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TRUs (TOTAL RETURN UNITRUSTS)

INTRODUCTION

Wolf & Leimberg

The conclusion is new, but inescapable. The way we draft long term trusts has a major effect on the investment performance of the trust. It is no longer sufficient for counsel to draft a trust which is legally perfect; the provisions in today's trust documents must match the facts, and integrate the financial circumstances, needs, and objectives of the parties for whom they are created. They need to recognize the realities of today's financial markets and facilitate rather than fight against the long term investment goals of the trust. Blind acceptance and usage of the classic and typical trust using the age-old concepts of principal and income ("income rule" trust) must give way to consideration of new trust forms which bring the interests of the income and remainder beneficiaries together to maximize the trust's total return.1

This trust for the new millennium is the Total Return UniTrust (TRU),2 a model which will provide greater returns for both the current and the remainder beneficiaries.

THE TOTAL RETURN UniTRUST (TRU) DEFINED

The Total Return UniTrust is designed to impartially balance the interests of the current beneficiary and the remainder beneficiary while enabling the trustee to pay out as much as possible to the current beneficiary. In essence the TRU is an express noncharitable UniTrust. It requires a payout one or more times a year to the current beneficiary of a stated and fixed percentage of the fair market value of the trust's assets - as revalued each year on the same date, but averaged over a three year period to smooth out the market's ride. As a complex trust, a TRU is not required to distribute all income currently. So if, in a given year, income is greater than the percentage amount that is required to be distributed to the current beneficiary, it can be accumulated for the benefit of both current and remainder beneficiaries.3

The TRU unites the interests of the trustee, current beneficiaries, remainder beneficiaries, and investment managers (similar to its charitable counterpart4) by paying more each year to the current beneficiaries as the value of the investment "pie" increases and thus encourages the use of an investment portfolio that strives for maximum after-tax returns and long term capital growth. This, of course, is an investment philosophy also readily embraced by remainder beneficiaries, thus placing both parties in the same investment boat. As partners in success, a rising economic fortune enriches both beneficiaries.

THE PROBLEMS WITH "STATUS QUO" TRUST DESIGN

Using the income rule trust approach, today's trustee is faced with the nightmare of an investment decision-maker's Hobson's Choice:

(1) invest for long-term growth and make the remainder beneficiaries happy - but fail to meet the needs and desires of the current beneficiaries for adequate amounts of income,

(2) invest to maximize income - but alienate the remainder beneficiary who, of course, seeks the largest possible capital growth, or

(3) try to please both by a middle-of-the-road approach which typically results in insufficient income and mediocre and unsatisfactory capital appreciation.

This approach pleases neither party. This antiquated model clearly creates an antagonistic tension that constantly threatens to pull apart the key parties to the trust - the current beneficiary, the trustee, and the remainder beneficiaries.

INCOME BENEFICIARY RECEIVES

REMAINDER BENEFICIARY RECEIVES

INTEREST AND DIVIDENDS

CAPITAL GAINS AND GROWTH

Prefers Investments in BONDS Prefers Investments in STOCKS

An almost inevitable result of this obvious diametric opposition of interests5 is the all-too-frequent manifestation by the beneficiaries of their unhappiness through mistrust, acrimonious communication, discharge, or attempted surcharge of the fiduciaries and investment team. The investment climate is poisoned from the inception of the trust. They just don't understand. We have set up the trustee to fail in the eyes of the beneficiaries. And this failure is not lost on beneficiaries who see trust values rise, while income has actually fallen because of the secular decline in interest rates.

This article is written in November, 1998, a month when both interest rates and dividend yields approach their lowest points in history. 30 year Treasury notes are producing only 5.15 percent, less than 85 basis points above 90 day T Bills which are yielding 4.32 percent. Average dividend yields are at 1.48 percent.

Assume a trust with $1,000,000 of investable assets. The traditional 65/35 investment mix even using 30 year Treasury Bonds will yield less than $25,000 after trustee's fees charged to income. Worse yet, computer modeling of this traditional investment mix from 1960 to 1997 and 1973 to 1997 shows the income beneficiary would have lost 40% of their income purchasing power with that investment mix. Nor would the principal have retained its value after inflation either. There is cause for their complaint!

