POLICY DIFFERENCES IN TOTAL RETURN LAWS

By Lyman W. Welch
Sidley Austin Brown & Wood
Chicago, Illinois
(Adapted from article published in Trusts & Estates Magazine June 2002)

Thirty-three states plus the District of Columbia have enacted total return legislation in the past three years.  Six additional states have such laws pending in their legislature.  (See Exhibit)  What explains this crescendo of legislative activity?  The driving force is the impact of modern investment policy on the traditional method for determining how much a trust pays to current beneficiaries.

Trusts commonly specify that trust accounting income is payable to the current beneficiary.  In the past, a trustee could comply with prudent man investment duties by buying and holding high quality bonds, supplemented by a usually smaller holding of conservative stocks, and expect to preserve value and produce an acceptable level of income.  But the investment environment has changed.  Trustees now face new economic realities including rapid changes in corporate finance, investment products and practices, as well as the compelling fact that the most attractive investments often pay little or no income.  Moreover, the shift to the prudent investor rule requires a trustee to manage the trust portfolio dynamically, managing risks and seeking investment returns judged appropriate to the facts and circumstances of the trust and its beneficiaries. 

The striking decline of distributable trust income as a percentage of total investment return too often creates unfairness to the current beneficiary.  For example, a portfolio invested 60 percent in large cap stocks and 40 percent in intermediate corporate bonds yields less than 3 percent compared to more than 5.5 percent ten years ago.  Yet the prudent trustee might expect a long-term average annual total return from this portfolio of 8 percent or more.  Conflict results:  how a trustee would invest to achieve the best total return too often conflicts with how a trustee would invest to achieve fair or necessary income distributions.  This increases trustee stress, litigation risk and disputes, all of which call out for a solution.

Total Return laws have been adopted to help solve this problem.  This legislation applies to so-called income trusts: that is, trusts that determine the return payable to current beneficiaries by reference to trust accounting income.  These new laws liberate the trustee to invest as the trustee thinks best for the maximum total return suitable to the purposes and circumstances of the trust without regard to whether that return is from income or capital appreciation.  In general, two different types of total return laws have been adopted.

Equitable Adjustment

The first approach grants trustees an equitable adjustment power.  This empowers the trustee to increase (or decrease) distributable income by transferring principal to income (or vice versa) to the extent the trustee determines necessary to comply with the trustee’s duty of impartiality to both current and future beneficiaries.

The power to adjust was first adopted by the National Conference of Commissioners on Uniform State Laws in 1997 as part of its revised version of the Uniform Principal and Income Act (“UPAIA”).  This revised act includes in section 104 the equitable adjustment power described above.

In the thirty jurisdictions that have adopted UPAIA section 104 (See Exhibit), the trustee of every trust for which income determines the amount distributable to current beneficiaries has a duty to consider annually (or at least periodically) whether the trustee’s duty of impartiality requires an adjustment between income and principal.  For example, if the trustee’s investment decisions reduce income distributable to the current beneficiary below the level the trustee determines appropriate, the trustee has discretion to transfer a compensating amount from principal to income.

Unitrust Conversion

A second approach grants to the trustee a power to convert an income trust to a unitrust.  This is a different solution to the same problem.  Conversion to a unitrust changes the definition of income for the trust, substituting a distributable amount determined as a percentage of trust assets revalued at least annually.  The consequence is that current and future beneficiaries share as partners in the total investment results, and the trustee’s investment decisions are no longer inhibited by distribution requirements.  The unitrust is increasingly popular among estate planners, and now ten states have adopted total return legislation permitting trustees to convert income trusts to a statutory unitrust, and at least four additional states are considering such legislation. (See Exhibit)

Some states have adopted hybrid approaches combining part or all of both the unitrust conversion and equitable adjustment methods. (See Exhibit)

Fundamental policy differences

This article does not propose to detail the multitude of variations in the 39 different total return statutes.  Rather it will consider the fundamental policy differences between the two primary forms of such legislation. 

