A Charitable Solution for the Fixed Income Investor

Keith Kellum; Joan Crain

For clients with charitable intentions, it is critical to consider all options for lifetime and legacy giving.

Balancing expenses and income streams has long been considered a cornerstone of fiscal responsibility. Financial advisors often place particular emphasis on the "spending rate," or the percentage of money taken out of an investment portfolio to fund a current lifestyle.

While this ratio is critical, attention to actual cash flow — that is, the dollar value of the cash generated by the portfolio — can be equally important to sustaining a nest egg for a lifetime and for future generations. Investors with sufficient inflows can keep their assets invested without having to sell at depressed prices or forgo the future growth potential of currently illiquid assets to generate funds to support their daily living expenses. In addition, current cash flow is a natural focus for most investors, who are typically reluctant to "invade principal."

Investors have historically depended to a significant extent on their fixed income (bond) portfolios to generate cash-flow streams. Unfortunately, when interest rates are falling, the projected cash flow from this traditional source is disappointing. This paper offers a possible alternative strategy, particularly for clients who are charitably inclined.

Current Fixed Income Environment

Global interest rates have fallen to historic lows since the Great Recession of 2008/2009 as central banks introduced aggressively stimulative monetary policy to stabilize financial markets. With rates falling from the historic highs enjoyed in the 1980s (under a markedly different economic and monetary policy environment), bond investors enjoyed a 20-year bull market in fixed income.

Under the new regime of persistently lower rates, many investors accustomed to 5% coupon, high-quality, tax-exempt bonds have found few fixed income alternatives offering similar yields and fewer still, if any, with comparable risk (such as duration or credit). Finding investments that will generate sufficient cash flow to support one's lifestyle and basic needs can be challenging. While some investors purchased bonds with longer maturities or lower credit ratings in an effort to maintain cash flow, many other investors and fund managers turned to alternative investments offering higher yields, such as real estate investment trusts (REITs), master limited partnerships (MLPs), or convertible and preferred securities. Investors are often unaware of the increased risk these investments introduce into their portfolios vis-à-vis high-quality bonds, bypassing traditional asset allocation frameworks in a singularly focused quest for yield.

Rather than reaching for interest income or cutting back on expenses, investors may find that investing for total return may be a better alternative to income-focused portfolio allocations. Capital appreciation can supplement or replace interest as a source for recurring cash disbursements. Especially for investors with longer investment time horizons, equity investments can help support annual spending goals over long periods of time and likely offer better risk-adjusted returns when paired with conservative fixed income than high-risk, high-yield assets on their own. Concurrently, many clients seek a solution that will replace, at least partially, the cash flow that was such a satisfying feature of owning bonds.

Charitable Remainder Trusts

For clients wishing to include a charitable legacy in their estate plans, charitable remainder trusts (CRTs) can offer another alternative to generating regular income. Moreover, a carefully constructed CRT strategy can integrate lifetime income needs with good estate planning and total-return investment management when carefully woven into a client's total wealth strategy. First, a quick primer on how charitable remainder trusts work:

CRTs are a type of split-interest trust where one party has a current income interest and another party has a remainder interest. Typically, the CRT will make annual distributions back to the individual who set up the trust, and at the end of the trust's term all remaining value will pass to a charity designated by the creator.

CRTs are, however, highly customizable. Trusts with level annual distributions each year, for example, are called Charitable Remainder Annuity Trusts (CRATs), while Charitable Remainder Unitrusts (CRUTs) distribute a fixed percentage of the trust's prior year asset value. CRUTs therefore allow payments to increase or decrease over time depending on the level of the trust's distributions relative to investment performance.

CRTs can also last for a fixed term of years (up to 20 years), the life of the creator or another designated income beneficiary, or the joint lives of creators and/or family members or friends. The payments themselves must be at least 5% of initial assets or trailing market values, though they can be much higher as long as certain actuarial tests are met.

CRTs also offer a number of income tax advantages. When a CRT begins, the creator receives a charitable deduction for income tax purposes based on the actuarially expected value passing to charity. This charitable deduction can be used in the same tax year the trust is funded, or possibly carried forward as permitted by tax law. Also, if appreciated assets are contributed to the trust and then sold, liability for the tax on the capital gain will flow to the income beneficiary as the annual distributions are received, deferring recognition of the tax over a number of years.

From an estate tax perspective, because all remaining assets pass to charity, the value in the CRT will not be included in the creator's estate. Only the annual distributions received from the trust would be included.

Client Example: Mrs. Smith

Mrs. Smith, age 65, currently has a relatively conservative investment portfolio, which she relies upon for her income in retirement. She wishes to leave money to her alma mater at her death, but fears a larger allocation to equities could jeopardize the security of her income.