Accounting income is reduced in direct proportion to the relative proportion of the portfolio invested in equities.6 If the entire $1,000,000 is invested in equities, the current beneficiary would receive $14,800 - before payment of either trustee's fees or income taxes! This is clearly insufficient for most current beneficiaries. If the entire $1,000,000 is invested in fixed income assets, the current beneficiary could receive up to $51,500 before trustee's fees and taxes - assuming a 5.15 percent return could be realized. But this would totally sacrifice long-term growth. Since under state trust law, a trustee has a fiduciary duty of impartiality7 as between current and remainder beneficiaries, neither course of action is plausible. Perhaps the only way a trustee can be impartial - given the impossibility of finding an investment mix that will produce both adequate income and reasonable growth - is to disappoint both parties - but to disappoint them in equal measure.

As a practical matter, the trustee of the traditional income rule trust must try to satisfy the income need. The only tool available is the asset allocation, which unfortunately is also the factor which determines almost all of the investment total return.8 Most trusts are intended to last for a term of more than 10 years and many are intended to last for one or more lives. Some are now designed to last for a dynasty.9 Yet by their emphasis on income, the overwhelming majority of these trusts do not take into consideration the long-term historical track record of stocks and bonds and the well-recognized fact that the true inflation-adjusted long-term return from stocks is almost four times the return from bonds.10 Nor does classic trust design take into consideration that the longer the investment horizon, the more likely common stocks will outperform other forms of investments.11

The classic income rule trust tends to pay out relatively less in peaks of markets when interest rates have fallen but more in periods of high interest rates and low markets. The result is a negative dollar averaging effect and a corresponding increase in investment risk assumed by the remainder beneficiaries.12

No overall investment analysis should fail to overlook the impact of the twin wealth diminishers of inflation and taxes. Yet that's exactly what happens in the classic trust model. The greatest part of equity return occurs in the form of growth rather than income. This appreciation, which will eventually find its way into the hands of the remainder beneficiary, typically grows income tax deferred. When the asset is sold, the capital gain on the equity is blessed with a maximum tax loss of 20 percent. This should be compared with the 39.6 percent levied on the interest and dividends paid to the income beneficiary.

So in every respect, the classic trust design is flawed. Trustees are thwarted by this "hold the principal" and "pay the income" investment constriction from investing in the best interests of both parties and maximizing the full tax and financial utility of every dollar of trust assets.13

ADVANTAGES OF THE TRU

A TRU can address the problems of the classic trust design and result in considerable advantages to all parties