All the total return laws give the trustee discretion to change the definition of income, for trusts to which they apply, in order to provide fairer sharing of total return by current and future beneficiaries.  The key policy difference distinguishing the various laws is the extent of discretion granted to the trustee, as determined by the standards limiting the trustee’s exercise of discretion.  Such standards establish the guidelines for the trustee, the expectations of the beneficiaries and the principles by which the trustee’s actions will be judged.

Granting trustee discretion is a double-edged sword.  It confers flexibility to accomplish trust purposes, but also increases risks of mistake, abuse and dispute.  Each state enacting total return legislation must make value judgments balancing the perceived need for discretion against these risks, based upon the unique values, presumptions and historic experience of the community and its leaders.  An examination of the key design choices made in the different total return laws demonstrates a wide variety of views on how much trustee discretion is advisable.

Standards governing equitable adjustment.  Impartiality (or partiality) to the current and future beneficiaries as provided by the terms of the trust sets the standard governing exercise of the equitable adjustment power.  It appears that all of the states adopting the equitable adjustment form of total return legislation incorporate verbatim from UPAIA the standard that:

“A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee determines that the trustee is unable to comply with [the duty to administer the trust] impartially, based on what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries.” [1]

The comments to UPAIA section 104 elaborate that:  “section 104 does not empower a trustee to increase or decrease the degree of beneficial enjoyment to which a beneficiary is entitled under the terms of the trust, rather, it authorizes the trustee to make adjustments between principal and income that may be necessary if the income component of a portfolio’s total return is too small or too large because of investment decisions made by the trustee under the Prudent Investor Rule.”

This standard establishes parameters limiting the trustee’s exercise of the equitable adjustment power.  As the above quoted comment makes clear, the amount of any compensating adjustment made under section 104, at least as envisioned by National Conference of Commissioners on Uniform State Laws, appears to be confined to compensating for the marginal decrease or increase in trust income resulting from the trustee’s investment decisions.  This leaves considerable latitude for the trustee to exercise judgment on whether and how much compensating adjustment is appropriate, but arguably limits such adjustments to the incremental amount that trust accounting income is increased or decreased by the trustee’s investment decisions.

Broad interpretation of the equitable adjustment standard.  It is important to note that the equitable adjustment statutory language alone, when considered separately and apart from the uniform act commentary, can be read more broadly to authorize a trustee to make adjustments as the trustee deems necessary to promote fair sharing of total return among beneficiaries, in accordance with their interests as provided by the terms of the trust. 

Therefore a trustee arguably could properly administer the statutory equitable adjustment power without exclusive regard to the incremental impact of investment decisions on trust accounting income.  For example, a trustee could use as a guideline in determining appropriate equitable adjustments:  (a) a unitrust calculation, (b) an inflation adjusted annuity value, (c) the discounted value of cashflows statistically likely to be distributed to the current and future beneficiaries respectively from a chosen distribution amount or percentage, (d) a floating index determined by the trust’s own historic returns, (e) a floating index determined by selected market indicators, or (f) a wide variety of hybrid methods for determining a fair current return.  Any of these alternative methods for implementing the equitable adjustment power would still be governed by and literally satisfy the statutory standard of impartiality. 

A broad interpretation of the equitable adjustment power is warranted because it is unclear what methodology to use in determining the impact of investments on distributions over time.  In addition, more than just the trustee’s investment decisions impact current returns.  Changed economic circumstances also have caused trust accounting income often to be less than a fair current return as a percentage of total return in many cases.  The statutory language lends itself to interpretation that the equitable conversion power authorizes a trustee to correct this unfairness.  However, whether equitable adjustment statutes will be administered and interpreted liberally or restrictively in the various states is yet to be seen.

Impartiality is relative to the terms of the trust.  To understand the equitable adjustment power, it must be noted that the impartiality standard itself requires judgment.  It does not simply mean treating current and future beneficiaries equally, but rather requires subjective judgment on how investment returns should be shared between current and future beneficiaries in carrying out the terms of the trust.  Significantly, it appears that all of the equitable adjustment statutes incorporate verbatim UPAIA’s definition of “terms of a trust”.  This key phrase in the statutory standard is defined broadly to mean “the manifestation of the intent of a settlor or decedent with respect to the trust, expressed in a manner that admits of its proof in a judicial proceeding, whether by written or spoken words or by conduct.” [2]   Therefore, the equitable adjustment statutes ask the trustee to look beyond the four corners of the trust instrument and to make subjective judgments about the purposes of the trust, the intent of the settlor, whether some beneficiaries are intended to be favored, and to determine what is a fair and reasonable current return in the context of the facts and circumstances of the trust.

