which is followed in part or in its entirety by the majority of states. The many reforms now included as part of this law were driven by the great inflation experienced in the 1960s and 70s, academic research providing a new understanding of the investment process, the globalization of markets, and the availability of new investment options.
Because inflation has been absent from much of the conversation concerning retirement income, I thought I would share with you some commentary by F Philip Manns, Jr., a professor of Law at the Liberty University School of Law, on a court decision that led to The New Zealand Trustee Amendment Act of 1988. This Act led the common law world of trustee management investment standards away from the English law “legal list” approach to a “prudent person” standard favored in the United States. The prudent person standard revolves around the idea that trustees should invest in a portfolio designed to maximize income, minimize risk, and maintain impartiality between income and remainder beneficiaries.
In its most narrow sense, Mulligan holds that the trustees failed their duty of impartiality by favouring the life income beneficiary over the remainder beneficiaries. The co-trustees, PGG Trust Limited (PGG) and Mrs. Mulligan, life income beneficiary and widow of the deceased settler, invested solely in fixed income securities, thereby preserving the nominal value of the trust property and not its real value. In 1965 when financial investment by the trust began, the trust property was $108,000; in 1990, when Mrs. Mulligan died, the trust property was $102,000. While the numbers of dollars of trust property (nominal amount) essentially was maintained throughout administration of the trust, inflation in New Zealand between 1965 and 1990 had been substantial. The inflation equivalent value of $108,000 in 1965 was $1,368,000 at the time of trial in Mulligan (In New Zealand dollars. The equivalent adjustment of $108,000 US dollars would be have been $540,000 over the same period of time. – My addition). Quite obviously, deciding whether the trustees were required to maintain either nominal value or “real value” would have dramatic consequences.
Currently, the memories of the most recent recession and the losses incurred to both real estate values and common stock values are affecting retiree decisions. They are choosing to invest their retirement nest egg into some form of income generating asset with a perceived guarantee of principal, without considering the possibility of changes over the next few decades. However, I can assure you that change will take place in all financial markets, and anyone who does not prepare for change will come to regret their actions.
The Uniform Prudent Investor Act recognizes that the future will change. You can read the entirety of the Act at your leisure, but for now I want to highlight a few points from the South Carolina Code:
Section (C) (1) A trustee shall invest and manage trust assets as a prudent investor would by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
Section (C) (2) A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
Section (C) (3) Among other circumstances provided in item (1) of this subsection which a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:
(a) general economic conditions;
(b) the possible effect of inflation or deflation;
(c) the expected tax consequences of investment decisions or strategies;
(d) the role that each investment or course of action plays within the overall trust portfolio, including financial assets, interest in closely held enterprises, tangible and intangible personal property, and real property;
(e) the expected total return from income and the appreciation of capital;
(f) other resources of the beneficiaries;
(g) needs of liquidity, regularity of income, and preservation or appreciation of capital; and
(h) an asset’s special relationship or special value to the purposes of the trust or to one or more of the beneficiaries.
Section (C) (4) trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.
Section (D) A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.
Section (G) Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of a trustee’s decision or action and not by hindsight.
Until next time,
Kendall J. Anderson, CFA