Miller Revisited: What is a Realistic Rate of Return?

 By

Charles F. Vuotto, Jr., Esq.
Lee Ann McCabe, Esq.
Blanche Lark Christerson, Esq.
Michael J.A. Smith

August 4, 2003

This article will address one simple question: Is the Miller rate of return still realistic in light of the current economic climate?  It is well ingrained in our jurisprudence that a court must consider the income-generating ability of assets that the parties receive  in Equitable Distribution when determining their respective rights and obligations relative to spousal and child support.[1]  Although the New Jersey Supreme Court’s decision in Miller v. Miller, 160 N.J. 408 (1999), was the first in this State to unanimously hold that a reasonable rate of return,[2] different from the actual rate of return, can be imputed to a payor’s investment assets, the concept of imputing income was not new to the Court.[3]  This concept  is now codified within N.J.S.A. 2A:34-23 (b) (11),[4] which provides that “the income available to either party through investment of any assets held by that party” is to be considered in the alimony calculus.  The conclusion reached from review of the statutory and case authority is that when fixing alimony and child support incident to divorce, income should be imputed when a party’s asset-based capital is under-utilized.  Specifically, a spouse cannot insulate his or her assets from a support calculation by investing them in a non-income producing manner inconsistent with the marital lifestyle.  In other words, an individual could not invest solely in growth-oriented investments, which generate little or no income and claim that his income should not be increased by the court based on a reasonable rate of return. 

To arrive at a reasonable rate of return, the Supreme Court in Miller directs that a court should take a five-year average of the long-term corporate bond rate based upon Moody’s Composite Index on A-rated Corporate Bonds[5] or, if that is not available within a “reasonable time,” the court should use a “comparable source, such as the Lehman Brothers Five Year Average on T-Bonds Index”. [Emphasis added][6]

The Supreme Court found this to be “the most equitable solution for imputation of income to Mr. Miller’s investments.”  This method, the Court held, would provide a “prudent balance between investment risk and investment return.”   The Court made it clear that Mr. Miller did not have to actually invest his entire portfolio in long-term corporate bonds.  Rather, he was free to diversify and invest his assets, as he deemed appropriate.  The Court’s decision required only that no matter how Mr. Miller chose to invest his assets, reasonable income would be imputed for purposes of the alimony calculus.

The Miller  approach currently results in a rate of return of 7.48%, the five-year average of corporate bonds from 1998 through 2002.  (Note that the  year-to-date average, through July 15^th , is 6.38%;  see Table 1 below). Accordingly, the question is whether this Miller approach for calculating  an appropriate rate of return is realistic.  In the real world, when we are representing a dependant spouse who will receive a half a million dollars of assets, wherein only $200,000 are liquid and appropriately subject to the imputation of income[7], is it appropriate to assume that he or she can generate $14,960 in taxable income per year?  Asked another way, is it realistic to expect that either a dependant or a supporting spouse actually will receive those funds to supplement support needs or obligations in light of the current economy and future forecasts for it ?

It is acknowledged that Mr. Vuotto and Ms. McCabe, two of the co-authors of this article, previously wrote on the Miller decision and concluded that, based upon the dictates of the Supreme Court, a 7.44% rate of return was appropriate at that time.  However, that article did not address the economic and financial feasibility of that approach, but simply explained the directives of the Supreme Court incident to its decision in Miller.  This article, with the assistance of the co-authors from Deutsche Bank, will attempt to address the central question from the perspective of financial advisors with experience in the market place.

Noteworthy in the analysis of the Miller decision is the Supreme Court’s quest for a guideline of  reasonable income based upon a  “prudent balance between investment risk and investment return” – in other words, a reasonable rate of return on a diversified pool of assets without regard to any fixed (or outmoded) definition of “income.” Coincidentally, the challenge to codify such a “reasonable rate of return” has been at the forefront of evolving fiduciary law for close to a decade and has culminated in legislation that the co-authors of this article believe could be readily applied to the economic issues in matrimonial law.

