Victor Rommely and his siblings, fourth-generation members of a successful family, are the beneficiaries of an irrevocable trust established in 1920 by their great-grandfather. The trust instrument provides that all income (interest from fixed-income securities and dividends from equity-type securities) be distributed equally among the current beneficiaries, and that a portion of the trust principal may be distributed (at the trustee’s discretion) to pay for a current beneficiary’s health care. Undistributed principal is to be retained for the benefit of the fifth generation.
Historically, the trust has earned and distributed satisfactory income, but a substantial drop in interest rates has caused the income earned by the trust to decline significantly during the past three years. Rommely and his siblings are middle-aged, and one brother relies on the distribution to maintain his standard of living. All four are unhappy with the amount of their distributions and are pressuring the trustee to invest a greater percentage of the assets in income-producing investments. The trustee, however, believes that complying with the family’s request would not be a prudent long-range investment strategy and, therefore, he is reluctant to do so.
Heidi L. Steiger: It’s the classic situation where you have conflicting interests between the current and future beneficiaries. As a trustee, you really need to look at the beneficiaries who are getting income now as well as the fifth generation, who is going to get the principal. You can’t make decisions that favor one or the other.
Robert C. Lawrence III: This seems to be a problem that is coming up with some frequency. Who has the income interest and who has the principal interest sometimes creates tension. If you invested in fixed-income securities, you would have more income but less growth. Whereas if you invested in longer-term, growth securities, you would have less income and more growth. At the end of the day, the fiduciary owes a responsibility to both the income beneficiaries and the remainder [future beneficiaries]. Historically, we started with the “prudent man” rule: What would a reasonably prudent man do with his assets? Recently, that evolved into the “prudent investor” rule, and a whole new set of factors were introduced to measure whether the fiduciary is meeting an appropriate standard. The “prudent investor” rule focuses on the process, not the performance, of trust investments. With this standard, we also have a new concept called the total return unitrust. The object of a total return concept is that you don’t have to worry about balancing the best interest of the beneficiary with the remainder interest.
Jane Tse: The majority of the states have adopted this new approach, but not all. The trustee—in a state which has adopted such law—has the fiduciary obligation to see whether or not it’s prudent to take advantage of the new legislation.
RL: Normally in a trust, there are two concepts: income and principal. Income is what is paid to the current beneficiaries, and that usually is interest from fixed-income securities or dividends from equity-type securities. But for accounting purposes, the original principal is the capital that you start with and appreciation. For example, you start with 100 shares of IBM and it costs, say, $10,000. You sell that at a gain; the capital gain—although taxed—would be part of the principal.
When you look at the reasonably prudent man rule, and to a lesser extent the reasonably prudent investor rule, you run into this conflict. Whereas with an adjustable rate of return or a total return unitrust, you don’t because you measure income as an adopted percent of the capital value of the trust on a given date.
A total return trust might say the income beneficiaries will be entitled to a fixed percent. Four percent is the statutory amount in New York. You value the trust, and 4 percent of that value will be paid to the beneficiaries during that year. You can invest on the basis of long-term growth if that makes sense. Or you can adjust [the rate], but you’re not worried about [the trustee’s] divided loyalty between the income beneficiary and the future generations. I think that’s a very modern approach and will gain popularity because it eliminates concerns that have been in the minds of all advisers and fiduciaries.
HS: An obvious problem is if the trust was set up in a state that [hasn’t adopted the law]. You would have to go to the courts to see if you could move the trust to a state that does have this law.
Diane Lederman: If you have beneficiaries with different needs, they might consider splitting it into different trusts: one for each beneficiary. The trustees would be able to invest in an allocation that more closely fits the needs of the beneficiaries—one might need more income than the other.
HS: But you haven’t escaped the issue of current beneficiaries versus future beneficiaries. It does make the situation easier because you can differentiate among the four beneficiaries, but it doesn’t make the problem of the future beneficiaries go away.
RR: How does a fiduciary decide which trust approach—a total return rate or an adjustable rate—is best?
RL: In New York, the fiduciary can look at the performance of the trust and what the markets are doing each year and [determine] an amount that would be paid to the income beneficiaries rather than adopting—as in a total return unitrust—a fixed amount that will be the same year in and year out.
JT: It could be that the current beneficiaries started to make a lot of money, and they would rather have the trustee accumulate income for their children. If you have a fixed 4 percent payout, that may be too much.
RL: If the fiduciaries don’t reach that decision in a responsible fashion, they would have potential liability. Whereas with the total return unitrust, the fiduciary would not be subject to potential liability because [the rate] would have been blessed by the court.
I think that the case where [the adjustment] is done on an annual basis provides more flexibility, especially if the performance of the trust wasn’t very good. If the income is only 1 percent, and the capital appreciation is zero, to pay the 4 percent, you would be taking capital. The trust would be going down. Look at the last three years where you have negative return on capital and low income. You could deplete the trust rather rapidly, and that’s why I think that the adjustable system is more appealing. By doing an adjustable rate or total return rate trust, the beneficiaries know what income they are going to get—or on the adjustable basis, they have a pretty good idea.
If the Rommelys ask the trustee to invest in fixed-income securities, it would provide more income, but that may not be in the long-term best interest of the trust in terms of capital growth. By going to a total return rate or adjustable rate approach, it meets their needs and also the trust’s needs in as flexible a manner as possible.
HS: This trust is grandfathered and exempt from generation-skipping taxes, but a total return unitrust is not. The IRS is supposed to issue regulations that will allow the exemption to continue, so you want to wait before establishing a total return unitrust.
Mark Watson, vice president of financial capital services at Asset Management Advisors (561.746.8444, www.amaglobal.com) in Palm Beach, Fla., developed the client profiles. Watson is a Certified Financial Planner, Certified Public Accountant, and Personal Financial Specialist. He is based in the company’s Orlando office.