    • Current and remainder beneficiaries find it easier to understand and accept the importance of a "total return" (i.e., maximizing income plus growth in the overall long-term value of the trust's assets) investment philosophy. Returns to both parties are increased and the interest of current beneficiaries are harmonized with remainder beneficiaries
    • Since both key parties to the trust have similar interests14, the mission of the trustee and investment team can be more focused. More than ever, investment decisions can be based on the needs and risk tolerances of the beneficiaries. This restores asset allocation to its proper place in investment planning.
    • There is less likelihood of dissension between the current and remainder beneficiaries. Without sacrificing investment return, the TRU can be custom fitted to the needs of the current beneficiary as well as the growth-oriented hopes of the remainderperson. Impartiality can co-exist with maximization of total return.
    • In a "discretionary trust"15 where the trustee is given absolute and total discretion to spray capital and sprinkle income among beneficiaries, when there is discord in the family or with the decisions of the trustee, that flexibility can work against both the trustee and the objectives of the grantor. But the TRU does not give the trustee such unbridled discretion and therefore the potential for criticism, second guessing, or family feuding is significantly reduced. Furthermore, the fully discretionary trust can not be used where the marital deduction is required whereas the TRU can be structured to qualify.16
    • Use of a TRU diminishes the potential that trustees will be surcharged by remainder beneficiaries who, with 20-20 hindsight, claim those trustees invested too heavily in income producing assets.
    • The threat of lawsuit against a trustee by income beneficiaries who charge the trustee with investing too much of the trust's assets for long-term growth is likewise reduced.
    • Because distributions for the entire year can be calculated at the beginning of each year, current beneficiaries can anticipate their cash flows more accurately and engage in more effective financial planning.
    • Through the concept of "pruning"17 of equity investments, that is, the supplementation of current yield with the judicious sale of a sufficient number of shares of an equity security to match the desired payout to current beneficiaries, more of each payment to the current beneficiary will consist of capital gains and non taxable return of cost basis rather than ordinary income. This planning mechanism significantly reduces the current beneficiary's reportable income, significantly increasing the beneficiary's after-tax spendable income compared to the fully ordinary income payments from the classic trust.18
    • Through a three-year "smoothing provision"19, a TRU can dampen or eliminate the effects of temporary dips in the market and the consequent volatility of the amount paid to the current beneficiary from year to year.
    • Even though interest rates may fluctuate widely in the marketplace, the TRU can minimize or eliminate the impact on the current beneficiary.
    • The TRU is viable even in "down markets" and can actually increase returns by making a more favorable asset allocation possible and by dollar averaging in bull and bear markets. This theory has been tested by computer simulations, starting at the worst possible time in modern history, January 1, 1973, the beginning of the longest bear market since the Depression. Using an all equity investment mix, with a 4% distribution rate and the three year smoothing rule, the distributions declined 30% over three years in this worst case scenario, but from that point on the TRU increases its distribution every year for 21 straight years and ends the year 1997 with twice the market value and twice the payout of a 60/40 income rule trust20! By smoothly and automatically reducing the payout, the TRU protects the trust from excessive damage in an extended bear market, an important protection21.
    • If the TRU is used within the context of an estate plan, the distribution rate can be used as a highly effective tool to leverage tax planning. To a considerable extent, by targeting the drafting to favor either the current or remainder beneficiary, it will also be possible to channel benefits away from the IRS while at the same time investing for total return. For example, if a high percentage payout is used in the marital trust under a formula which pays out the greater of (a) accounting income or (b) the set UniTrust payout rate, and a relatively low percentage payout is set in the bypass (credit shelter) trust, the amount subject to tax from the marital trust will be diminished considerably22 while the estate tax free buildup in the bypass trust will be significantly enhanced23. In fact if the surviving spouse isn't receiving sufficient income, an invasion of the marital trust's corpus could satisfy that need and simultaneously further reduce the amount taxable at the surviving spouse's death.
    • Through sophisticated computer modeling, planners can factor in and better understand the additional real world costs that impact upon the returns enjoyed by a beneficiary of a trust. These include the significant cost of trustee's fees24, transaction costs25, and portfolio turnover26 as well as taxes27 and inflation.
    • Computer modeling of historical markets and portfolios should also make it possible to shape the terms of a trust much more closely to the objectives of the parties. This mental planning paradigm shift and newfound ability to simultaneously simulate a multiplicity of scenarios properly focuses new attention on the satisfaction of the human needs of clients28 and away from the single minded obsession of practitioners on the minimization of death taxes.
    • As is the case of a CRUT, the TRU can never be totally exhausted. Compare this with an "indexed payout" trust29 which attempts to assist the current beneficiary by increasing payments based on inflation. Studies show that the use of an indexed payout trust in a highly inflationary period could result in a complete exhaustion of the trust's assets. An inflation indexed payout starting in 1973 at 5% of the trust from a 100% equity portfolio would have totally exhausted the trust by 1990.30 Computer modeling of the same trust starting in 1960 during a much lower inflationary period still reduces the trust to zero by 1989. Insulating the current beneficiary from the risk of inflation in an indexed payout trust increases risk to the trust corpus.

