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Wednesday, May 8, 2024
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Case Studies |
Achieving a Proper Balance
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Case:
Martha White retired five years ago after teaching 40 years at the local elementary school. She never married and has an older brother and sister who live close by. Martha's pension, Social Security income and fixed-income investments provide her with adequate income but inflation has begun to have an effect on her income stream. She has saved well over the years and does have $900,000 in fixed-income investments, but the current return on those investments averages about 5-6%. She has what one would term as an "oversimplified financial plan" in that she has invested 100% of her money in fixed-income investments such as certificates of deposits and treasury notes and bonds. Martha doesn't understand stocks and feels that those kinds of investments are just "too risky." Therefore, she has adopted a very safe (but very low-yielding) investment approach.
Martha is now becoming very concerned that should she live another 25 or 30 years, inflation will greatly impact the purchasing power of her income. She has already seen that happen over the five years since she retired. The basic necessities of life such as food, clothing and shelter are taking a larger and larger bite out of her fixed income. She feels a need to increase her income stream but likes the security of tried and true investments with little or no risk of loss.
To keep herself busy, Martha has been volunteering a couple of days each week at a local children's home tutoring the children in many subjects including math and reading. She has been very effective in helping many of the children increase their skills in these subjects and feels she is really making a difference in these children's lives. The children's home has become one of her favorite charities and she thinks that she will leave a substantial portion of her estate to the home upon her passing.
Question:
One day after a tutoring session, Martha decided to talk with the Director of Development, Nathan Williams, and discuss with him her desire to make a bequest to the children's home. Nathan was very pleased that she had decided to do so and encouraged her to find an attorney to make a change in her Will. In the conversation, Martha brought up her concern about being on a fixed income and was wondering if Nathan had any ideas about how to increase her income. She reiterated the fact that she wanted to maintain a very safe investment portfolio.
Solution:
Nathan asked Martha whether she had ever considered a charitable remainder trust in her financial planning. Martha said that she hadn't because she was not acquainted with what they are and how they work. Nathan then went on to describe the unitrust and annuity trust, their advantages and how they could work to provide Martha with an increased income stream over her lifetime. Martha was intrigued and asked him which he would recommend for her - the unitrust or the annuity trust. Nathan's reply was, "Both! Let me explain."
Nathan said he would recommend placing $200,000 of her fixed income investments into an annuity trust. At her age, an 8% payout would meet the various IRS tests and, therefore, Martha would receive an annual income of $16,000 per year from the annuity trust for the rest of her life. This trust would provide her with a fixed and unchanging income providing her with a very dependable cash flow. The income would be in excess of the return of 5-6% she is receiving on those investments currently.
Nathan then suggested that she take another $250,000 and fund a unitrust with a payout rate of 6%. She would immediately begin to receive income of $15,000 per year, which would increase if the trust assets increased in value over the years. In fact, if the trust investments yielded a return of 9%, her annual income in year 10 would be over $20,000, and in year 20 the annual distributions would be over $25,000. This would provide her with increased income with the potential to offset future inflation by participating in the growth of the trust corpus.
He then said there would be a very substantial gift to the home upon her passing. Assuming that both of the trusts yielded on average 9% over the years, the home could expect to receive approximately $600,000 from the trusts when she passed away, a very nice gift indeed. And, with each trust professionally managed, she can be confident that the trust investments will be well diversified in both fixed-income and equity instruments that will generate a total return benefiting both her and charity.
Martha was very pleased with Nathan's recommendations because they provided her the proper balance she was searching for, a fixed income stream in tandem with a fluctuating stream of income to help offset inflation.
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