Even in the strongest families, conflicting interests between income and remainder beneficiaries can create tension and turn the trustee’s job into a delicate balancing act. By aligning your beneficiaries’ interests, a total return uni-trust (TRU) can relieve this tension and allow your trustee to concentrate on developing the most effective investment strategy.
A Difficult Job
When a trust is designed to provide benefits for two classes of beneficiaries, often in different generations, it presents a difficult challenge for the trustee.
For example, let’s say Susan’s will establishes a trust that pays all its income to her husband, Mark, for life (the “lifetime beneficiary”), and then divides the trust assets equally among her three children from her first marriage (the “remainder beneficiaries”). The trust names Susan’s friend, Jennifer, as trustee. Mark outlives Susan by 10 years.
Jennifer has a fiduciary duty to act in the best interests of all the beneficiaries, but traditional trust design makes it difficult for her to be impartial. Suppose Susan leaves $2 million to the trust. To provide Mark with a steady income stream, Jennifer places the trust assets in fixed-income investments that generate a 5% return. Mark receives income of $100,000 per year, and when he dies the trust’s principal — still $2 million — is distributed to Susan’s children. Not a bad inheritance, but its value has been eroded by 10 years of inflation.
Suppose, instead, that Jennifer invests the trust assets in growth stocks that earn a 9% annual return. Ten years later, the trust’s value has appreciated to more than $4.7 million. That’s good news for Susan’s children, but this approach likely generates little or no income for Mark.
To make everyone happy, Jennifer makes a compromise: She invests half of the assets in growth stocks and the other half in fixed-income vehicles. The $1 million in fixed-income investments generates $50,000 per year for Mark, and at the end of the trust term the principal is still $1 million. The other $1 million, however, has grown to nearly $2.4 million. Thus, the total amount in the trust is almost $3.4 million.
A TRU Introduces Flexibility
The advantage of a TRU is that it frees the trustee to employ investment strategies that maximize growth (total return) for the remainder beneficiaries without depriving lifetime beneficiaries of income. Rather than pay out its income to the lifetime beneficiary, a TRU pays out a fixed percentage (typically between 3% and 5%) of the trust’s value, recalculated annually, regardless of the trust’s earnings.
Going back to our previous example, suppose Susan’s trust is designed as a TRU that makes an annual payout to Mark equal to 3.5% of the trust’s value, recalculated annually. Jennifer, relieved of the duty to generate income for Mark, invests the trust assets in a diversified portfolio of growth stocks that yield a 9% annual return. Mark’s payments from the trust start at $70,000 and grow steadily over the trust’s term, reaching more than $113,000 by year 10.
At the same time, the value of the trust principal grows to more than $3.4 million, which is distributed to Susan’s children at the end of year 10. Thus, the lifetime beneficiary and the remainder beneficiaries are better off with a TRU than they would have been under the compromise approach described earlier.
The Details Count
If you’re considering implementing a TRU, it’s important to plan carefully. Ask a financial advisor to project the benefits your beneficiaries will enjoy under various scenarios, including different payout rates, investment strategies and market conditions. Keep in mind that, for a TRU to be effective, it must produce returns that outperform the payout rate, so don’t set the rate too high.
Be sure to investigate your state’s trust laws. Some states disallow TRUs. Also, many states establish payout rates (or ranges of permissible rates) for TRUs, so your flexibility in designing a TRU may be limited. Finally, if a trust is required to pay out all its income to a current beneficiary, be sure that uni-trust payouts will satisfy the definition of “income” under applicable state and federal law.
A trustee’s job can be difficult when trying to balance the interests of various beneficiaries. Having the foresight to include a TRU in your estate plan can help relieve family tension later and make your trustee’s job easier. Contact us to learn more.