Choosing the Payout Rate:
Let's consider first the decision concerning
establishing the payout rate itself.
If your immediate need is for high income levels,
choosing a relatively high payout rate makes some
sense. But if you are a donor beginning retirement,
you should choose a payout rate that leaves sufficient
funds in the CRT each year to keep your trust income
ahead of projected inflation.
One approach would be to specify a relatively high
payout rate, say 8 percent, and permit payment to be
made from principal if trust net income is insufficient
to meet this obligation to the beneficiary. In such a
case investment would be almost entirely for growth
purposes and well-capitalized growth stocks might be
the place to look.
From 1946 through 1991, the best U.S. stocks have
produced a return averaging about 12.7 percent
annually. With an 8 percent payout and a growth stock
investment policy, after administrative costs, it can
reasonably be expected that about 4 percent of the fund
could be added to trust principal each year.
The difficulty with this approach is that the
annual rate of return left in the CRT each year must at
least equal or surpass the annual rate of inflation, in
order to preserve the purchasing power of future
distributions and the ultimate remainder interest. An
equal problem will be that annual payouts will be
highly variable from year to year, because of
inevitable fluctuations in the stock market. The
donor/beneficiary must be willing to put up with this
variable payout prospect as the price of higher
investment income.
Economic realities in the U.S. and the world will
make it difficult, if not impossible, to produce a
gross income return in excess of 8 percent, even if the
CRT portfolio is invested totally in fixed income
holdings, assuming the purchase of investment grade
debt instruments. Expenses chargeable to income must
also be subtracted, so the net income is likely to be
even lower. For comparison's sake, consider that the
highest quality long term bond yields have historically
averaged about 4 to 5 percent a year. Assuming that
the CRT will hold long term bonds to maturity, this
part of the trust principal will not grow with
inflation. Remember that if the CRT principal does not
grow, neither does the income of the beneficiaries.
As an illustration of what happens when these
factors are applied to CRT investment, a good case can
be made that a conservative 5 percent payout rate will
have the best all around results in the long term, if
there is the right mix of investments and careful
management.
Assume in year one $1 million available for
investment; a total trust investment mix of about 40
percent bonds with an annual 7 percent rate of return,
30 percent Standard and Poor's 500 stocks with a return
of 12.7 percent, and another 30 percent split evenly
between fast-growing U.S. and international small
equities with rates of return of about 15 to 16 percent
plus. Under this investment mix, with a 5 percent CRT
payout rate, the $1 million will blossom in 20 years to
about $4,800,000, of which $2,326,000 will be paid out
to the beneficiaries.
Compare this with the choice of a higher 7 percent
CRT payout rate; the same $1 million invested totally
in safe no-growth long term bonds at 7 percent net
annual return, in 20 years will leave only $1 million
in principal, after cumulative annual beneficiary
payments of $1.4 million.
Check that comparative 20-year record again: a 5
percent payout rate with a carefully mixed investment
policy produces $2.3 million in benefits; a 7 percent
payout rate with a no growth investment policy produces
$1.4 million in benefits. The 5 percent choice ends up
with $4.8 million remainder for charity, the 7 percent,
only $1 million - each with concomitant charitable
income tax deductions for the donor in the first year
based on the rate of payout chosen in year one.
