Conventional wisdom concerning distributions from trusts involving an income beneficiary whose interests differ from the remainder beneficiaries (“the remaindermen”) begin with a common model that says one beneficiary (usually a spouse from a second marriage) gets the income from the trust during her lifetime (“lifetime beneficiary”)and upon her death, the remaining principal passes to the remaindermen, usually the first decedent’s children or grandchildren.
This model has obvious fatal flaws from the start because the lifetime beneficiary is interested in maximizing the income during her lifetime and the remaindermen want the trust principal to grow. Most financial advisors recognize that these are mutually exclusive objectives that must be reconciled.
The manner in which the principal is invested is determined by the trustee subject to the trustee’s fiduciary duty to consider the needs of both the lifetime and the remainder beneficiaries. In a well written trust, the Trustmaker will include instructions detailing whether the Trustmaker intended the trustee to give greater consideration to the interests of the lifetime beneficiary or the interests of the remaindermen. But in many cases no instructions are included and the independent trustee is left to exercise its fiduciary duty in a neutral manner to provide a reasonable amount of income and provide for some growth to preserve the principal for the benefit of the remaindermen.
The Trustmaker also has the opportunity to control how the story unfolds by his or her selection of a trustee. If the income beneficiary is the trustee, the trustee must recognize the fiduciary duty to the remaindermen, but often income to the lifetime beneficiary becomes paramount. If a remainderman is the trustee, then growth usually is given more weight in the portfolio. But in every case, the natural conflict
remains between the competing interests. The discontent ranges from a general environment of unhappiness to full blown litigation over the manner in which the trustee exercises its fiduciary duty.
Now, there is a way for everybody to have their cake and eat it too! By using a “Unitrust,” sometimes called a “Total Return Trust,” everybody gains. A Unitrust provides that the income beneficiary instead of receiving the income from the trust, receives a set percentage of the net asset value (NAV) of the trust determined annually and usually paid monthly. A commonly used percentage is 4%. That accomplishes a number of important quantifiable objectives:
- 4% of the NAV will usually distribute more to the lifetime beneficiary than the income generated from a balanced portfolio (Balanced portfolios are desirable methods of insuring that the trustee is properly discharging its fiduciary duty to both the income and remainder beneficiaries).
- The trustee is freed from the artificial restraints of having to invest for income or growth and can follow both the “Prudent Investor Rule” and “Modern Portfolio Theory” which means that a diversified portfolio is created based on a predetermined appropriate risk tolerance which minimizes the risk of losing value to inflation or to market declines.
- Both the lifetime and remainder beneficiaries are hoping for the same result, an increased portfolio value, because the larger the growth, the greater the 4% payout becomes and the greater the remainder becomes.
- This is a really important concept in those cases where a lifetime beneficiary can be expected to live nine or more years than the decedent because over that length of time an interest oriented portfolio in times of modest inflation will see the value of the income decline dramatically, while the Unitrust naturally keeps up with inflation with increasing annual payouts while the principal also grows.
Of course, the important element for this strategy to succeed is that the money is invested by a proficient investment advisor. A good portfolio should be designed to have the minimum downward risk necessary to generate 3 to 4 points above the annual payout rate (A portfolio that returns 8% on a regular basis is good enough to pay 4% to the income beneficiary, up to 2% to the investment advisor and still retain 2% for growth). As with all investment portfolios, the beneficiaries must educate themselves enough to oversee the investment advisor’s choices.
It is difficult to find any detriments to this type of planning when you have beneficiaries with competing interests.