    AS YET UNANSWERED ISSUES AND PROBLEMS

    Computer models of TRUs assume the IRS will honor an "ordering" provision or an allocation provision in the trust document to provide taxation similar to the way CRUT distributions are made, i.e., a tier system which treats payouts as being taxable by the recipients rather than to the trust and made first from ordinary income, then short term capital gain, then long-term capital gain. The best method of prescribing this result is not clear yet, and if the IRS were to ignore the source of the distributions prescribed by the trust, they would tax all capital gains to the trust itself. If this should occur, even though it might be advisable to make the payout to the current beneficiary slightly smaller, the overall economic benefits of the TRU remain essentially undiminished.31

    Another issue is the impact of the level of payout on the overall effectiveness of the TRU. Computer models suggest that in the long run, taking into consideration the long term effects of taxes, costs, and inflation, a lower payout rate equates to higher growth and a more stable and smooth distribution level. A three to five percent range is suggested in most cases. A higher payout rate can be used if the primary objective of the grantor is to favor the current beneficiary (e.g. a spouse). A lower payout rate should be employed where the grantor's primary goal is growth and the financial enrichment of remainder beneficiaries is a priority (e.g. a dynasty trust). But note well that the more conservative (less stocks) the investment mix, the less one can afford to pay out and keep up with inflation32!

    What is the "optimal" payout rate? Some think that 4 or 5% is too high. Computer analysis indicates that over the period from 1960 to 1994, with an all equity portfolio, a 4% payout yielded the highest after-tax income to the current beneficiary at the end of the period which seems to strongly confirm a 4% payout is a feasible payout for an all-equity portfolio, but the longer the period, the lower the optimum rate. Very significantly, New York's EPTL-SCPA Legislative Advisory Committee has issued a report recommending a 4% payout on a UniTrust basis with a three year smoothing rule as a new definition of "income" for future trusts if the trust instrument does not define it differently.

    WHAT TO DO WITH EXISTING TRUSTS

    Ideally, states will adopt statutory rules giving express authority for court reformation of income rule trusts into a TRU. This would allow trustees of existing trusts to invest for total return. The new statutory provisions could, with the consent of all parties, afford sufficient protection for all concerned by allowing a reformation to a conservative 4% payout UniTrust or, by Court Order, with perhaps a range of payouts of 2 to 7% depending upon the needs and goals of the trust.

    CONCLUSION

    The TRU enables an investment policy which increases overall return and allocates it more fairly between the current and remainder beneficiaries. Computer modeling of trust portfolios so that taxes, expenses, turnover, and other real world considerations can be factored into the trust's design has the potential of transforming the design and drafting of trusts. The impact of a given trust provision can be tested through numerous simulations. The asset allocation flexibility and stock pruning ability of a TRU trustee not only make it possible to provide a higher level of net after-tax income for the current beneficiary; they make it more likely that the needs and goals of all the beneficiaries - and the objectives of the grantor-client - will be met.

    Robert B. Wolf is a principal of Tener, Van Kirk, Wolf & Moore, P.C., Pittsburgh, PA. A.B., 1968, Yale University; J.D., 1971, University of Virginia. He is Vice Chairman of the Probate and Trust Law Section Council of the Allegheny County Bar Association. His article entitled Estate Planning With Retirement Accounts: Top Tax Tips and Traps for the Estate Planner appeared in the April 1992 edition of the Pennsylvania Bar Association Quarterly. The January 1996 edition of the Pennsylvania Bar Association Quarterly contains his later article A Living Will For The People-Allegheny County's Legal And Medical Associations Jointly Endorse A Uniform Advance Medical Directive. For the past two years he has written and spoken extensively on the subject of the design of a new generation of trust vehicle. His articles, Defeating the Duty to Disappoint Equally-The Total Return Trust, and Total Return Trusts-Can Your Clients Afford Anything Less, referenced in this article, constitute the seminal work in computer modeling and verifying the value of the Total Return Unitrust, which is producing national discussion. He is a fellow in the American College of Trust and Estate Counsel and has been listed in the book The Best Lawyers in America since 1993.

