Often, one of the objectives
of a trust-based financial plan is to separate the benefits of property
ownership into current and future portions. In a marital deduction trust, to
take a routine example, a surviving spouse must have the right to all the trust
income, paid at least annually, and in the future, after that spouse’s death,
the remainder beneficiaries (typically, the children or grandchildren) will
receive what is left in the trust.
Measuring “income”
But that phrase “all the
trust income” can be a source of surprising contention. Traditionally, trust
income consists of dividends and interest. Capital gains and losses affect the
amount of principal and, therefore, accrue to the beneficiaries. So, should the
trustee invest for maximum growth, for maximum income or for some of each? When
stock prices are shooting up, and dividends are not keeping pace (as happened
in the 1990s), finding the right balance may be tricky. If you add to the mix
the relatively low interest that we’ve experienced over the last few years, it
becomes even harder to wring an income consistent with beneficiary expectations
out of a portfolio.
In recent years new trust
forms have emerged that try to reduce the potential for conflict between income
and remainder beneficiaries over a trust’s investment policy. Called a total
return trust or a private unitrust, this approach calls for paying
the income beneficiary a fixed percentage of the trust’s value, determined
annually. If stock prices move higher, the income beneficiary shares in that
good fortune. This approach frees the trustee to invest trust assets for total
return, a direction that trustees have been encouraged to take by changes
around the country in state laws governing fiduciary investing. IRS regulations
recognize this approach as well.
The question of flexibility
There isn’t as much flexibility in setting the payout
rate for a total return trust as one might surmise. Set the rate too low, and
the income beneficiary won’t have enough to live on. Set it too high, and there
is a real risk that the trust will be depleted, leaving nothing for the remaindermen.
That’s why some planners are uncomfortable with the inflexibility of the total return
format. Volatile financial markets can have unwanted effects on fixed formulas.
For that reason several alternative approaches also have been developed for
balancing the needs and meeting the expectations of beneficiaries from multiple
generations.
The table below briefly summarizes some of the many
strategies that have emerged to balance the interests of current and future
beneficiaries.
What does a trust beneficiary receive?
|
|
Definition of income
|
|
Traditional trust
|
Interest and dividends
|
|
Total return trust
|
Fixed percentage of assets, determined annually
|
|
|
Fixed dollar amount, adjusted for inflation each
year
|
|
No-drop unitrust
|
Fixed percentage of trust assets, with a floor to
protect income beneficiaries
|
|
Capped unitrust
|
Fixed percentage of trust assets, with a ceiling to
protect remainder beneficiaries
|
Fully discretionary trust
|
Trustee decides annually what is best for
beneficiaries, taking into account their circumstances and financial market
conditions
|
