Funds designed to supply income over long-term intergenerational timelines should review how their current distribution policies would stack up following a financial crisis, a new Melville Jessup Weaver (MJW) paper argues.
The MJW paper, authored by newly-appointed principal, Ben Trollip, found a wide discrepancy in post-crisis long-term outcomes depending on the distribution model funds have adopted.
In the study, MJW modeled the performance of three common trust distribution systems – constant distribution, capital and reserve accounts, and the Yale/Stanford approach – in the wake of a simulated global financial crisis (GFC) event.
Tracking a notional $50 million fund across a 25-year investment history marked by a GFC-like crash in year five (equating to a 15 per cent drop in portfolio value), the MJW study shows the capital and reserve accounts model – where distributions can sink to zero in bad years to protect capital – in particular, produces divergent long-term effects.
Popular among community trusts, the capital and reserves account system – as expected – preserved, and even exceeded, the original trust capital pool over the notional 25-year period, but distributions could be suspended for up to almost a decade following the crisis, according to the MJW research.
“It is also worth pointing out that this model results in a large downward skew in the range of distributions, regardless of investment markets…,” the report says. “That is, the rule that ceases distributions in the wake of poor investment returns greatly impacts the actual distributions paid.”
Meanwhile, the constant distribution model and the Yale/Stanford approach (which varies annual payouts based on a formula taking into account distributions over the previous year and the long-term average rates) yielded similar results over the 25-year period.
The MJW analysis shows while both approaches were less likely to preserve capital over the 25 years they also had a much higher probability of maintaining reasonable annual distributions over the entire period.
Overall, the report says selecting an appropriate distribution model is “one of the most important decisions a charitable organisation must make”.
“… trustees should ask themselves what their priorities are,” the MJW study says. “While the desire to maintain the long-term real value of capital may push trustees towards a Capital/Reserve Account system, the potential to greatly decrease (or even cease) distributions in the short-term may not be acceptable.
“This may lead the trustees to choose a different approach, such as the Yale/Stanford system, which maintains a level of predictability in the year-to-year distributions.”