    Stephan R. Leimberg is CEO of Leimberg and LeClair, Inc., an estate and financial planning software company and President of Leimberg & LeClair, Inc., a publishing and software company in Bryn Mawr, Pennsylvania. He is the 1998 Edward N. Polisher Lecturer of the Dickinson School of Law, and recently co-authored, with noted attorney Howard Zaritsky, TAX PLANNING WITH LIFE INSURANCE: 2nd Edition, THE NEW BOOK OF TRUSTS - POST '97 TAX LAW with attorneys Charles K. Plotnick and Daniel Evans, HOW TO SETTLE AN ESTATE with Charles K. Plotnick, and THE LAWYER'S GUIDE TO RETIREMENT, 3rd Edition. Leimberg is creator of NumberCruncher '98, Business QuickView, and Estate Planning QuickView, and most recently, TOWARD A ZERO ESTATE TAX , a PowerPoint client- oriented estate planning seminar.

    A nationally known speaker, Professor Leimberg has addressed the Heckerling (Miami) Tax Institute, the NYU Tax Institute, the Notre Dame Law School and Duke University Law School's Estate Planning Conference, the National Association of Estate Planners and Councils, the AICPA's National Estate Planning Forum, and the ABA Section on Taxation.

    Endnotes:

    1.

    Studies show clearly that "If the goal is for the principal value of one's savings or the trust to keep up with inflation, the lower the equity mix, the less one can afford to pay out. And yet the accounting income available in the current market from the same investment mix appears to be exactly the reverse of what the trust can pay out and be able to retain its value. But this is precisely the instructions given the trustee by an income rule trust! The income rule trust approach is not just wrong - it is backwards!" "Over long periods of time, it appears that the amount which can be spent is in direct proportion to the percentage of equities and varies only a little bit depending on what periods are involved, provided the period is long enough to be fairly representative of the long-term markets." Robert B. Wolf, "Total Return Trusts: Can Your Clients Afford Anything Less?" 24 ACTEC Notes 45, 46 (1998). PNC Private Bank worked with Author Wolf in creating the computer programs to investigate and ultimately validate the concept and design of the Total Return Unitrust and has approved it as a favored trust design.

    2.

    Also called the Total Return Trust. Further information on the Total Return Unitrust can be found in outlines published by the Pennsylvania Law Institute and in Robert B. Wolf, "Defeating the Duty to Disappoint Equally - the Total Return Trust, 23 ACTEC Notes 46 (Summer 1997), and 32 Real Prop. Prob. & Tr. J 45 (Spring 1997), "Total Return Trusts: Can Your Clients Afford Anything Less?" 24 ACTEC Notes 45 (Summer 1998), 33 Real Prop. Prob. & Tr. J 1 (Spring 1998), William L. Hoisington, "Modern Trust Design: New Paradigms for the 21st Century, 5-5, 5-6 (Materials for Miami Tax Institute, January 1997); Joel C. Dobris, "New Forms of Private Trusts for the Twenty-First Century - Principal and Income, 31 Real Prop. Prob. & Tr. J.1 (Spring 1996); and R. Rosepink, "The Total Return Trust - Where and How to Tax Capital Gains", Trusts and Estates, October 1998, Pg. 12; Dan Rottenberg, "Liberated Trust: To Generate More Wealth and Reduce Family Tension, Opt for a UniTrust," Bloomberg Personal Finance, December 1998, Pg. 101.

    3.

    An exception applies in the case of marital trusts and is discussed below.

    4.

    Although the basic principal of the Total Return UniTrust and the Charitable Remainder UniTrust are the same, i.e., the current beneficiary's financial interest is tied to the ups and downs of the value of the trust so that an increase in overall value results in an increase in the amount paid out in a given year to the current beneficiary - and vice versa - the TRU is not subject to any of the onerous 5%, 10%, 50%, or 20 years tests or requirements imposed on split interest charitable transfers. And unlike a CRUT beneficiary, the current beneficiary of a TRU can enjoy the market's ride better with the three year smoothing rule, the trust equivalent to the invention of coil springs. The widespread beneficial use of CRUTs since their inception with the TRA of 1969 illustrates the benefits of trusts designed for total return. There is anecdotal evidence of private unitrusts existing during the same time period, only to become extinct during the bear market climate of the 1970's. Computer modeling has verified their long term viability, however, even in the 1970's, when stocks, bonds and cash all came up short against inflation. See the text at Notes 20 and 21,infra.

    5.

    This was not always the case. Prior to 1959, stock dividend yields exceeded bonds, but systemic inflation changed all of that.

