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2. investing

Special Needs Trusts:
Developing an Investment Strategy
By Brian Walsh, CFP®, CLU®
Summary
A Special Needs Trust enables families to provide funding for a loved one’s
ongoing necessities without jeopardizing his or her eligibility for government
benefits. This function makes a Special Needs Trust the cornerstone of most
financial plans for families with children with special needs. Many resources
address the intricacies of Special Needs Trusts while relatively few address
the importance of developing a suitable investment strategy once the trust is
funded. The purpose of this whitepaper is to discuss the important factors to
consider when developing an investment strategy for Special Needs Trusts.
Types of Special Needs Trusts
There are two general categories of Special Needs Trusts: First-Party Special
Needs Trusts and Third-Party Special Needs Trusts. A First-Party SNT is
created using the beneficiary’s own assets such as personal assets, personal
injury settlements or outright inheritances. A Third-Party SNT is created
using the assets of others such as lifetime gifts or inheritances paid directly
into the trust. The special needs trust should provide the trustee with
complete discretion of payments from the trust to provide “supplemental
and extra care” over and above that which the government provides. There
should also be spendthrift provisions to protect the trust against creditors
or government agencies trying to obtain funds to pay for debts of the person
or family.
The Role of the Trustee
The extensive and complex role
of the trustee can be segmented
into three distinct functions
with respect to the assets held
within the Special Needs Trust:
distribution, administration and
investment. The foundation of the
distribution function is maintaining
a relationship with the beneficiary.
After receiving a request for
distribution from the beneficiary, the
trustee determines its appropriateness
by interpreting applicable rules as
outlined in the trust document.
The administration function of the
trustee requires much more technical
expertise. This function begins
with the trustee taking custody of
trust assets, which can vary from
investments to tangible assets such as
a home. Throughout the duration of
the Special Needs Trust, the trustee
performs ongoing accounting in
order to prepare all applicable filings
with third parties for government
benefits and taxes.
The final function of the trustee
related to the investment of trust
assets includes the selection of
appropriate investments, monitoring
investments and ensuring that trust
assets are managed in a prudent
manner. A written Investment Policy
Statement can have a significant
impact on keeping the investment
function in compliance with
prudent investing practices and help
mitigate liability. The IPS identifies
the appropriate asset allocation,
benchmarks, and performance
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measurement procedures. The
guidelines will also provide clear
understanding between the trustee,
investment consultant and investment
managers regarding investment
objectives, goals and guidelines.
Investment managers can be accessed
through pooled investment vehicles
such as mutual funds or separately
managed accounts. Investment
managers invest in securities
according to their stated investment
philosophy and objectives. For
example, a fixed income manager
will invest in various fixed income
securities. Pooled investment vehicles
provide professional management,
diversification, liquidity and
economies of scale. For this reason,
pooled investment vehicles have
become the primary method for
investing trust assets.
Investment consultants take
an independent and unbiased
approach in assisting the trustee
with the investment trust’s assets.
Investment consultants help develop
the Investment Policy Statement,
tailor an asset allocation specifically
suited to the beneficiary’s needs and
perform ongoing due diligence in
relation to the investment managers.
Since top-performing investment
managers typically specialize in
certain asset classes, no one manager
is likely to offer superior performance
in each asset class. The objectivity of
an investment consultant allows him
or her to provide the trustee with
insight and expertise in the prudent
investing of trust assets.
The Uniform Prudent
Investors Act
The rules governing the investment
of trust assets are established under
the Uniform Prudent Investor
Act, which clearly describes the
powers and duties of the trustee.
The Uniform Prudent Investor
Act instituted five fundamental
modifications to the investment
of trust assets. Developments
over the past generation related to
investment theory prompted the
necessity to adapt the standards
of prudent investing. Although
not expressly mentioned in the
UPIA, the underlying principles of
modern portfolio theory are found
throughout the act. Based on the
fundamental relationship between
the UPIA and modern portfolio
theory, in order to understand the
standards of prudent investing
established through the UPIA, one
must also understand the basics of
modern portfolio theory.
The first modification established
through the UPIA allows the trustee
to evaluate all decisions as part of
the entire portfolio rather than as
individual investments. This view
enables decisions to be made in
relation to their impact on the
portfolio rather than in isolation,
which is a basic tenet of modern
portfolio theory.
