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How to Improve Trust Returns and Reduce Conflicts with Total Return Trusts

"THE MORE THINGS CHANGE...." How many products have been around for over 500 years and have remained unchanged? There is no longer any real market for oil lamps and flintlock rifles. Yet, many Twenty First Century trust documents could easily have been drafted by Dickens’ fictional lawyer in “Bleak House.” Trusts were first created in the Sixteenth Century. To a great extent, they have not evolved to meet modern needs. This Newsletter discusses why traditional trust design often leads to conflicts and poor performance. We will then discuss one solution, the Total Return Unitrust. NOTE: This is not a typo. They are called “unitrusts,” not “unit trusts.”

Income to “Wife,” -- Remainder to “Children.” In the “olden days,” most wealth was based on land ownership. Prudence dictated that only the income not needed to maintain the property be distributed so that the assets could benefit many generations. Many trusts provided for the income to be distributed to one person for life, with the assets ultimately passing to the next generation. A great number of documents are still designed this way.

Most wealth today is in the form of stocks, bonds and other securities. Investment returns on these assets is not limited to “income” as that term is used in trust documents. Trusts which provide for distributions based on “income” can cause tensions among beneficiaries and can seriously prevent a trustee from obtaining the best investment results.

Hypothetical Situation. Morris is married to Doris. He has two children from his first marriage, Boris and Horace. He wants to provide for Doris and, at the same time, make sure that his assets ultimately benefit Boris and Horace. His lawyer, Algonquin J. Calhoun, drafts a trust that provides: “The trustee shall distribute all of the income of the trust to Doris. When Doris dies, the trustee shall distribute the principal of the trust to Boris and Horace.” Morris names the First National Big Bank as trustee. Doris is the “income beneficiary” of the trust. Boris and Horace are called the “remaindermen” because they receive the remainder of the assets after Doris’ lifetime.

First Problem – Conflicts Between Beneficiaries. As an income beneficiary, Doris will probably only receive dividends, interest, rents and similar items. Even though capital gains are taxed as “income,” all appreciation is normally allocated to “principal.” Doris will want the trustee to invest to maximize current returns. Boris and Horace will press for growth oriented investments. The trustee is caught in the middle.

Second Problem: Sub-par Investment Performance. Unless the trust document directs otherwise (and the vast majority do not), a trustee must balance the interests of the current beneficiary with those of the remaindermen. Many trustees take a Solomonic approach and invest half in bonds for income and half in stocks for growth, resulting in sub-par performance. Only half of the portfolio is generating income and half of the portfolio is positioned for growth. The beneficiaries complain and the trustee is criticized for something that it didn’t cause.

Third Problem: Unpredictability of Distributions. Many trusts are created to give the beneficiary, often a spouse or a child, a reasonably steady and predictable source of support. What can the “income beneficiary” count on? In the 1980s, she might have received 16%. Today her income may be less than 3%. She will have years of feast and years of famine. These fluctuating distributions bear no rational relationship to the beneficiary’s needs.


Discretionary Trusts. If a trustee has broad discretion to distribute income and principal to the current beneficiary, doesn’t this get us out of the “income only” dilemma? Not really. Although the current beneficiary will have access to principal, the trustee still has to balance her interest with those of the remindermen who can possibly sue the trustee, claiming that it exercised its discretion inappropriately. Additionally, many trust beneficiaries, especially widows, are reluctant to have to ask a trustee for money.

Power to Adjust. A statue called the “Principal and Income Act” allows a trustee to make an “adjustment” and augment income returns with an allocation of principal, as long as the trustee acts in a fair and impartial manner. The power to adjust is an excellent way to increase distributions from older trusts. It is not an elegant solution for trusts that we’re creating because control is totally in the trustee’s hands. The trustee could possibly still be criticized and the beneficiary does not have a reliable stream of distributions.


Total Return Investing. The income-principal distinction found in many trust documents has no relationship to the way people invest their own assets. Most investors look for total return. Although a dollar of long term capital gain is worth more than a dollar of interest, what really counts is total return -- how many more dollars one has at the end of the year. The art of investing lies in balancing reward against risk. Many studies have concluded that the most efficient portfolios, with the greatest potential for reward at the least risk. As we have seen, a trustee will have difficulty using this efficient investment paradigm for a traditional trust. We need to look to a trust architecture that is compatible with current investment wisdom.

