Well-Performing Portfolios and Well-Disguised Insolvency Patrick J. Collins, Steven M. Fast & Laura A. Schuyler
The Secret to Life According to Charles Dickens: Annual income 20 pounds, annual expenditure 19 pounds, 19 and 6, result happiness. Annual income 20 pounds, annual expenditure 20 pounds ought and 6, result misery. Page 2
The Secret to a Successful Trust Portfolio Trust Assets > Trust Liabilities... Result = Happiness Trust Assets < Trust Liabilities... Result = Misery Page 3
Trust Liabilities: Distributions to Current Beneficiaries Capital Preservation/Growth for Remainder Beneficiaries Page 4
Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. Page 5
Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. How is the trust portfolio doing relative to its liabilities? NOT how the trust portfolio is doing in relation to the S&P Page 6
Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. How is the trust portfolio doing relative to its liabilities? Are there enough assets to distribute amounts to the current beneficiary and preserve capital for the remainder beneficiaries? Sequence Risk Feeding the Bear Page 7
1. Use Risk Models Judiciously. Page 8
Page 9 Simple, 2-Asset Class Portfolio
Page 10 Diversified Portfolio
Diversified Portfolio + Fees Page 11
Diversified Portfolio + Fees + Longevity Page 12
Diversified Portfolio + Fees + Longevity + Taxes Page 13
Page 14 Summary
Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. Page 15
Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. The NH model (simple Monte Carlo model) produces the most optimistic results in each case, perhaps underestimating risk. Page 16
Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. The NH model (simple Monte Carlo model) produces the most optimistic results in each case, perhaps underestimating risk. The Bear model (regime-switching model, assuming initial bear market) produces the most pessimistic results in each case, perhaps overstating risk. Page 17
2. Locate the Free Boundary. Page 18
The Free Boundary Free Boundary Line Unfeasible Feasible Region $0 Wealth Deficit Wealth Surplus Page 19
The Free Boundary Present Value of Trust Assets [Stochastic Present Value of Distributions to the Current Beneficiary + Stochastic Present Value of Capital Preserved for Remainder Beneficiaries + Stochastic Present Value of Fees and Investment Expenses.] Page 20
The Free Boundary Present Value of Trust Assets [Cost of an Annuity for the Current Beneficiary + Stochastic Present Value of Capital Preserved for Remainder Beneficiaries + Stochastic Present Value of Fees and Investment Expenses.] Page 21
The Free Boundary Wealth to Annuity Cost Ratio (WACR) = The Ratio of the Trust s Value to the Cost of Purchasing an Annuity for the Current Beneficiary and Returning Capital to the Remainder Beneficiaries Page 22
Example 1: Bob & Joanna Assumptions: Bob s Goal: Provide for his wife Joanna for her lifetime. Initial Trust Value = $1 million Joanna is 70 years old. Joanna needs distributions of $61,800 per year. Page 23
Example 1: Bob & Joanna Is Bob s goal feasible? Page 24
Example 1: Bob & Joanna Is Bob s goal feasible? Page 25
Example 1: Bob & Joanna 5 Years Later... Is Bob s goal feasible? Page 26
Example 2: Bob, Joanna & Children Assumptions: Bob s Goals: (1) Provide for his wife Joanna for her lifetime and (2) preserve the original principal (as adjusted for inflation) for his children. Initial Trust Value = $1 million Joanna is 50 years old. Joanna needs distributions of $42,000 per year. Page 27
Example 2: Bob, Joanna & Children Are Bob s goals feasible? Page 28
Example 2: Bob, Joanna & Children 20 Years Later... Are Bob s goals feasible? Page 29
Free Boundary: Summary If the only goal is to provide for the current beneficiary, the free boundary is located at a WACR of 1. Page 30
Free Boundary: Summary If the only goal is to provide for the current beneficiary, the free boundary is located at a WACR of 1. If there are dual goals of providing for the current beneficiary and preserving capital for the remainder beneficiaries, a higher WACR is necessary because the portfolio must grow to sustain the remainder beneficiaries interest on a constant dollar basis. Page 31
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. Page 32
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? Page 33
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? Page 34
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? Page 35
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? 4. Divide the portfolio into two funds? Page 36
What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? 4. Divide the portfolio into two funds? 5. Buy an annuity and invest the balance? Page 37
Summary Monitor the trust portfolio and inform the beneficiaries in a meaningful way. Use Risk Models Judiciously. Locate the Free Boundary. Review Options. Page 38