Charitable-Trust Donors May Be Surprised by Lower Payments in Bear Market

If the stock market continues to fall, some donors who set up charitable trusts could be in for a shock. Many contributors have received misleading projections from fund raisers about the financial benefits they would receive from the trusts, experts say.

At issue are projections used to market charitable remainder unitrusts, which provide donors with annual income in exchange for the gift. The problem is that fund raisers often use projections that make it appear that donors’ payments will go up every year when in fact they could drop substantially in the event of a stock-market downturn, experts say.

“Many non-profits we talk to are concerned about a bear market,” says Eric Swerdlin, president of Swerdlin White Huber, a Cedar Knolls, N.J., company that manages planned-giving assets for several charities.

“The next time the markets are bad,” he says, “you could have a lot of 82-year-old donors walking around with these colored graphs showing them getting more money every year. They could be in for a rude awakening.”

Donors set up unitrusts with gifts of appreciated stock or other assets and, in return, receive tax breaks and annual income; after a period of years, assets left in the trust go to a designated charitable organization.

During the long bull market, charitable remainder unitrusts have become increasingly popular, planned-giving experts note.

The amount of income that donors receive from a unitrust is based on a fixed percentage — usually 5 to 7 per cent — of whatever the donated assets are worth at the beginning of the year. Many donors believe that such annual readjustments of their trust income give them a better hedge against inflation than do other types of trusts, where the income is a set amount that could be eroded by inflation.

In recent years, the strategy has worked fine. Inflation has been low, and the roaring market has caused many unitrusts’ value to grow at such a clip that the donors have become accustomed to payments that are significantly higher than the projections they were originally given.

The projections that fund raisers use to estimate donors’ unitrust payments involve complex calculations. In addition to the fixed percentage that donors receive and many other variables, fund raisers also plug in an average rate of market return, such as 9 per cent, that the donated assets can be expected to earn in any given year.

But using an average market return — even a conservative one — does not account for the fact that the invested assets may earn significantly less than that average in a particular year, especially the market goes south.

What’s more, some fund raisers have become lulled by the booming market of recent years and have inched up the averages they use to project returns on donated assets in unitrusts.

“Historically the return on the Dow has been in the 10-per-cent range, but in recent years, it’s been 15 per cent, so now some of the illustrations for donor income I’ve seen assume 12 per cent,” says Barlow Mann, chief operating officer at Robert F. Sharpe & Company, a Memphis fund-raising consulting firm. “That could be a problem. Hopefully, fund raisers communicated the risks, but in some cases gift illustrations have been presented without adequate disclosure.”

Despite such potential problems, there is nothing inherently wrong with using an average rate of return to project payments, some experts say. In fact, officials at PG Calc, a Cambridge, Mass., company that makes planned-giving software, say that fund raisers should use an average rate of return in unitrust projections.

No one can predict the future of the market, notes Peg Carlson, PG Calc’s vice-president for client services. An average, as long as it is tied to the market’s historical performance, she says, is a useful indicator.

While the stock market has historically earned close to a 10-per-cent average return since its inception, Ms. Carlson says, the number that fund raisers use may need to be lower now, closer to 8 per cent. The reason: With the bull market yielding 15 per cent annual returns or better, experts say that the market is due for a correction.

But even when fund raisers do use conservative averages, says Mr. Mann, some of them have not made it clear enough to donors that their projected unitrust payments are simply best guesses and that the stock market — and their income — could go down.

Another problem is that some donors simply do not understand the complexities of charitable remainder unitrusts. Years after setting up a unitrust that has earned handsome returns, they may not recall that the income estimates they were given were not guaranteed minimums. They might end up blaming the charity when their payments drop.

To lessen the chance of that happening — especially given the market’s recent volatility — some charities are considering reaching out to donors who have set up unitrusts.

Fund raisers at Lutheran Hour Ministries, for example, are considering whether to send a letter to some 1,200 donors asking them to give the organization a call if they have concerns about effects of market dips on their planned-giving income.

Concerns about charities’ donor relations in a bear market led Mr. Swerdlin, the investment manager, and his colleagues to design new software to project unitrust income. Instead of relying on the same average return every year, it produces a chart that shows what annual payment a donor could expect to see if the market performed at various levels — from its best to its worst historically — during the lifetime of the trust. The chart also shows how the market’s performance at those various levels will affect the amount left over for charity when the unitrust expires.

For example, as the chart shows here, a 65-year-old donor who set up a $100,000 unitrust to pay out 5 per cent of its value each year could receive payments that vary widely. If the market performed within 5 per cent of its best historical average during the life of the trust, the donor would get $6,393 annually. If the market performed at its worst, the donor would get $3,749.

The chart also shows how different levels of market performance would affect the amount left over for charity when the unitrust expired after 20 years. At best, the charity could receive $193,185; at worst, it would end up with $40,301.

Tom Cullinan, executive director of gift planning at the University System of Maryland, in Adelphi, says those fluctuations are important to show donors.

“Many people in planned giving only have experience in an up market,” he notes. “This is a reminder that investments move up, down, and sideways.”