    6.

    23 ACTEC Notes at 50, 32 Real Prop. Prob. & Tr. J. at 57.

    1. See Robert Freedman, Proposed New Prudent Investor Rule, Pa. B. News 10 (Sept. 23, 1996) and Restatement (Third) of Trusts (1990) and the newly revised Uniform Prudent Investor Act 7B U.L.A. 21 (West Supp. 1997) which provide that absent a trust provision to the contrary, a trustee must attempt to balance the interests of both the income and remainder beneficiary with as much impartiality as possible under the circumstances. Section 104 of the UP&I Act provides authority for trustees of existing trusts to adjust between principal and income to fairly allocate total return where the trust document doesn't provide the trustee with adequate discretionary power and the trustee is investing as a prudent investor. Specifically, the authors read the Act as allowing a trustee to recharacterize principal or adjust it so that - under appropriate circumstances - a certain amount of appreciation can be distributed as income. Likewise, to be fair and impartial to both parties, a trustee is allowed to accumulate income. Obviously, if impartiality is not an issue, the trustee can take appropriate steps in making recharactorizations to accomplish the grantor's intent under the economic conditions and investment alternatives available. Unfortunately, the trustee is left by the uniform law with little specific guidance. Merely because they don't have guidance as to when and how to use the Section 104 powers, trustees are not likely to use it. Indeed concern over Section 104 powers has held up adoption of the Revised UP&I Act in some states, and in others Section 104 has been removed. So the best course of action is for the planner to build in a trust design that takes into consideration the realities of the financial markets and changing tax laws, i.e., a total return unitrust model.
    2. In the classic "income rule" trust the rule "totally dominates the asset allocation policy" and results in the popular 60% equity and 40% fixed income mix in order to provide a reasonable level of accounting income and potential for growth. But one flaw of this mix, according to James P. Garland in the article "A Market-Yield Spending Rule for Endowments and Trusts" published in the Financial Analysts Journal of July/August 1989, is that the stock portion of the portfolio cannot rise fast enough in a significantly inflationary environment to make up for its bond component - which does not offset inflation at all. The result is an approach which "cannot tolerate even modestly high inflation." Id at 53. He makes two important additional observations, first a concern with the potential for volatility in the distributions and second, the fact that dividend yields seem to track inflation and seem to provide a "smooth" income stream
    3. See Leimberg, Plotnick, Evans, and Miller, 'The New Book of Trusts: Trusts after the 1997 Tax Law Changes", Leimberg & LeClair, Inc. (610 924 0515).
    4. From 1926 to 1997, inflation has averaged about 3.1 percent. During that time, the annual return of stocks, bonds, and Treasury Bills was:

    Large

    Capitalization

    Stocks

    Intermediate

    Government

    Bonds

    Treasury

    Bills

    Total Return 11%

    5.22%

    3.76%

    Inflation adjusted 7.9%

    2.12%

    .66%

    11.

     

    COMMON STOCKS AS BEST PERFORMING ASSET CLASS: 1926-1997

    One Year Periods - 65 Percent of the Time

    Five Year Periods - 84 Percent of the Time

    Fifteen Year Periods - 93 Percent of the Time

    Twenty Year Periods - 100 Percent of the Time

    12.

    23 ACTEC Notes 63-66, 32 Real Prop. Prob. & Tr. J. 90-95.

    13.

    Of course, the planner must take into consideration the objectives of the grantor and the family unit and weigh the relative importance of keeping payments to the current beneficiary adjusted for inflation or maximizing growth for the remainder beneficiaries. Dan Rottenberg, in "Liberated Trust: To Generate More Wealth and Reduce Family Tension, Opt for a UniTrust," Bloomberg Personal Finance, December 1998, Pg. 102, points out that the language in most trust documents reflecting an obsession with preserving principal at all costs is rooted in the agricultural 19th century when most trusts involved land rather than money. This is why most trust managers have attempted to gain safety by investing primarily in bonds.

    14.

    If the grantor-client's overriding concern is the financial welfare of the current beneficiary, planners should consider an indexed annuity trust.

