Total Return Trusts: Why Didn’t We
by: Thomas D. Begley, Jr.
The total return trust is an idea whose time has come. With the arrival of the Prudent Investor Rule and the development of the modern portfolio theory, Trustees now have great flexibility to invest aggressively and to improve the total return for both income beneficiaries and remaindermen.
2. TRADITIONAL TRUSTS
Traditional trusts were known as income rule trusts. Under these trusts, the trustee held the principal and distributed the income. There was inevitable conflict between the income beneficiary who wanted trust assets invested to produce the highest possible income and remainder beneficiaries who wanted trust assets invested for growth. The trustee has a duty of impartiality and the inevitable result was that everyone was unhappy.
Investment duties of trustees were defined by the Prudent Person Rule. Under the Prudent Person Rule the trustee had a duty to make such investments and only such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of the income to be derived. (Emphasis added)
3. TOTAL RETURN TRUST
Total return equals ordinary income plus capital appreciation. The total return trust is based on the Prudent Investor Rule and the diminished distinction between Income and Principal.
3.1. Prudent Investor Rule
Under the Prudent Investor Rule the trustee is charged with investing trust assets as a prudent investor would do given the purpose, terms, distribution requirements and other circumstances of the trust. The Prudent Investor Rule has been adopted in most states. It is a default rule. Under trust law, the terms of the trust instrument control. State statutes governing trust investments apply only if the trust instrument fails to define the trustees investment duties. If there is no Prudent Investor statute in a given state, the draftsman must design the trust to include prudent investor standards. Conversely, if the state has a prudent investor statute and the grantor does not want to follow that statute, the draftsman must design the trust so that the trustees investment duties are otherwise restricted.
Interestingly, the Prudent Investor Rule applies only to trustees and to trusts and not to executors or personal representatives of decedents estates.
3.2. Modern Portfolio Theory
Value is a function of (1) the total return that assets are anticipated to generate, and (2) the risk that the actual return will fall short of the anticipated return. In a departure from Prudent Man Investment Standards, the risk analysis focuses on the entire portfolio, not on individual assets.
3.3. Distinction Between Income and Principal
The traditional distinction between income and principal is diminished under modern portfolio theory. The focus under modern portfolio theory is on total return, including income and appreciation. The focus is on the total portfolio rather than on individual assets comprising the portfolio. The result of this new approach is to diminish the distinction between income and principal and to encourage total return investing and total return trusts.
3.4. Total Return Trust
There are two types of total return trusts. One is an annuity trust which pays a fixed amount per period without regard to income or principal. The other type of total return trust is a unitrust which pays a dollar amount per period equal to the total return of the trust without regard to income or principal. The unitrust, therefore, pays a percentage of trust assets and unitrust payouts fluctuate with fluctuations in the value of unitrust assets. Most total return trusts tend to be unitrusts.
For example, if a total return unitrust provides for payment of 5 percent of the trust assets to the lifetime beneficiary and the trust is $1 million, the annual distribution to the life beneficiary is $50,000. If the trust increases to $2 million, the annual distribution to the lifetime beneficiary will increase to $100,000. Conversely, if the trust assets decline to $800,000, the annual distribution to the lifetime beneficiary would be $40,000.
In a total return annuity trust the payment might be fixed at $50,000. Assuming a $1 million trust, the annual distribution would be 5 percent. However, if the trust assets increased to $2 million, the annual distribution would remain at $50,000. If the value of the trust assets declined to $800,000, the annual distribution would remain at $50,000.
Whether to select an annuity trust or a unitrust will depend on the relative needs of the lifetime beneficiary and the remaindermen.
4. INVESTMENT CONSIDERATIONS
4.1. Asset Allocation
The single most important factor in investment performance over time is asset allocation. Over the past 50 years the return on the Standard and Poor 500 has been 13.5 percent per annum. Over the same period of time the total return on Long-Term Government Bonds has been 5.9 percent, and Treasury Bills 5.3 percent. During the same period of time the Consumer Price Index rose by 4 percent. At the present time the dividends from the stocks comprising the S & P 500 is approximately 1.5 percent.
4.2. Current Returns
In 1998 the percentage of assets which must be allocated to produce a 5 percent income stream was 95.32 percent. A 50-50 mix of stocks and bonds would yield only 3.16 percent. Few trustees would agree to a 95.32 percent asset allocation in favor of fixed income securities if the trustee took seriously its duty of impartiality between the income beneficiary and the remainderman.
