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PG Calc's Featured Article
Exploration of Investment Rate Assumptions
PG Calc’s Planned Giving Manager (PGM) allows users to specify the investment assumptions employed in “Life Income Projections” (Program 3) and “Lead Trust Projections” (Program 4). We believe this flexibility allows gift planners to model gift scenarios with assumed values they deem realistic and appropriate to the cases at hand. This article reviews the rationale for our default investment assumption settings and explores the process for determining investment assumptions that are reasonable within the realm of historical outcomes and future possibilities.
Programs 3 and 4 estimate the results of gift plans over the long run, typically the combined life expectancy of all beneficiaries. This could be a period of 20 or 30 years, or in some cases, even longer. The ultimate outcome of a gift arrangement will be driven primarily by that length of time, the payout rate of the gift vehicle, and the investment performance of the gift assets. A 5% charitable remainder unitrust, for example, that lasts 25 years and earns an average annual return of 4%, will have a dramatically different outcome from the same trust, over the same amount of time, earning an average annual return of 8%. In addition, the existence of investment management fees on principal, separate from annual investment returns, can further affect results and distort differences. The same types of comparisons can be made between similar Lead Trusts.
The average rates of annual returns and the existence of management fees on principal (or lack thereof) are only some of the investment assumption choices available to the user in PGM. Programs 3 and 4 also include choices for specifying relative amounts of tax free income and income taxed as qualified dividends, the relative proportion of annual asset turnover, management fees as a percent of income, cost of sale as a percent or sum, recognition of capital gains in a particular year, and specifications for how management fees are to be charged. Nonetheless, the three most important choices are Rate of income (%), Rate of capital appreciation (%), and Management fees: percent of principal. The other choices will have influence not so much the overall results of the projections as the taxation of distributions from the trusts over their years of existence.
Annual Rates of Return
The term “annual rate of return” is used frequently in connection with the investment of financial assets. The concept is also referred to as “annual rate of investment return” or even simply “rate of return” and means the total financial benefit derived from a stock, bond, or some other type of investment vehicle over a one-year period. The term is also used to specify the total amount of benefit of holding a combination of financial vehicles (“a portfolio”) over a one-year period. The amount is expressed as a percentage of the total value of the asset or portfolio at the beginning of the period of measured time. Generally speaking, the rate of return consists of a combination of principal and income – how much the principal value of the holding changed over time and how much income was earned and collected (chiefly dividends from stocks and interest from bonds).
In PGM, the default assumption for the average annual rate of return is 8%. This number is comprised of a 3% rate of income and a 5% rate of capital appreciation. Put another way, we assume that the typical investment portfolio of a planned gift will earn 3% of the principal value in dividends and interest, and will appreciate by 5% of the principal value over the course of each year.
Where did we come up with those numbers, and how do we justify using them as default assumptions? We should probably note a couple of things before going forward with this discussion. To start, we are using assumptions that indicate the average returns over a period of many years – using a 5% rate of capital appreciation does not mean that we expect to see an increase in principal value of 5% for any particular year, but rather, that we expect over the long run to see an average annual increase in principal value of 5%.
There could (and probably will be) dramatic fluctuations in the results for the individual years, but we need to use an overall assumption of the mathematical average over time.
In addition, we need to remind ourselves, our potential donors, and their advisers, that there is no right or wrong answer to these investment assumption questions. We are trying to approximate the ultimate outcomes of gift plans, and there is no sure way to predict the future. We can only operate based on a combination of what has happened in the past and a consensus of the likelihood we will experience similar patterns in the future.
The Role of Investment Assumptions
So what does the past have to say regarding the results on investment portfolios in the United States? If we look at the historical results for the majority of stocks since exchanges have existed and records have been kept, we see total long-term average rates of return in the neighborhood of 8-10%.1
Average rates of return this high may come as a surprise to those who have paid particular attention to market outcomes over the past several years – are we forgetting or somehow overlooking the double-digit negative returns that occurred in certain years since the turn of the millennium? The answer, of course, is no, but we need to be a little more specific, because the details are vital to our overall assumptions. The major stock indices in the U.S. over the past 10 years have indeed seen some dramatically negative returns – portfolios representative of those indices have lost as much as 30-40% over one year in particular (2008). For example, the Dow Jones Industrial Average and the S&P 500 Index, despite having had some years of positive double-digit results, have produced average annual rates of return over the past 5- and 10-year periods of around 1% or less. But are returns this low realistic for projecting the outcomes of planned gift scenarios going forward?
We have recently witnessed the worst economic crisis and financial meltdown since the Great Depression. The stock markets have rebounded to some extent but the economy is still struggling to turn around. It may take several years for investment portfolios to make up for losses sustained over the past few years. But we know from experience that the typical life income gift arrangement lasts more than 10 years. Since these gift arrangements tend to span 15 or 20 years (or more), we believe gift planners should be using average historical returns over roughly the same amount of time. When computing those average returns for the past 15 and 20 years, the results fall into our historically normal range of 8-10%.
