The Modern Way To Give: The Total Return Trust

Too many trusts these days are set up the old-fashioned way. I see them all the time. The result is that all the beneficiaries of the trust are short-changed, and they often end up angry at each other, the trustee, and the grantor. A once-generous endowment eventually becomes a legacy of discontent.

Suppose you want to provide for your surviving spouse, your children, and your grandchildren. On your death, your investments go into a trust. The trust pays money to your spouse for life, then to your children for life. After that your grandchildren get the principal.

Where most trusts go wrong is to specify that the spouse, then the children, receive all the income and only income from the trust for their lifetimes. That made some sense decades ago when stocks had yields almost as high as bond interest, and when the stock market was much less developed. It also made sense when life expectancies were much shorter. Today, this formula means problems.

The trustee has a quandary. The trust can be invested to generate maximum income for the spouse and children. Normally that means putting at least 95% of the trust into bonds or other high-yield investments. That might be fine the first few years. But as the years go by, inflation reduces the value of the income to the spouse. More income is needed to maintain the standard of living. That is difficult, because the entire income is being distributed each year.

In addition, interest rates might continue falling as they have done since 1982. As bonds mature, the principal is reinvested to earn less than the previous bonds earned. That means the trust is earning less income each year.

If the trust started generating $50,000 of income and inflation is 2% annually, at the end of 10 years the surviving spouse needs over $60,000 of income to have the same purchasing power. After the spouse dies, the children receive income for the rest of their lifetimes. If everyone lives to a ripe old age, and inflation continues at 2%, at the end of 40 years $110,000 of income is needed to maintain the purchasing power of the initial $50,000 income.

Meantime, the grandchildren realize that they are being shortchanged. Since the trust is invested for income and all the income is distributed, the principal of the trust has not increased by one dollar. Plus, inflation has cut the purchasing power of the principal in half. The grandchildren also realize that if the principal had been invested in a stock index fund and appreciated on average 10% annually, every $100,000 would become over $4.5 million after 40 years.

The solution is to avoid the income-only trust and adopt a total return trust, known as a unitrust.

Here’s how it works. The trustee invests for total return constructing a long-term portfolio. The beneficiaries are not paid income. Instead, they are paid a fixed percentage of the value of the trust each year. The payout usually is in the 3% to 5% range.

If the payout is 5% and the trust earns a 7% total return the first year, the beneficiary receives a distribution of 5% of the trust value, and the trust principal increases by the other 2%.

The beneficiary’s payout will vary with the fluctuations in the trust’s value. What if there is a bear market soon after the trust is set up? There are several ways to cushion this. You can provide a minimum payout to the beneficiary. For example, you can say the distribution will be 3% of the trust value or $50,000, whichever is greater. You even can index the minimum distribution to inflation. Or you can provide that the payout will be based on a rolling three- or five-year average of the trust’s value instead of each year’s value. In addition, the trustee is allowed to use principal to make distributions to the beneficiary when the income or total return is insufficient.

The main risks are bad investments by the trustee and a long-term market decline shortly after the trust is created. You can avoid the first risk by careful selection of a trustee or money manager.

Long-term studies of the market’s historical returns show that an account can last a long time, even if it begins with a long bear market, if the annual distributions are no more than 5% of the market’s value. To make the trust last, put a reasonable limit on the annual distributions from the trust.

As you can see, there are a number of ways that the distribution formula can be written to meet your family’s needs and your goals.

The unitrust also gives the trustee flexibility to adjust the portfolio’s investments based on the outlook for the economy and the markets. If the trustee believes that the stock market is about to enter a prolonged period of underperformance, the portfolio can be shifted primarily to bonds.

Another advantage is that under the unitrust, the trust and the beneficiary are likely to realize long-term capital gains instead of ordinary income. That is a tax-advantage that increases the after-tax value of this strategy.

Even with the risks of the unitrust, there is only a probability that the risky events actually will occur. With the income-only trust, however, it is almost certain that inflation will erode the purchasing power of both the income and the principal.