    15.

    Discretionary trusts do make it possible to invest for total return because by definition the trustee has great flexibility in the decisions of what, when, and to whom to make distributions as well as the ability to vary the investment policy to the changing financial world and the circumstances and objectives of the family unit. As long as the family is comfortable with the actions of the trustee, the discretionary trust is highly desirable.

    16.

    E. James Gamble, president of the American College of Trust and Estate Counsel, is quoted as saying, "To qualify for the marital deduction, the trust must specify that the spouse receives the greater of either the income or the percentage share." See Lynn Asinof, "Estates and Trusts: A Special Summary and Forecast of Federal and State Developments", The Wall Street Journal, Sept 16, 1998, Pg. A1.

    17.

    Pruning entails the sale of just the right amount of securities to pay out the needed amount to meet the projected distribution level. This requires separate sales of securities in addition to the normal trust portfolio turnover. This complexity and cost has been factored into a computer model illustrating the advantages and impacts of a TRU. Wolf, supra n. 1, at 49-50.

    18.

    Readers will find that a TRU illustrating a total return of 8 % (dividends of 2 % and capital growth of 6%) and a 4% payout can actually distribute 24% more in after-tax distributions over a 16 year period than a taxable fixed income fund with the same pre-tax total return primarily because a significant portion of the proceeds of the "pruned" stock - particularly at the inception of the investment process - are a return of the grantor's basis and therefore can be recovered income tax free. Selective pruning, therefore, equates to tax efficiency and higher after-tax return. Incredibly, after 16 years, the trust balance is also 24% greater! See Wolf, 24 ACTEC Notes 47-48, 33 Real Prop. Prob. & Tr. J 7-8. Note, however, that the extent to which the double benefit of pruning, i.e., deferral and the shelter of basis, is available will vary depending upon the turnover of the portfolio.

    19.

    The difficulty with a strict UniTrust payout is that there is likely to be too much fluctuation in the payout. Although asset-based UniTrust formulas do - to some degree - self adjust during bull and bear markets - there is also a strong correlation between the rate of payout and volatility of distributions; higher distribution rates equate to greater volatility and a lower total return over a long period of time. The reason is that larger early year payouts result in a diminution in the power of compounding.

    Smoothing rules were first developed within the context of university budgets, which are highly inflexible and ill-suited to absorb significant swings in endowment income on a year to year basis. As a result, most schools have adopted some type of smoothing rule. Perhaps the simplest of these smoothing rules is to provide for a UniTrust payout over rolling averages of three to five years of UniTrust values. The use of a UniTrust payout based upon a percentage likely to be no more than the real return provides a sensible theoretical base for endowment spending. A number of prestigious universities use moving averages to smooth their endowment income. The payout tends to average between 4% and 6%. Yale University uses a smoothing rule that incorporates a target percentage of current market value and a spending component from the previous year's expenditures. See Wolf, note 1, 23 ACTEC Notes 57, 32 Real Prop. Prob. & Tr. J. 75.

    20.

    Review these simulation results at Table 6 of Wolf, supra n. 1 at 24 ACTEC Notes 63.

    21.

    Subject to the trustees discretion to distribute additional amounts as needed for the beneficiaries' health, maintenance and support. While the TRU method sets the trust on a course to maximize the trust's financial returns, there is no substitute for the trustee's judgment in response to human needs.

    22.

    It is possible to wear a UniTrust down but not out.

    23.

    An all equity credit shelter trust of $650,000 would have grown to $10,815,549 from 1960 to 1997 with a 2% TRU even after taxes and expenses.

    24.

    In return for these fees, trustees safeguard, invest, and distribute trust assets, prepare fiduciary income tax returns, and account for income and corpus to the trust's beneficiaries, taxing authorities, and courts. Trustee's fees include not only the safety of trust funds but as importantly the judgment of the trustee.

    The more often stock is bought or sold, the higher the transaction costs will be. This cost is determined by the investment style of the investment manager and by the per share costs of purchases and sales. A 1% "round trip" assumption for a purchase and sale is a low assumption for retail brokerage rates but high for an institutional investor where trades at 5 cents or less per share are typical.

