Andrea Broughton / 29 Jan 2020

Trusts In Captivity

SBK Planning Series:
By Claire Craighill, CFP

The use of trusts to direct the disposition of assets has been around for centuries.  The law of trusts first developed in the 12th century, at the time of the Crusades and under the jurisdiction of the King of England.  The notion of articulating your wishes for future heirs can be both prudent and necessary.  But, creating a trust for generations requires one to attempt to predict the future, accounting for unknown events that might mitigate or undermine the transfer of wealth.  Assumptions must be made with consideration of current law, known facts, and various notions about the character of a potential heir.  Not surprisingly, things don’t always go as planned when we set out to predict the future.

Modern Trust Law: Defining the Relationship between a Trustee and Beneficiaries

In modern trust law we can create both inter-vivos trusts, during our lifetime, as well as testamentary trusts, which determine how property is invested, owned and distributed following our death.  A “trustee” is responsible for carrying out the terms of the trust.  Not to be confused with the owner or the beneficiary, the trustee has a fiduciary duty to the beneficiaries of the trust to own, invest and deal with the property prudently for the duration of the trust.  A trustee who violates that duty can be held liable to beneficiaries.

Often a trust identifies two tiers of beneficiaries, current and future.  Current beneficiaries represent the individuals that benefit most today, often by receiving the income from the trust during their lifetime.  Future beneficiaries, also called remainder beneficiaries, stand to inherit the wealth once the current beneficiaries pass away.  So, how does a trustee manage the assets with a fiduciary duty to both current and future beneficiaries?

The institutional answer to this question has long been to clearly not favor either beneficiary by investing 50% of the assets in income producing investments or bonds, with the other 50% focused on growing the trust principal with assets like stocks.  In this arrangement it would be difficult to suggest either tier of beneficiary is getting preferential treatment, and the trustee can sleep at night.

The practice of a 50/50 asset allocation was standard operating procedure for professional trustees for decades.  So where’s the rub?  We need only look to our recent interest rate environment for a great example of what could go wrong with this practice.

Low interest rates on bonds produce little income for the current beneficiary and a 50/50 allocation for a portfolio that could literally last multiple lifetimes may not make sense

from a total return or growth perspective for the remainder beneficiary.  However, the fear from breaking from this tradition (and the threat of litigation) was strong enough for trustees to continue this common practice.  These trusts and the beneficiaries were captive to an outdated system.

Uniform Acts and Statutes Bring Help

Fortunately, the Uniform Principal and Income Act and the Uniform Prudent Investor Act were introduced in the 1990s and provided a legal basis to manage these trusts more intuitively, providing cash flow for the income interest, as well as growth opportunity for the remainder interest.  The first act authorizes a trustee, under certain circumstances, to make an “equitable adjustment” and re-characterize income as principal and principal as income, if the trustee determines this is necessary to treat beneficiaries impartially.  The second act provides for modern portfolio theory in investing and evaluating investment decisions for the health and growth of the portfolio.

While these acts have given us more room to reasonably manage trust assets, there’s another form of captivity which is often overlooked or taken for granted.  It’s not uncommon for a beneficiary of a multigenerational trust to feel powerless to impact change.  Some individuals acting as trustees may also experience a similar sensation.  Beneficiaries and trustees of trusts that have been around for generations can fall victim to a pattern of operation that no longer suits the circumstances of the heirs.  These trusts are typically irrevocable trusts created by someone who passed long ago, presumably casting their wishes in stone.  The essence of the creator’s intent is often clear enough, but the specific direction in the document, under current circumstances, may actually go against the overall objective of preserving the wealth for the future.

All is not lost.  There are strategies that can be utilized to bring outdated directives into line with current circumstances while remaining true to the original intent of the creator.  These strategies may include the decanting and merging of trusts or the use of an Administrative Trustee.

Wine lovers know that the term “decant” means to pour wine from one container into another in order to open up the aromas and flavors of the wine.  In the world of irrevocable trusts “decant” means the legal process through which the trustee appoints or distributes trust property in further trust for the benefit of one or more of the beneficiaries.  In other words, the trustee transfers some or all of the property held in an existing trust into a brand new trust with different and more relevant terms.

In addition, some states, such as Delaware, enable a trust creator or beneficiary to select an investment advisor independent from an Administrative Trustee, allowing for the separation of investment management and trust administration.  The investment advisor of choice is responsible for the investment discretion while the Administrative Trustee fulfills the fiduciary duty of trust governance.  This division of directed responsibilities can help alleviate pressure between a trustee and beneficiaries, while also protecting the purpose of the trust.

These types of strategies are not without their complexities, but the advantages can be significant.  With careful review and analysis of the planning opportunities that are currently available there is often a path to improve the trust environment for all concerned – trust creators, beneficiaries, and trustees.

A thorough review of your trust and estate documents is always a good idea and can often lead to a better understanding of the alternatives that exist for generational planning.  To learn more about our services, our people, and the different ways we assist families, please visit our website at www.sbkfinancial.com.

SBK is a wealth advisory partner offering holistic, independent and objective wealth management services.  Our customized and comprehensive approach enables us to generate tailored solutions for you and your family – every step of the way.