The Performance of Trust Funds

The average trust fund in the United States has underperformed the S&P 500 by 2.3 percentage points annually during 2004-2014, according to a study released by the U.S. Trust. That may not be quite the indictment you think it is, as the specifics of underperformance were not examined. A lot of times, when you’re dealing with seven-figure portfolios, you start to enter that wealth preservation mode and U.S. Treasuries start to become an important of the picture.

If 25% to 50% of the principal is invested in things paying 3%, it makes sense that even shrewd stock pickers would have trouble keeping pace with a basic index fund. But it is also possible that the trust management was a result of mediocre investment selection that could have been fueled by poor incentives in the trust management field.

Shackelford O’Connor McSwain, one of the primary influences behind the original prudent man-investor statute, has written extensively on the poor incentives that exist for those engaged in trust management.

McSwain argues this: To deliver superior value from common stock investment selection, you must choose investments that are materially different from the S&P 500. If you put 10% of a trust in large energy companies, 11% in consumer staples, and 13% in healthcare, you’re not going to beat the S&P 500 because you are mimicking the S&P 500. But the problem is that there is no strong incentive to put together a portfolio of assets that is substantially dissimilar from the S&P 500.

Almost 1 out of 6 trust fund managers get fired over the course of a beneficiary’s lifetime, and of those firings, 84% of them involved one of the following two factors: (1) Trust value declines of 25% or more that lasted longer than eight calendar months, or (2) delivering less than 60% of the value of the Dow Jones during a bull market that lasts at least three years.

People like to keep their jobs, and trust managers full under the category of “people.” Either explicitly or implicitly, every trust manager in the country is aware of this incentive that can affect their decisionmaking. It’s a permutation of the old line in sales departments: “No one ever gets fired for choosing IBM” but plenty of people get into trouble for taking a chance on a new upstart that turns out to be junk. This is why most trust funds contain about 30% to 50% in bonds, and the rest in stocks that loosely mirror the S&P 500, and the net result is performance is going to be somewhere in the range of 5% to 7%. Factor in the trust management fees, and you will end up with total returns that slightly exceed the toll of inflation–you might be looking at one to two percent in purchasing power gains per year.

It will almost be that way because of the incentive structure for managers in the trust fund industry. There’s roughly four boxes that human behavior can fall into: You can try be generally conventional, and succeed at it. You can try to be generally conventional, and fail at it. You can try to be generally unconventional, and succeed at it. You can try to be generally unconventional, and fail at it.

If you pursue the unconventional route in trust fund management, the results are not symmetrical. If you deliver 11% annual returns, well above the industry norm, you might get a good reputation and generate a higher income due to the larger amount of assets under management. Maybe you’ll get a performance raise. But it’s the kind of thing that might raise your overall lifestyle from a 7.5 to a 9.

On the other hand, you can make unconventional asset selections and deliver substantial underperformance. You can lose impatient clients quickly. You can get fired within a year or two when your superior doesn’t like to see the declining assets under management. That 7.5 lifestyle can turn into a near 0 in a hurry when you find yourself out of work.

In other words, the percentage lifestyle increase from being unconventional and right is far outweighed by the percentage lifestyle decrease if you are unconventional and wrong. This puts a strong bias for management teams to own the same types of stocks that everyone else does, as well as a collection of bonds that can tighten the range of your overall performance and make clients not feel the ebbs and flows of stock market volatility as much. This limits client dissatisfaction, and keeps trust managers employed. But it also ensures that trust fund beneficiaries will only outpace inflation by a little bit, and reinforces trust funds in general as a place to preserve wealth rather than substantially enhance it.

None of this underperformance is necessarily bad. If someone sets aside $3,000,000 for you, you can perpetually withdraw $150,000 every year and then your progeny can do the same. The real risk of disappointment (and this extends to all areas of life) is where expectations exceed reality. Particularly, if someone is looking at a trust fund in the $500,000-$750,000 range, and then think this amount makes them set for life. If you need to withdraw $55,000 per year (the average U.S. household income from it), you will deplete it sometime in your life. It would be better to ignore it for your years and let the funds pile up.

I’ve seen too many people write in to me, using the S&P 500 Index as a baseline for the projected returns of their trust funds, and asked what I thought could be a maximum withdrawal amount. I didn’t respond to any of these e-mails because that would be unlicensed practicing, but I am regularly disappointed to see people making two mistakes. First, they underestimate the fees. And second, they overestimate returns. If I were running the calculations, I’d plan for 4.5% growth of principal, and I’d cap my realistic anticipation for net-of-everything returns at 6%.