As interest rates have fallen over the last decade, Mrs. Smith has gradually earned less and less on her municipal bond portfolio, though the bonds themselves have increased in value. Though her portfolio has average annual coupon payments of 4.71%, she must buy new bonds at substantial premiums (higher prices than the par values), making the effective yield much lower. Alternatively, she could cut back on her spending. However, since she doesn't live extravagantly this is becoming increasingly difficult for her.

Aware of Mrs. Smith's desire to eventually leave some money to charity, her advisor suggested another option: Instead of retaining a largely fixed income portfolio, Mrs. Smith contributed $1 million of her bonds to a Charitable Remainder Unitrust. The trust pays her 5% back for her lifetime, so she expects to receive $50,000 per year back from the trust. The bonds she contributed, by contrast, would have paid a coupon of $47,100, and her net yield would have been about half of that figure because of the premium she had to pay to purchase the bonds. After the bonds are placed in the trust, the trustee of the CRUT diversified 60% of the bonds into stocks and 3% into alternative investments, increasing the portfolio's expected return. The gain realized on the bonds was recognizable by Mrs. Smith over the first few years while she received a charitable income tax deduction of $453,510, which she used in the first year of funding.

By using the CRUT structure, Mrs. Smith was effectively able to take a current, fixed income-like interest in her future gift to charity, with the charity taking the remainder equity-like interest. This split-interest trust planning enabled Mrs. Smith to leave a larger legacy to charity while maintaining an income stream to support her basic spending in retirement. Given the current capital market environment, this structure even afforded Mrs. Smith the ability to keep up with inflation, as the unitrust payments are projected to grow over time while her bond portfolio would be expected to shrink if she were spending the coupons.

The Value of Advice in Wealth Planning

These entities can be quite flexible and nuanced, so it is critical to work with a broadly based team when evaluating wealth-strategy options. In fact, the real value of this strategy is its ability to integrate a client's investment strategy with their estate plan. Funding CRTs with the right assets can enhance income tax benefits while providing cash flow from alternative sources of "fixed income" through annual unitrust or annuity distributions.

Through careful coordination, CRTs allow clients to diversify concentrated assets, invest for total return and, in this case, substitute an attractive cash flow for a portion of the interest income from an investor's traditional fixed income exposure when rates are low. For clients with charitable intentions, it is critical to consider all options for lifetime and legacy giving with a nod to their own lifestyle needs and investment risk tolerances. In the right situations, CRTs provide an opportunity to accomplish multiple investment, wealth and tax objectives within a defined structure and plan.

  • This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. The Bank of New York Mellon, Hong Kong branch is an authorized institution within the meaning of the Banking Ordinance (Cap.155 of the Laws of Hong Kong) and a registered institution (CE No. AIG365) under the Securities and Futures Ordinance (Cap.571 of the Laws of Hong Kong) carrying on Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. The services and products it provides are available only to “professional investors" as defined in the Securities and Futures ordinance of Hong Kong. The Bank of New York Mellon, DIFC Branch (the “Authorised Firm") is communicating these materials on behalf of The Bank of New York Mellon. The Bank of New York Mellon is a wholly owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. The Authorised Firm is regulated by the Dubai Financial Services Authority and is located at Dubai International Financial Centre, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the Federal Reserve and authorised by the Prudential Regulation Authority. The Bank of New York Mellon London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon is incorporated with limited liability in the State of New York, USA. Head Office: 240 Greenwich Street, New York, NY, 10286, USA. In the U.K. a number of the services associated with BNY Mellon Wealth Management's Family Office Services– International are provided through The Bank of New York Mellon, London Branch, One Canada Square, London, E14 5AL. The London Branch is registered in England and Wales with FC No. 005522 and BR000818. Investment management services are offered through BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, One Canada Square, London E1C 5AL, which is registered in England No. 1118580 and is authorised and regulated by the Financial Conduct Authority. Offshore trust and administration services are through BNY Mellon Trust Company (Cayman) Ltd. This document is issued in the U.K. by The Bank of New York Mellon. In the United States the information provided within this document is for use by professional investors. This material is a financial promotion in the UK and EMEA. This material, and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. BNY Mellon Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland BNY Mellon Investment Servicing (International) Limited is regulated by the Central Bank of Ireland. BNY Mellon Wealth Management, Advisory Services, Inc. is registered as a portfolio manager and exempt market dealer in each province of Canada, and is registered as an investment fund manager in Ontario, Quebec, and New Foundland & Labrador. Its principal regulator is the Ontario Securities Commission and is subject to Canadian and provincial laws. BNY Mellon, National Association is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. BNY Mellon is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept any responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. Trademarks and logos belong to their respective owners. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2019 The Bank of New York Mellon Corporation. All rights reserved.