From Balancing Act [1], by Donald Jay Korn, September 2003 Financial Planning magazine.
“A total return [2] trust operates without the safety net of enforced conservatism,” notes Patrick Collins, a financial analyst in San Francisco who has written extensively about such trusts. “Therefore, it is vital to shape carefully the language of distribution [3] provisions, lest the corpus run out of money prior to the end of the planning horizon. Distribution provisions both reflect and govern reasonable spending expectations, which in turn provide the targeted return [4] for asset allocation [5] and asset management decisions. Grantors and beneficiaries must determine a suitable balance between growth expectations [reward], failure rates [distributions below an acceptable dollar amount], and bankruptcy risk [portfolio [6] value approaching zero].”
Putting distribution and investment management “on autopilot” is fraught with danger, according to Collins. “You will need to use customized simulation programs for modeling,” he explains. “Commercially available Monte Carlo programs won’t be adequate.” (See “Fair Shares” at the end of this story for an example of customized modeling.)
What lessons has Collins learned from his simulations and his work with total return trusts? “Costs matter a lot,” he says. “Small decrements compounded over long horizons really chew up wealth.” Therefore, passive investments might be the best choices for total return trusts. The added costs of active management [7] may lead to a search for higher returns, but planners might not want to stretch too far.
“With asset allocations greater than 70% equity, expected values may increase sharply, but floor values or bankruptcy rates may be increasing faster,” Collins explains. “These risk/reward tradeoffs are important to trustees and beneficiaries.”