The Deutsche Bank co-authors and their colleagues have had to address the concept of a “reasonable rate of return” in light of New York’s Principal and Income Act (the “Act”).  The Act was signed into law on September 4, 2001, and became effective on January 1, 2002.  It was codified at EPTL (Estates, Powers and Trusts Law) 11-2.3(b)(5), 11-2.4 and 11-A, and was a logical outgrowth of New York’s Prudent Investor Act,[8] which itself was effective as of January 1, 1995.  The purpose of the Prudent Investor Act was to recognize modern portfolio theory and its “total return” concept and provide fiduciaries with the broadest possible latitude in investing for the benefit of all interested parties, both current beneficiaries and the remaindermen who will eventually inherit the trust corpus at the end of the trust’s term.  That concept holds that a portfolio’s “return” should be measured not only by interest and dividends, but by capital appreciation as well.  Under that theory, trustees should be free to invest for the bigger picture, and maximize the total return of the entire portfolio.  While liberating in one sense, this approach did not resolve the inherent conflict between the income beneficiary (who typically wants maximum current “income”) and the remainderman (who wants the trust corpus to appreciate as much as possible in value with little or no regard to the amount of current income it can produce).  And that is because traditional definitions of “income” only took account of interest and dividends – not capital appreciation.  That has been most unfortunate for income beneficiaries, since capital appreciation, despite the market’s recent poor performance, has been the greatest source of return for equities in recent years.  This, coupled with low interest rates and dividend returns in the 1% to 2% range, [9] has meant that income beneficiaries have seen their incomes shrivel.

This situation could be ameliorated if the income beneficiary was also a discretionary principal beneficiary, and the trustee therefore could distribute principal for, say, the beneficiary’s “health, education, maintenance or support.”  If the income beneficiary’s interest was limited solely to income, however, no amount of modern portfolio theory was going to help him.[10]  Enter New York’s Principal and Income Act, which was based on the Uniform Principal and Income Act that was promulgated in 1997.  New York’s Act not only broadened the definition of income, it gave trustees the “power to adjust” between income beneficiaries and remaindermen.[11]  It also created an optional 4% unitrust provision that would allow trusts that selected this regime[12] to pay income beneficiaries 4% of the trust’s annual value.[13]

In adopting the Principal and Income Act, the New York legislature (not unlike the New Jersey courts noted above) sought to achieve an appropriate balance between a current beneficial interest (albeit in trust format) and a future interest – with a view towards preserving, if possible, the asset base over the life of the trust.  In its Fifth Report, the EPTL-SCPA (Surrogate’s Court Procedure Act) Legislative Advisory Committee (“the Committee”) stated that the proposed enactment of the Principal and Income Act “is not a minor technical adjustment to existing law. It represents a carefully considered, serious reformation of a critical aspect of the New York law of trusts – the definition of appropriate benefit currently distributable.”15 Furthermore, the Committee concluded that this “appropriate benefit currently distributable” could no longer be measured by the antiquated notion of trust accounting income. To do so would be “arbitrary, manipulable, and contrary to contemporary investment understanding.” The Report further stated that

Non trust investors seek a total return without prime regard to whether increases in holdings are categorized as principal or income. Investing primarily to obtain capital gain rather than current income can result in ‘too little income’ for the current beneficiary, even though income producing capacity is increased. To be forced to invest in order to obtain something classifiable as income (so that it can be distributed to a current beneficiary who is supposed to get income) can unduly constrain a trustee in making investment decisions. Over time both the current beneficiary and the remainderman could suffer.

This, in short, is why New York linked its Prudent Investor legislation with the more recently enacted Principal and Income Act. The focus of this sea-change in trust law would appear to be very much in concert with the reasonable return goal of the New Jersey courts. This brings us back, then, to the issue of what percentage currently satisfies the “appropriate benefit currently distributable” concept?