4.3. Trust Administration Cost
In addition to the obvious consideration of income produced by fixed income securities as opposed to dividend payments from equities, there are a number of other considerations which impact the amount of income which will be available to distribute to the income beneficiary. These costs include trustees fees, which tend to be about 35 basis points on income and can go as high as 60 basis points. Income taxes paid by the trust or by the beneficiary also influence the net return to the beneficiary. Trust tax rates are compressed so that it generally is advantageous to have income taxes paid by the income beneficiary. Transaction costs also impact the amount of money which will be available for distribution to the income beneficiary. Some trustees are very active in portfolio management and can turn trust assets over at a rate of roughly 100 percent per year. Other trustees are less active and turn-over may average 5 percent per year. The most passive management is by trustees who invest in index funds. Turn-over rates affect the total transaction costs paid by the trust and capital gains taxes incurred by the trust. Effectively managed trusts tend to incur short-term capital gains while less actively managed trusts tend to incur long-term capital gains or very little capital gains tax.
5. DESIGNING THE TRUST
5.1. Determining the Percent Payout
A number of factors influence the establishment of the percentage payout in a total return trust. Most testators or grantors have a bias toward protecting the spouse. This argues in favor of a larger payout. The trust, by its nature, is designed to provide inflation protection for both income beneficiaries and remaindermen. Robert B. Wolf argues that the maximum distribution should be 5 percent.
5.2. Reducing the Bumps
If a total return unitrust is used, the income beneficiary may be subjected to fluctuations in payout based on fluctuations in the value of trust assets. In order to minimize this disruption to the income beneficiary, a trust can be designed to use a payout based on a 3-year average of trust assets. This is known as smoothing.
In order to satisfy the testators/grantors bias toward protecting the spouse, the trustee can be given additional authority to increase the distribution using an ascertainable standard, such as a HEMS standard (health, education, maintenance and support). Alternatively, the trustee can be given authority to increase the percentage distribution if circumstances warrant. For example, if a unitrust authorizes a trustee to make a maximum annual distribution of 5 percent, the trustee might be given standby authority to increase that distribution to 8 percent if the situation dictates.
6. SPECIAL CONSIDERATIONS
6.1. Q-TIP Trust
There is a question as to whether a total return trust is appropriate in a Q-TIP situation. Federal law requires that all of the income of the Q-TIP trust be distributed to the spouse. Under a total return trust it is theoretically possible that the percentage distribution would be less than accounting income. The solution would appear to be to require that the trustee distribute the greater of accounting income or the designated percentage of total return.
6.2. Trust Design Considerations
A factor to consider in designing a total return trust is the life expectancy of the income beneficiary. Since one of the principal objectives in utilizing a total return trust is to protect against inflation and another objective is usually to provide for the spouse, the life expectancy of the income beneficiary may dictate the percentage of total return which will be paid to the lifetime beneficiary. A clients tolerance for risk is also a consideration. Trustees must be aware that there is market risk and also inflation risk. Strategies which tend to reduce market risk tend to increase inflation risk. A clients willingness to diversify is a major factor in some situations. Often clients worked for a company which provided stock options. The clients exercised these options and the company stock has performed extraordinarily well. They are reluctant to give up what for them has been a good thing in order to diversify. They have a strong bias toward retaining the original investment. Trustees should either obtain a strong written waiver of the duty to diversify or might even consider that the client purchase a hedge to minimize risk.
6.3. Delegation of Investment Authority
Under the Prudent Investor Rule there is a requirement of skill. The rule contemplates that certain duties might require knowledge and experience greater than that of an individual of ordinary intelligence, depending on the investment strategy to be employed. In such situations the trustee has a duty to obtain assistance. The restatement imposes standards of care that a trustee must observe in selecting and supervising agents and in determining the scope of delegation. While a trustee may engage an advisor such as a bank trust department, it can be argued that the trustee may not delegate the entire investment function. The trustee has a duty of due diligence to investigate the proposed manager. A trustee who retains an investment advisor cannot increase the trustees fees to cover this additional expense.
With the advent of the modern portfolio theory incorporated into the Prudent Investor Rule and particularly in todays investment climate, clients are much better served by total return trusts which encourage trustees to invest for total return rather than by traditional trusts which tie the trustees hands because of the quest for income at the expense of principal. Both lifetime beneficiaries and remaindermen are better served by total return investment strategies.