At this point we should pause and qualify our remarks. First, these numbers are based on “price-only” returns – they do not reflect the dividends earned on a real portfolio of stocks – so they might actually be understated by .5 to 1% annually. Moreover, these numbers are based on the historical performance of stock markets and do not reflect the returns for other commonly used asset classes; the typical investment portfolio for a charitable remainder trust – or any life income vehicle for that matter – likely would include a significant amount of fixed income assets (bonds) and some amount of liquid assets (cash).
So what would this rounding out of the theoretical portfolio do to our average annual return assumptions? Based on the most commonly quoted bond indices, the fixed income component of a portfolio constructed to support a life income gift arrangement would typically produce a long-term average annual return of 4 to 7 percent. This expectation is consistent with traditional investment theory, suggesting that in general, bonds produce somewhat lower returns than stocks; the offsetting positive attributes are that they offer higher rates of income (interest from bonds is much greater than dividends on stocks) and significantly better stability (much less fluctuation in value). Typically, bond values do not appreciate in parallel with soaring stock prices, but they also typically retain value when stock prices plummet, so they soften the otherwise more dramatic ups and downs of the portfolio and do not markedly alter overall average assumed rates of return over the long term.
Management Fees
As mentioned earlier, the amount of management fees on principal can have a significant impact on the outcome of a life income gift arrangement. As such, they deserve consideration when quantifying the long term investment process and estimating results. Managers of investment assets typically do not work for free, and the traditional rule-of-thumb has been to assume that investment fees will be in the range of .75 to 1.0 percent when expressed as a percentage of principal. Fees of this size can have a noticeable effect on the net results of a financial plan and the amount of fees should be determined prior to the execution of a life income gift arrangement. So why do we use zero in our default assumptions in Planned Giving Manager?
The reason is that many investment companies charge fees within asset classes, especially if the portfolio is comprised of one or more mutual funds. In fact, there is some degree of prohibition against asset managers charging fees both within the asset classes and also directly to the client account (this is referred to as “double-dipping of fees”). Because our universe of clients is so varied – we have charities that manage assets and don’t charge a direct fee, for-profit companies that manage assets and charge direct fees, and everything in between – we have chosen to simplify this aspect of the investment assumptions by using zero as the default. But if the PGM user knows for sure that an asset manager will be charging 1% or close to that amount directly to the portfolio for fees, those amounts should be expressed specifically in Management fees: % of principal.
Don’t do this in isolation
We wouldn’t feel comfortable setting these default assumptions without reaching out to clients who are involved in the business of managing assets. Although we have not conducted a scientific poll, our anecdotal experience has confirmed that PGM’s default assumptions are not excessive; in fact, we have spoken with a number of clients who use even higher overall rates of return. Which brings us to our final point: before running projections in PGM, the gift planner should consider who would be managing the assets of the portfolio. If the gift vehicle is a gift annuity (or some variation thereof), then the charity is at least responsible for engaging the asset manager for the gift annuity fund; and in some cases, the charity actually will serve as investment manager. If the gift vehicle is some kind of trust, questions should be asked initially as to who would serve as Trustee and also who would serve as investment manager. The gift planner (or financial planner) should then have a discussion with the potential asset manager regarding the appropriate investment assumptions to be used before modeling any kind of projection in PGM. If the gift planner is providing sample trust projections prior to having an opportunity to have such a discussion, then the gift planner should use investment assumptions that have been developed with the assistance of the institution's internal or external financial advisors.
We hope that this information is helpful, and we want to reiterate that there is no right or wrong answer as far as investment assumptions are concerned. We think it is significant that the U.S. economy is the most successful in history and has survived every disastrous cycle with a measurable rebound, but we also realize that this is currently an area of great uncertainty and speculation. There is no way to predict the future with certainty and we recognize that some PGM users will feel more comfortable using less optimistic assumptions.
Changing Investment Assumptions in PGM
Investment assumptions can be changed each time the user runs a projection in PGM. This is done in the Investment Assumptions window in Programs 3 and 4. When comparing two or three gift options, the user can enter different investment assumptions for each option, as appropriate. One can use this capability to compare the same gift plan under divergent investment assumptions to show how projected results change as investment performance varies.
Also, each PGM licensee can set his or her own default investment assumptions to populate the investment assumption questions each time PGM is launched. Set default investment assumptions by using the following process:
- Launch PGM.
- Go immediately to Program 3 (Life Income Projections) and/or Program 4 (Lead Trust Projections).
- Change the values under Investment Assumptions as desired.
- Click on the word “File” in the upper left corner, then choose “Startup Defaults.”
- Click on “Save Current Inputs as Custom Startup Defaults,” then click the “Save” button.
The custom investment assumptions will now show up automatically. To revert back to the regular PG Calc startup default assumptions, click on the word “File” in the upper left corner, then choose “Startup Defaults;” next click on “Restore PG Calc Startup Defaults” and then click on the word “Restore.”
Please feel free to contact us at 888-474-2252 or support@pgcalc.com if you have any questions about this article.
1 Sources: Barclays; Dow Jones & Co; Fidelity; Morningstar; Standard & Poor’s; Vanguard.
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