Standards governing unitrust conversion.  In contrast, the unitrust conversion statutes provide a management by exception approach.  Rather than granting discretion to make discrete, subjective judgments about income adjustments every year (or at least periodically), they grant discretion to elect into a relatively fixed regime of determining current return by an objective percentage of asset value.  Some versions of the unitrust conversion approach grant limited discretion (such as proposed statutes pending in Illinois [3] and Pennsylvania [4] and one enacted in Maine [5] ) and impose as a standard for conversion that it “enable the trustee to better carry out the purposes of the trust.”  Other versions of the unitrust conversion approach grant broad discretion (such as those adopted in Delaware [6] , Florida [7] and South Dakota [8] ) and provide no specific standard limiting the trustee’s decision to convert to a unitrust (other than the implied duties of fairness and impartiality).  Importantly, liberal unitrust conversion statutes grant the trustee discretion to select any distribution percentage which is not less than 3 nor more than 5 percent, to set whatever policies the trustee deems appropriate for valuation and administration procedures, and to decide without restriction how frequently the trustee may change the distribution percentage as well as valuation and administrative procedures.

Which method is better?

Which type of total return legislation is preferred depends upon one’s values and presumptions about trustees, trust beneficiaries, trust investments and trust purposes.  The more one believes it best to endow trustees with authority to fine-tune the current payout to fit changing circumstances, the more one will prefer a form of total return legislation granting broad discretion to the trustee, such as UPAIA’s equitable adjustment power or the liberal unitrust conversion approach of Delaware.  On the other hand, the more one believes it best to establish definite rules, limit the range of discretion granted to trustees, and reduce the number of issues and opportunities for mistake, abuse and dispute, the more one consequently will prefer a limited unitrust conversion approach, such as the pending Pennsylvania statute.  The maximum discretion and flexibility would be provided by combining alternative options of both an equitable adjustment power and a liberal unitrust conversion power, as exemplified by the statute Florida recently adopted.

Conclusion

Much is yet to be learned about how best to design and administer total return trusts in drafting estate plans and advising clients.  The new models for total return trust plan alternatives that will evolve and become standard forms for future generations are undreamed of today.  Existing total return laws are likely to be revised and redirected as new concepts develop in mechanisms to govern distributions dynamically in response to investment results and spending needs, in formulations for defining beneficial interests, priorities and purposes, and in architecture for layered decision-making authority and control.  In addition, new methods are needed to coordinate the distributions and investments of multiple trusts created at different times by several grantors for a single, extended family group.

For the present, total return laws enacted to date contribute invaluable new authority for trustees and beneficiaries to resolve conflicts which too often occur when trust investment and distribution policies clash.  Care, skill, and creativity will be needed to craft the best solutions for the administration and interpretation of these new statutes.  Trustees, trust beneficiaries and their advisors should be proactive in taking advantage of these new opportunities.

JURISDICTIONS THAT HAVE TOTAL RETURN LEGISLATION ENACTED, ADOPTED OR PENDING

NOTES:

• Codes in Parenthesis Indicate:

·          EA = UPAIA §104 equitable adjustment power

·          UC = Unitrust conversion

·          B = Both unitrust conversion and equitable adjustment power

·          P = Pending legislation

• 33 jurisdictions have enacted or adopted total return laws.

·          23 have UPAIA §104 equitable adjustment power only

·          3 have unitrust conversion only

·          7 have both unitrust conversion and equitable adjustment power

• 7 additional states have total return laws pending in the legislature.

·          3 have UPAIA §104 equitable adjustment power only

·          2 have unitrust conversion only

·          2 have both unitrust conversion and equitable adjustment power

• Asterisks indicate New Jersey and Louisiana adopted (and Ohio has pending) UPAIA §104 with a unitrust safe harbor.
• Above information believed current as of May 31, 2002.