New trust can ease conflicts among heirs

Published 12:00 am Wednesday, June 7, 2000

It’s a great way to make your heirs angry at you and at each other. You set up a traditional trust that’s designed to benefit more than one person upon your death. A good example would be a credit-shelter trust, where your surviving spouse would receive lifetime income from the trust, and your children (called “remaindermen”) would receive the assets left in the trust at your spouse s death or at the end of a specified term. Or perhaps it’s a trust in which your children receive current income and your grandchildren receive what’s left after your children die.

Obviously this presents a potential conflict of interest. The income beneficiary may want to maximize the income from the trust. That might suggest more conservative income-oriented investments such as Treasure bills and dividend-paying stocks. But the remaindermen aren’t interested in current income. They want long-term growth, such as through growth stocks and the reinvestment of dividends and capital gains. If all the income is siphoned off by the income beneficiary, the remaining assets not only won’t grow as much, they may actually shrink in real value due to inflation.

What’s a trustee to do?

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Leading-edge trustees are designing trusts as “total return” trusts. These trusts emphasize maximizing the overall return of the trust to benefit current and future beneficiaries. The income beneficiary still receives income, but some of that income may be through the sale of appreciated investments, not just dividend and interest income. The amount of income may be based on a fixed percentage of the total value of the trust, such as three to five percent. Since that income will fluctuate with the rise (and fall) of the value of the trust’s assets, the payout may be based on the trust’s average value over a three-or five-year period. Also, the trust language may dictate a minimum annual payout in dollars.

Presuming the trust assets are well-managed, and the income payout isn’t too high, the total value of the trust should grow over time. That means not only more after-tax income in the long run for the income beneficiary, but potentially a significantly larger pool of assets left the remaindermen.

Both parties win.

This approach to trusts may sound ridiculously obvious to anyone who has managed an investment portfolio, such as for retirement, especially in this day and age of high growth and low yields. However, to some extent trustees have been hobbled by an old trust concept called the Prudent Man Rule, which said trustees had to weigh each investment individually for risk, not as part of the overall portfolio. Thus, although the overall portfolio might be doing well, the trustee theoretically could be sued if only a single investment performed poorly. In a diversified, growth-oriented portfolio some investments will likely do poorly at any given time. Consequently, trust portfolios tended to be conservative, income-oriented and poorly diversified.

Many states, however, have adopted new trust investment guidelines in recent years that more closely follow what’s called modern portfolio theory. That theory says investors can minimize their risk and maximize return by mixing investments, some of them riskier than others, as long as the overall portfolio meets the investor’s needs and tolerance for a certain level of risk.

Thus, trustees can feel more comfortable spreading the portfolio into areas they shied away from before, such as international stocks and bonds, small-company stocks and private equity investments.

Total return trusts are not without their challenges. Such an approach can work well for a credit shelter trust, for example, but it presents problems for a qualified terminable interest property trust. In a QTIP trust, often used in remarriage situations, all QTIP income must go to the surviving spouse in order for the property put into the trust to receive the full marital deduction. Obviously, this creates a conflict of interest with the remaindermen (who may be children from a previous marriage). Also, some types of assets in a total return trust, such as a family business or real estate, can create liquidity problems.

Some of these conflicts can be resolved through other strategies, such as the use of life insurance or multiple trusts. Talk to your financial planner and estate planning attorney to see what will work best for you.