The second modification established
through the UPIA is that the tradeoff
between risk and return is the central
consideration of the trustee. There is
a fundamental relationship between
risk and return. Risk is segmented
into three components: market risk,
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industry risk, and company-specific
risk. Market risk is common to
all investments, and it takes into
consideration the impact of events
that affect the entire economy.
Industry risk is specific to firms in
a particular industry, such as the
risk faced from a shortage in
supplies. Company-specific risk
reflects the factors that specifically
impact a particular company, such
as the risk faced from a defect in one
of their products.
The third modification established
through the UPIA and another
one of the core tenets of modern
portfolio theory is diversification.
While diversification does not
guarantee against loss or ensure a
profit, it helps to reduce risk because
all investments do not move in a
uniform manner. Diversification is
achieved by spreading the portfolio
into assets that have varying degrees
of correlation. Correlation is
essentially how investments behave
in relation to one another under the
same economic condition. When
two investments move in the same
direction, they are highly correlated.
Conversely, when two investments
move in a different direction, they
are inversely correlated.
Studies have shown that market risk
accounts for 30 percent, industry
risk accounts for 50 percent, and
firm risk accounts for 20 percent of
the overall risk of an investment.1
Since market risk is common to all
investments, it cannot be eliminated
through diversification. Industry and
company-specific risk, which account
for roughly 70 percent of total risk,
may be reduced significantly through
a well-diversified portfolio. Therefore
underdiversification of the trust assets
expose the portfolio to risk without
the corresponding higher expected
return. Since understanding the tradeoff between risk and return is the
central consideration of the trustee, it
may be imprudent for the portfolio
to take on uncompensated risk.
Achieving proper diversification
led to the fourth modification
established through the UPIA –
allowing the trustee to assess the
appropriateness of individual
investments within a goal of
achieving the risk/return objectives
of the trust. While it may seem
counterintuitive to invest in asset
classes with high levels of risk,
such as international or alternative
investments, diversification is
achieved by investing in many
different kinds of asset classes.
Therefore, a portfolio that includes
risky assets with investments with
historically lower risk can have the
effect of lowering the overall risk
profile of the portfolio.
The historic superior long-term
return of equities may justify the
increased volatility in short-term
price movements as long as the total
risk of the portfolio is suitable. Since
international markets comprise a
significant proportion of the overall
global economy, it may be impossible
to achieve proper diversification
without international investments.
Studies have shown that, in spite
of the unique risks associated with
international investments, a welldiversified portfolio containing them
is about a third less risky than a
portfolio only containing domestic
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investments. That is because
international investments tend to
have a lower correlation to domestic
investments, therefore providing
greater diversification and potential
reduction of risk.2
The same justification can be used
for including alternative investments
when developing a well-diversified
portfolio. Alternative investments take
a non-traditional approach that allows
them the potential to enhance returns
while reducing risk. Alternative
investments such as private equity,
commodities, currencies, real estate,
high-yield bonds and derivatives may
have a low-to-inverse correlation
with traditional investments such
as equities and fixed income.
While detractors have noted that
these investments may be illiquid,
untransparent and have high fees,
alternative investments also have the
ability to be more flexible and invest
in a broader array of assets, which
may enhance overall portfolio returns.
These factors have led to the use of
alternative investments in prudent
investing to potentially achieve
diversification and enhance returns.
The fifth and final modification
established through the UPIA is
that delegation of duties related
to the role of the trustee is now
permitted subject to safeguards.
As the investment function of the
trustee grows more complex, there
is a greater need for specialized
expertise to prudently invest the
assets of the trust. Delegation allows
trustees to leverage the unique
expertise of investment professionals
while they focus on serving the
needs of the beneficiary. In order to
fulfill their fiduciary responsibility,
a trustee should establish safeguards
specifically related to delegation in
the Investment Policy Statement.
Considerations in Developing an
Investment Strategy for a Special
Needs Trust
When developing the investment
strategy of the Special Needs Trust,
it is imperative to understand the
unique circumstances specifically
related to this type of trust. These
circumstances can be separated into
four broad categories: time horizon,
spending policy, risk tolerance and
tax status.