Total Return Unitrusts. Studies of investment returns, such as the ones conducted by Ibbotson Associates, conclude that, over a long term, such as twenty years, a diversified portfolio of stocks and bonds should produce a total return of approximately 10% per year. Because of the inherent conflicts in the administration of traditional trusts, trustees have been prevented from achieving this result.

We’re looking for a trust architecture which will solve all of our problems. There should be no restraints on the trustee’s ability to pursue a total return investment policy. The current beneficiary should receive a steady, relatively predictable stream of payments that keeps pace with inflation. The fund should grow in value over time so that the remainder beneficiaries are treated fairly.

A “Total Return Unitrust” is a variation of a fairly common estate planning device, the Charitable Remainder Unitrust. The current beneficiary receives a distribution of a specified percentage of the trust’s value each year. The amount of the distribution is based on the value of the trust, not in its income. If the value of the assets increases, the distribution also increases. If the value declines, the distribution decreases. The percentage to be distributed can be based on the beneficiaries’ needs and the expected investment returns. It need not be one fixed rate throughout the term of the trust.

We have all seen sometimes wildly gyrating interest rates. Traditional income-based trusts may not give the beneficiaries a reasonably predictable stream of distributions. A properly designed Total Return Unitrust will have a “smoothing provision.” The distributions will be based on a moving average of the trust’s asset value, perhaps based on the preceding three or five years.

Here are two examples of how we’ve use Total Return Unitrusts:

FIRST EXAMPLE: Let’s revisit Morris, Doris, Boris and Horace. Suppose that Morris creates a Total Return Unitrust that provides Doris with a 4% annual distribution. Doris is young enough that one can reasonably assume a 10% annual total return during her lifetime. Of that 10%, we allocate 3% to pay income taxes, leave 3% in the trust for future growth and distribute 4%. Studies have shown that, in a long term trust, distributions in the 3.5-4.1% range can be made almost indefinitely while retaining the purchasing power of the trust principal. Now everyone is happy. Doris has an “income” that will increase as the fund appreciates. Boris and Horace see their remainder growing. The trustee is free to pursue the most efficient investment policy.

SECOND EXAMPLE: Larry is a widower with three children, Harry, Gary and Mary. He is comfortable leaving Harry and Gary their shares outright, but has some concerns about Mary, who is a bit of a spendthrift. Larry wants to provide generously for Mary, but doesn’t think that she could handle an outright distribution of her entire share. He wants Mary to be the primary beneficiary of a trust. He is not concerned about Mary’s children. He creates a Total Return Unitrust that gives Mary a 6% annual distribution. In addition, an independent trustee may make distributions for Mary’s support and medical care, considering her other resources. With a 6% distribution, it is likely that the fund will eventually be exhausted. However, Larry did his homework. He consulted his financial advisor who did some Monte Carlo simulations which estimated probable investment returns over Mary’s life expectancy.


Marital Deduction Trusts. Most marital deduction trusts require that the surviving spouse receive all of the trust income, at least annually. A Total Return Unitrust can qualify for the marital deduction as long as it contains a specific provision. The surviving spouse must receive the greater of the trust’s income or the distribution percentage.

Turning 35% Income into (for now) 15% Capital Gains. In our “income only” trust, the trustee is compelled to realize reasonable income from dividends and interest. Interest income is taxed at rates as high as 35%. Long term capital gains are currently taxed at 15%. In a Total Return Unitrust, there is no distinction between income and principal. The trustee is able to raise cash for the annual distribution by paring some of the growth. This effectively creates an “income” that is taxed at capital gains rates.

CONCLUSION: Total Return Unitrusts solve a great many of the problems created by older trust designs. They allow the trustee to try to maximize returns and reduce conflicts among beneficiaries and between beneficiaries and trustees. They are not a cure all and are not for everyone. Some clients will be better served with another type of Total Return Trust – or even a traditional “income only” trust. However, Total Return Unitrusts should be considered in many situations, especially in planning for second marriages and for children who may not be able to handle an outright distribution.

This short piece is only an overview of Total Return Unitrusts. It is not meant to be advice for any specific situation.