Many estate plans needlessly and unintentionally pit family members against each other. Old-fashioned, out-of-date trust formulas are the problem. The issues easily could be avoided by using some modern Estate Planning trust strategies instead of relying on what used to be tried-and-true trust provisions.
Trusts once primarily were the province of only the wealthy. Now, trusts fit well in many estates, so more plans have trusts. That means problems with trusts are more frequent, and they’re happening to estates of all types. The Federal Reserve’s zero interest rate policy and poor stock market returns are making the problem worse, and the problems are so prevalent now they’re almost normal. Your estate planning needs to adapt to these new trends to meet your goals.
A typical trust is designed to benefit more than one generation. The first generation usually is a surviving spouse and is called the income beneficiary. The terms of the trust provide that the income beneficiary receives all the income earned by the trust. The second generation usually consists of the children of the marriage, and they are known as the remainder beneficiaries. Of course, the trust also might be expected to provide for more than two generations, and any additional generations also are remainder beneficiaries.
Estate Planning Strategy #1
There’s an inherent conflict between the two generations. The income beneficiary naturally wants and needs the trust invested to earn maximum income. The remainder beneficiaries, on the other hand, want the trust to maximize long-term growth. They want as much money as possible available to them down the road.
Under trust law and a standard trust agreement, income is defined as only interest, dividends, royalties, and rent. Capital gains aren’t income. They are added to the trust principal.
The conflict once didn’t amount to much, because interest rates were high enough that a portion of the portfolio could be invested in bonds and generate enough income for the surviving spouse while leaving a significant portion invested for growth. The stock market rose steadily, so the growth was enough to make the remainder beneficiaries happy. Those days are over, thanks to the steady decline in interest rates since 1982 and the Fed’s current zero interest rate policy.
The trustee of the standard, old-fashioned trust has to try to adapt the portfolio’s investment strategy to resolve this inherent conflict. It’s a tall order.
With today’s low interest rates, most likely all or most of the trust must be invested in bonds to meet the income beneficiary’s needs, and it still might come up short. The remainder beneficiaries aren’t going to like that, of course. There won’t be any growth in the principal, and it will lose purchasing power due to inflation. The trustee could generate higher income through more risky income investments, but that puts both the principal and future income at risk.
The result of this conflict is that there are more cases of beneficiaries suing trustees over the investment strategy.
Estate Planning Strategy #2
There’s no reason for this conflict to exist. There are tools at the disposal of trust creators, trustees, and also beneficiaries.
When you’re the trust creator, you need to create a modern trust, often known as the total return trust. Lawyers also refer to it as the unitrust.
In the total return trust, the ?income beneficiary? doesn’t receive payments only from the income of the trust. Instead, the trust agreement says the income beneficiary will receive a percentage of the trust’s value as of the close of the previous year. Usually the payout is 3% to 5% of the value. There also can be variations. For example, the income beneficiary might receive the percentage until it reaches a maximum dollar level. Or the income beneficiary could receive a stated percentage the first year and have that dollar amount increased subsequently for inflation or some other factor. The key is the income beneficiary’s payments are determined by a formula instead of the type of income or investment return.
Estate Planning Strategy #3
The total return trust has advantages for all parties.
The trustee is free to develop the right portfolio strategy for the long term or for current market conditions. He doesn’t have to worry about generating enough interest and dividends to sustain the income beneficiary’s standard of living. Instead, the trustee can use our ?hedge fund? mutual fund strategy or one of our managed portfolios. When distributions need to be made, fund shares or other assets can be sold.
The income beneficiary should be happy, because payouts will be based on the trust’s value or some other standard and not on the income earned. The remainder beneficiaries know the trust is being invested for total return and that the diversified portfolio is likely to achieve a higher return than one that tries to meet the income beneficiary’s needs.
The total return trust isn’t fool proof. In tough markets such as we’ve had since 2000, the trust might not be able to generate much of a positive return, depending on the investment strategy. Then, the trust’s value will steadily decline as the income beneficiary receives an annual payout of a fixed percentage of the trust’s value, making the remainder beneficiaries unhappy. The income beneficiary also won’t be happy. When the rate of return is lower than the percentage the income beneficiary receives, the trust’s value will decline, and that will shrink future payouts. Even so, the total return trust like has better results for everyone than the traditional trust.
Creating a unitrust is a great idea for someone engagning in estate planning now. But what about when a traditional trust already is operating? Fortunately, steps can be taken to mitigate the problems of traditional trusts.
One step is for the trustee to read carefully the trust agreement. Often there’s language in a standard trust that allows the trustee to periodically make distributions of principal to the income beneficiary, sometime known as a power of adjustment.
Another move is to check state law. About 44 states now allow a trustee of a traditional trust to use principal to pay income beneficiaries when the income of the trust has declined. The trustee must petition the court for permission, but it’s a routine proceeding.
A third move is to petition a court to become a unitrust. About 25 states allow a court to make this move upon request of a trustee or beneficiary or both.
All parties to a trust need to realize that the investment landscape has changed. The bull market from 1982-2000 is over, and interest rates are at very low levels and likely to stay there for several more years. Both total returns and income are going to be harder to come by as long as the developing world continues its deleveraging from the high debt levels that were accumulated during the credit boom. But the right trust terms allow the trustee to adapt to these circumstances and continue to meet the goals of the trust without pitting the beneficiaries against each other.
RW September 2012.