    25.

    The more often stock is bought or sold, the higher the transaction costs will be. This cost is determined by the investment style of the investment manager and by the per share costs of purchases and sales. A 1% "round trip" assumption for a purchase and sale is a low assumption for retail brokerage rates but high for an institutional investor where trades at 5 cents or less per share are typical.

    26.

    Higher turnover equates to higher expenses. Turnover varies from about 5% in passively managed index funds to in excess of 100% per year for actively managed mutual funds according to the Consumer Reports article of May 1997 entitled, "Mutual Funds You Can Live With". The turnover rate of a portfolio is expressed by the decimal equivalent of the following fraction:

    Portion of Investments Bought & Sold During Year

    Total of All Investments

    The impact of these expenses is both observable and measurable.

    27.

    Taxes include capital gains and ordinary income. Consideration must also be given to the fiduciary income tax rules which accelerate the point at which higher rates are reached. The tax impact of turnover discussed above depends on such factors as (a) the tax bracket of the investor, (b) the type of entity (trust, estate, partnership, or individual), (c) cost basis, and (d) holding period. The effects of all these factors in combination must be examined over time. Capital gains taxes in an actively managed portfolio drive up expenses considerably and highlight the great importance of low turnover.

    28.

    Our computer modeling allows us to address such questions as: "How much can the trust pay out while fighting the ravages of long term inflation on current distributions and the overall principal in the trust?" "At what point will asset turnover seriously impact upon real returns?" and "How much fixed income investment can we afford to have in a long term trust?"

    29.

    Index payout trusts are most viable when market conditions and beneficiary expectations can be met with the payout rate close to the dividend yield from the portfolio's equities. Such trusts are highly effective where the risk to the portfolio is not too great.

    30.

    See Wolf, supra note 1, 24 ACTEC Notes 56, 33 Real Prop. Prob. & Tr. J. 30. Indexed payout trusts should probably be considered where the beneficiary's life expectancy is relatively short or where for some other reason (e.g. to provide an "essentials" level of support for a child but not to discourage incentive) the grantor's primary objective can be accomplished over a relatively short period of time and with relatively low payout rates.

    31.

    Reg. Sec. 1.643(a)-3(a) which states that a gain from the sale or exchange of a capital asset is ordinarily excluded from DNI (distributable net income) - unless such gains are allocated to income under either the terms of the governing instrument or local law, or they are allocated to principal and actually paid out to the trust's beneficiary during the taxable year, or utilized under the terms of the governing instrument or the practice followed by the fiduciary in determining the amount which is distributed or required to be distributed. There is some question as to whether or not a "specific event" or "economic substance" test is required to be satisfied to give an ordering rule effect. However, an express allocation of the necessary gains to income by the governing instrument should have the expected effect. Author Wolf intends to obtain a ruling to this effect. See also PLR 8728001 and Robert J. Rosepink, "The Total Return Trust - Where and How to Tax Capital Gains", Trusts & Estates, Oct. 1998, Pg. 12.

    32.

    Wolf, supra n. 1, Graph 3, 24 ACTEC Notes 60.

    ADDITIONAL REFERENCE LIST: "Prudent Investor Rule, Modern Portfolio Theory, and Private Trusts: Drafting and Administration, Including the 'Give-Me-Five' Unitrust," Jerry Horn - 33 Real Property, Probate and Trust Journal p. 1 (Spring 1998). "Sample Will Provisions for a Total Return Unitrust," Pam Schneider - handout materials at 1999 ABA-PTL Estate Planning Teleconference. "Using a Trust Protector in Asset Protection Planning" by Bill Ensing - Asset Protection Journal, p.1.

 

COMMON STOCKS AS BEST PERFORMING ASSET CLASS: 1926-1997

One Year Periods - 65 Percent of the Time

Five Year Periods - 84 Percent of the Time

Fifteen Year Periods - 93 Percent of the Time

Twenty Year Periods - 100 Percent of the Time

     

     

     

Prefers Investments in BONDS

Prefers Investments in STOCKS

 

 

 

 

 

 
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