An investor’s time horizon takes
into consideration the length of
time before distributions begin and
how long those distributions will
last. A thorough understanding of
the time horizon is extremely
important when developing a
suitable investment strategy. Based
on a comprehensive financial plan,
including the beneficiary’s life care
plan, distributions can begin
immediately or defer until a future
date. The duration of the distributions
are impacted by the anticipated life
expectancy of the beneficiary, and
with advancing innovations in
medical technology, many
individuals with special needs have
a life expectancy that is comparable
to the general population.
Once the time horizon is
established, the focus can be shifted
to understanding the spending
policy of the Special Needs Trust.
Typically a beneficiary will receive
annual distributions to fund the gap
between the costs of living and the
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income received from employment
and/or government benefits. The
trustee has full discretion regarding
distributions, and it is important for
the trustee to consider the impact
of distributions on government
benefit eligibility. In addition
to annual distributions, many
beneficiaries will need to make
major purchases such as replacing
vehicles, renovations in equipment or
improvements in their living facility
to accommodate their disability.
Properly planning for significant
future expenditures will ensure that
money is available when it is needed
most. The final consideration in the
spending policy is factoring in any
remainder beneficiary interest as
part of a comprehensive estate plan.
Remainder beneficiaries may impact
the investment strategy but should
never take precedence over the
primary beneficiary.
The time horizon and spending
policy of the Special Needs Trust
are important factors, but careful
analysis of the trade-off between risk
and return in the portfolio is the
central consideration of the trustee
under the Uniform Prudent Investor
Act. An investor’s risk tolerance is
often described as their ability to
handle volatility in their portfolio.
Historically there is a fundamental
relationship between the long-term
return of an investment and the
degree of short-term price volatility.
Past investment experience and
the availability of assets other than
the Special Needs Trust will also
contribute to the suitable amount
of risk of the portfolio.
As the investment strategy develops,
it is vital to understand the income
tax treatment of the Special Needs
Trust. The difference between
individual income tax rates and trust
tax rates is dramatic. The tax rate of
the trust’s income may impact the
choice of underlying investments held
by the trust. Depending on the type
of Special Needs Trust and how it was
established, the taxation may be based
on the grantor, beneficiary or trust.
The details regarding the type of tax
treatment for Special Needs Trusts
and how that is determined is beyond
the scope of this whitepaper, but once
that is understood, it must be factored
into the investment strategy.
Time horizon, spending policy, risk
tolerance and tax status all play a
unique role as they are integrated
into the investment strategy. The
time horizon determines the capital
growth necessary while balancing
volatility constraints from the risk
tolerance. The spending policy
governs the importance of income
generation as the tax efficiency
of that income is determined by
the tax status of the Special Needs
Trust. Integrating these factors
when forming the appropriate
asset allocation is the single most
important decision related to
investing and accounts for nearly
94 percent of historical returns.2
After all factors are considered,
a suitable investment strategy
will enable the Special Needs
Trust to remain the cornerstone
of the beneficiary’s financial plan
throughout their lifetime.
About the Author
Brian Walsh, CFP®, CLU® is a Financial Advisor. He began his career in the financial
services industry in 2006, providing general financial planning services specializing
in risk management solutions. After becoming a CERTIFIED FINANCIAL PLANNER™
practitioner, Brian transitioned to Baird in 2011. Brian earned his Bachelor of Science
degree in finance from Valparaiso University.
In his free time, Brian serves the community as the corporate development director
for Autism Speaks Wisconsin, treasurer for the Wings Academy for Students Who
Learn Differently, board member for the Young Nonprofit Professional Network and
associate board member for Bethesda Lutheran Communities.
Brealey, Richard. An Introduction to Risk and Return from Common Stocks. 2nd. x. Cambridge, Mass.: MIT Press, 1983.
188. Print
1
Brinson, Gary P., L. Randolph Hood and Gilbert L. Beebower. “Determinants of Portfolio Performance” (1986). Financial
Analysts Journal, vol. 42, no. 4 (July/August):39–44.
2
Langbein, John H., “The Uniform Prudent Investor Act and the Future of Trust Investing” (1996). Faculty Scholarship Series.
Paper 486. http://digitalcommons.law.yale.edu/fss_papers/486.
Uniform Prudent Investor Act, drafted by the National Conference of Commissioners of Uniform State Laws.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered
awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirement.
©2012 Robert W. Baird & Co. Incorporated. rwbaird.com. 800-RW-BAIRD. First use: 10/2012. MC-36745.
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in the U.S., which it