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How the Fiduciary Discovered What’s Wrong With Emphasizing Income

May 25
00:57 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Sophisticated investors already know why it’s important to avoid income. Quite simply, the government taxes income at a higher rate than capital gains. Not only is bond interest taxed at a higher rate than capital gains, but dividend income can be 732045_95459727_eroded_pennies_stock_xchng_royalty_free_300taxed twice (albeit less so under the Bush Tax Cut). Money the company uses to pay dividends is taxed once at the corporate level as earnings. This in part explains why corporate dividend rates fell prior to the Bush Tax Cut and rose thereafter. Dividends are generally taxed again at the individual level and, despite the Bush Tax Cut, mostly at a rate higher than that of capital gains.

Unshackled by trust law or fiduciary duty, private investors adjusted their investment strategies in the post-WWII era. Within a generation, both academic theory and practical evidence mounted against income investing. Then, in 1969, fiduciaries received a one-two punch that forever changed how they would manage their investment policy.

The previous article in this series described the evolution of trust law through ERISA. But ERISA was merely the culmination of the watershed events that occurred in the 1950s and 1960s. Up until then, most trust law adopted the “preserve the principal, spend the income” philosophy first created in medieval times. This remained the dominant view as late as 1969 despite the fact Federal laws passed during the Depression stabilized the stock market, making equity investments far less speculative than they were in the nineteenth century.

Why did the emphasis on income remain as long as it did? The answer lies in the particulars of the development of trusts following the signing of the Magna Carta. Recall these trusts as a rule had two beneficiaries. The grantor’s heirs had rights to any income derived from the lands. Today we’d call the heirs “income beneficiaries.” The Church or the King would inherent the land (literally) once the heirs passed away. In today’s terms we’d call the Church or the King the “remaindermen.”

Trust attorneys will immediately recognize this construct as a “split-interest trust.” As long as the underlying asset (land) remained relatively insulated from the long-term ravages of inflation, the remaindermen didn’t mind the fiduciary’s duty to manage for income. But remember, as we moved from an agrarian society to an industrial society, bonds began replacing land. Trustees became more concerned with growth in the underlying asset, sometimes risking the portfolio’s income generating ability. (For further explanation of this conflict, see “401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?Fiduciary News, May 17, 2011.)

In 1830 this conflict came to a head in the celebrated case of Harvard College v. Amory. Any CFA, CTFA or other professional investor knows of the case as the originator of the “Prudent Man Rule.” In this case, the Massachusetts Supreme Judicial Court required trustees to act “on how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”

Many cite the Prudent Man Rule as the umbrella under which fiduciaries receive protection for selecting individual assets in a portfolio. Of interest – and much relevance to our discussion – are the specifics of the case. Harvard’s argument held that it should be allowed to invest in an annuity which, they said, had demonstrably less risk than common stocks. The court rejected this because the annuity would have paid the beneficiary a much lower income.

Although modified over the years, the basic assumption of the Prudent Man Rule held, and fiduciaries continued to invest all trusts as if they were split-interest trusts. But trust documents themselves advanced over the nearly two centuries since Harvard College v. Amory. Trusts, and their related kin endowments, began featuring beneficiaries with rights to both income and principal.

Trustees ignored these obvious changes and the obvious changes in the investment environment and stuck to the letter of the law for fear of being sued. The negative impact of investing for income was felt by all trusts as inflation began to eat away at their principal. Nowhere was this most damaging than to endowments. In 1969, the Ford Foundation sponsored two reports that would usher in a change that would impact all fiduciaries. The first report, more of a legal white paper, argued the Prudent Man Rule did not apply to endowments. Why? The report stated the clear reason to not apply the Prudent Man Rule lies in the fact the income beneficiary is also the remainderman.

It is the second report, Managing Educational Endowments, that would prove beyond a shadow of a doubt of the dangers of investing for income. After explaining the theoretical dangers of investing for income and safety (i.e., the Prudent Man Rule), the report then shocked the investment world by comparing average returns of major university endowments to balanced funds and growth funds. In both cases, hampered by the Prudent Man Rule, the endowments fell far short of private investor returns (to the tune of underperforming balanced funds by 9% over the ten year period and underperforming growth funds by 160% during those same ten years).

Today, almost every professional accepts the maxim that investing for total return is far better than investing for income. In fact, rather than targeting a 5% income yield, most advisers have adopted the principle set forth by Managing Educational Endowments stating an endowment should spend 5% of its total portfolio value annually. (Incidentally, this same 5% rule is often applied to retirement withdrawals, too.)

The Ford Foundation showed all fiduciaries that investing for income limits capital appreciation. It limits your choice of investments to those which emphasize income generation and income generating investments usually aren’t the best for generating capital growth. Furthermore, over time, investing for income often promotes a reduction in the real value of principal. Some income generating investments (bonds) offer no capital growth. As a result, they really promote capital decay once you take inflation into account.

 

Part I: What do Robin Hood, Investment Income and Fiduciary Duty have in Common?
Part II: Plan Sponsor Warning: What’s Wrong with Emphasizing Income?
Part III: Is Income Really the Only Way for a 401k Fiduciary to Meet Certain Financial Objectives?
Part IV: If Income Doesn’t Matter, What Should Plan Sponsors Look For?
Part V: How the ERISA Fiduciary Can Avoid the 1st Deadly Sin – Whither “Time Diversification?”


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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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