While the New Jersey courts have focused essentially on bond fund indices to answer this question, the co-authors submit that a more equitable approach might well mirror the philosophy of fiduciary law.  That approach assumes an asset base that is diversified between equities and fixed-income holdings, and is balanced between investment risk and investment return. As previously stated, New York’s default percentage is the 4% unitrust amount. New Jersey’s Uniform Principal and Income Act of 2001 omits the unitrust concept but, like New York, has power to adjust provisions.  Those provisions are more versatile than New York’s in that they anticipate periods of both extremely low and extremely high income returns (recall the days of double-digit interest income!). The New Jersey Act states that

A decision by a trustee to increase the distribution to the income beneficiary or beneficiaries in any accounting period to an amount not in excess of four percent, or to decrease that period’s distributions to not less than six percent, of the net fair market value of the trust assets on the first business day of that accounting period shall be presumed to be fair and reasonable to all of the beneficiaries.16

Many other states have now enacted similar legislation designed to balance the interests of current beneficiaries and future takers of the assets.

Thus, given the present economic environment, is four percent the appropriate payout, as the New York default and New Jersey ceiling number suggest? We at Deutsche Bank contend that even this number, in most circumstances, is too high for the long-term financial health of both the current beneficiary and the future inheritor of the principal. In general, that is why we have been reluctant to consider the optional unitrust provision (this can also only be reversed by a court proceeding) and have tended to favor the power to adjust. 

Regarding the optimum payout percentage (illustrated in Table 3 below), we would point out that a trust that invests 65 percent of its assets in stocks and 35 percent in bonds has an 80 percent chance of maintaining its inflation-adjusted value over 20 years if the annual payout is 3 percent of market value. But once that payout goes to 4 percent, the probability of maintaining purchasing power drops to 60 percent. If the annual payout rate moves up to 5 percent, the probability of maintaining purchasing power plummets to 25 percent. Also, the larger the equity component, the better the “survival” rate. That is, while a heavier weighting in equities means that both current and future beneficiaries assume greater risk, that risk is evenly shared – and the probability of maintaining purchasing power is greatly improved. For example, a trust with an asset mix of 80 percent stocks and 20 percent bonds that pays out 3 percent annually has an 85 percent probability of maintaining purchasing power over that  20-year period.17

Therefore, while a 4 percent payout via the unitrust option or through exercise of the power to adjust may be suitable for specific situations (e.g., an income beneficiary with special needs or a truncated life expectancy), it would appear that an annual payout in the 3 percent range is more prudent and healthier for the longer term care of the income beneficiary, the sustainability of the asset base, and the ultimate well-being of the remainderman (i.e., a dependent spouse seeking to preserve  his or her savings).

Based on what surely appear to be common equitable goals of both fiduciary law and matrimonial law and given the analysis of a prudent and reasonable total return – or “appropriate benefit currently distributable” – we would conclude that the earlier findings of the Miller court, while looking at indices that appear reasonable on their face, nevertheless suggest a return that is too optimistic and possibly harmful to both parties in the longer term.

            Despite that statement, however, it is still possible to conclude that 7.48% is a reasonable rate of return based upon relevant New Jersey case-law; it is simply that looked at from the perspective of a financial institution, the question yields a different answer – namely, a 3% rate of return.   The selection of the correct rate in any particular action will rely upon the ingenuity and advocacy of counsel.

Table 1

Moody’s Composite Index on A-Rated Long-Term Corporate Bonds

Annual Average and 5-Year Average Yield

January 1, 1998 – December 31, 2002

Year to Date (January 2, 2003- July 15, 2003):  6.38%

June 1-30, 2003:  5.92%

Source: Bloomberg

Table 2

Chicago Board Option Exchange (CBOE) 30-Year Treasury Bond Yield Index

Annual Average and 5-Year Average Yield

January 1, 1998 – December 31, 2002

Year to Date (January 2, 2003- July 15, 2003):  4.73%

June 1-30, 2003:  4.38%

Source: Reuters

Table 3

Asset Mix/Payout Rate Table

Probability that portfolio will maintain purchasing power over 20 years

Source: Deutsche Bank Private Wealth Management, February, 2002

______________________

Charles F. Vuotto, Jr., Esq., and Lee Ann McCabe, Esq., are members of the firm Wilentz, Goldman & Spitzer P.A.  Blanche Lark Christerson, Esq., and Michael J.A. Smith are part of Deutsche Bank Private Wealth Management in New York City.