When an Inheritance Sets You Free
March 24, 2016
Jan is a single, 45-year-old engineer who lives in the Midwest. She and her married brother each recently inherited a trust worth $5 million from their parents, a pleasant surprise. Jan has lived carefully and saved diligently in a 401(k) defined-contribution retirement plan and a taxable portfolio. Over the past 22 years, her total portfolio has grown through shrewd investments to $2.9 million.
Jan views her inheritance as a windfall that could allow her to upgrade her lifestyle and live her dream: leaving her tedious job to devote her time and professional expertise to bringing clean energy to remote and underdeveloped communities.
Jan and her financial advisor have determined that she can support about $75,000 of her desired annual spending requirement of $275,000 from her savings. She would like to see if she can quit her job to donate her time and expertise to the clean energy cause, and still support the cause financially.
The trustee (Jan’s uncle) has authority to distribute the trust’s income and principal to Jan during her lifetime, but the trust documents indicate that the trustee should try to ensure that distributions do not deplete the trust’s future value. Since Jan does not expect to have children, the trust is likely to pass upon her death to her niece and nephew as remainder beneficiaries. The trustee wants to plan for the niece and nephew to receive a fair and equitable amount. Given the trust’s long time horizon, the trustee has invested it to provide moderate growth, with a 60/40 stock/bond mix.
How much can the trust safely distribute each year? Jan would like to enhance her lifestyle by receiving a pretax annual distribution of $200,000 from the trust, grown with inflation, to bring her total investment income to $275,000. Both she and her uncle initially thought that distributing 4% of the initial value each year ($200,000 of $5 million) might be reasonable, but they weren’t sure of the long-term implications for the trust or the remainder beneficiaries.
The gray area in the Display below shows an array of outcomes in market conditions ranging from hostile to great over time. The middle line represents the median projected result.
Under median market conditions, the trust would still have assets after 30 years, but if market returns are poor, the trust is likely to run out of money by year 25. In fact, there’s a 30% chance that these distributions would deplete the trust within 30 years and a 59% chance that they would deplete it within 40 years—well within Jan’s expected life span. The $200,000 annual distribution may be sustainable over 10- and 20-year horizons, but not over 25 to 40 years. Jan’s niece and nephew could very well get nothing.
What distribution would be sustainable? We tested various scenarios. An annual distribution of $132,000 (about 2.6% of the initial trust value) would be sustainable over Jan’s life expectancy, assuming that the portfolio retains its 60/40 stock/bond mix, as the left side of the next Display shows. Even under poor market conditions, there’s a very high probability that the trust would not be depleted. In typical markets, there would be $12.1 million remaining ($3.6 million in inflation-adjusted terms) for the remainder beneficiaries, as the right side of the display shows.
If Jan’s uncle increased the allocation to return-seeking assets in the trust, spending could be improved to $139,000, or about 2.8% of the initial trust value. As important, the trust would generate an additional $3.4 million (or $0.8 million in inflation-adjusted terms) for the remainder beneficiaries in typical markets, we project.
Low Expected Distributions
Both initial distribution rates fall below 3%, the rule-of-thumb rate that many professional trustees typically say would be sustainable for many decades. But 3% may be too high now because expected returns for stocks and bonds are likely to be lower in the decades ahead than in decades past, and inflation is likely to rise from low levels, in our view.
Jan won’t hit her targeted annual spending of $275,000. Nonetheless, she was pleased that the trust, when added to her own savings, would allow her to boost her pretax spending to over $200,000, enhance her lifestyle, and ensure that the trustee was fair to the remainder beneficiaries.
Jan and her uncle decided that, for now, Jan should contribute to the clean-energy cause by donating her time and expertise, rather than money. Her time and expertise are in themselves substantial gifts that may reduce her ability to return to work in the future at a comparable salary.
Jan and her uncle also agreed to monitor the value of the trust over time. If markets are favorable, they could consider raising the annual distribution so that Jan could enhance her lifestyle or give money to the clean-energy cause.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.