Investing for Grandchildren: New Estate Planning Rules

Some important Estate Planning and investment lessons were learned over the last few years by grandparents and grandchildren.

Not too long ago, many grandparents felt comfortable giving stocks in a few good companies to a grandchild with the advice never to sell. Other grandparents gave one or two mutual funds with the same instructions.

In the post-World War II era, many personal fortunes were built upon these simple estate planning strategies. A few stocks or mutual funds steadily compounded over decades to provide nice legacies for heirs. In recent years, however, change became compressed. A corporate evolution that used to take decades these days takes only a few years. Companies that used to be reliable blue chip stocks hit rough patches. Some disappeared or are close to disappearing.

A few lapsed blue chips are McDonald’s, Xerox, Polaroid, Bethlehem Steel, AT&T and virtually any utility company. Even companies with still solid businesses have poor stock market performance. Procter & Gamble and Coca-Cola each lost half of their stock market value at some point in the last few years. Mutual funds that were once lauded, such as the Janus funds, also disappointed investors. Other well-regarded funds saw their managers retire or change jobs.

Grandparents and grandchildren need to learn new rules of long-term investing. Buying and holding a few well-regarded stocks and mutual funds won’t work most of the time.

Here are a few rules to consider.

Buying individual stocks for the long-term still can be profitable. Brokerage commissions are incurred only when the stocks are bought and sold, and taxes are paid only when a stock is sold or dividends are paid. The reduced expenses and taxes can greatly increase long-term returns.

The portfolio, however, cannot be left without someone knowledgeable overseeing and managing it. Companies face expanding worldwide competition, changing technology, and a host of other fluid forces. While it is preferable to let a portfolio compound without paying a maximum 20% long-term capital gains tax, paying the tax is better than letting a stock decline by 50% or more.

When it is not practical to have a money manager or someone else oversee the portfolio, invest in mutual funds instead of stocks. Even here, more care must be taken to pick a fund than in the past.

I recommend choosing a value stock fund. These funds have less volatile returns. In particular, they lose less money in bear markets than other types of funds, especially growth stock funds. I also recommend avoiding any fund that depends on the skills or leadership of an individual. When leaving money for a grandchild, a longer-term solution is needed.

Choose a fund run by a committee or team, especially if the organization has been around for a few decades and has shown that it can make personnel transitions without reducing performance. Dodge & Cox Stock perhaps meets these criteria better than any other fund. The fund has been around many decades and its founders are long gone. Yet the process remains intact and produces steady, safe, solid returns. In addition, the fund is no load and has very low expenses. Tweedy, Browne American Value has similar qualities.

Diversification also is a good idea. While stocks have much higher long-term returns than bonds, long-term returns can be increased by adding some bonds to the account. Bonds rarely have a losing year, and they often increase in value when stocks are declining. The last three years are a prime example of how this diversification works. The S&P 500 declined 9.09% in 2000, 12.16% in 2001, and 22.21% in 2002. A popular bond index increased 11.63%, 8.42%, and 9.27% over the same period.

To get a diversified portfolio in one fund, Dodge & Cox Balanced is a great choice. Vanguard Wellesley Income or Wellington funds also fit the bill of owning value stocks and bonds in the same portfolio.
Another option to consider is a section 529 college savings plan.

The estate planning strateagies were created primarily for college education expenses, but there is no rule that account balances have to be spent that way. The money can be spent any way the beneficiary wants, though distributions of income and gains are tax free only if spent for qualified education expenses.

An advantage of some 529 plans is that the account will be professionally managed by the plan sponsor or a designated manager. The account will be diversified, and it will become more diversified as the grandchild gets older.

Most plans, however, require the account to be distributed by the time the original beneficiary is age 30, and the plan will be almost fully invested in bonds by the time the grandchild is 18. The plans also won’t work if the grandchild already is college age or older.

A relatively small amount of money still can be used to establish a fairly sizeable legacy for a grandchild. In the new investment environment, however, the estate planning strategies that made that money grow in the past probably won’t work well in the future.