Patti
S. Spencer, Esq.
Adam
R. Clark, Paralegal
SPENCER
LAW FIRM
2173
Embassy Drive
Lancaster,
PA 17603 (717) 394-1131 Fax:
(717) 431-3066
Adam@spencerlawfirm.com
Copyright
1999 Spencer Law Firm All rights reserved.
Patti S. Spencer, has practiced law
for twenty years with a concentration on taxation, estate planning
and closely-held business issues. A summa cum laude
graduate of Dickinson College, she received her J.D. and LL.M.
in taxation from Boston University School of Law. Ms. Spencer
is a member of both the Pennsylvania and Massachusetts bars.
She was a faculty member of the Graduate Tax Program at Boston
University School of Law and taught estate and gift taxation
from 1985-1992. She was also an adjunct professor in the J.D.
program at Boston University School of Law, teaching trusts
and estates and estate planning. Recently, she taught federal
taxation at Franklin and Marshall College. Ms. Spencer frequently
speaks at professional organizations and has published several
articles. A recent undertaking for her is writing a weekly
column in the Business Monday section of the Lancaster Intelligencer
Journal.
Prior to establishing her private practice,
Ms. Spencer held the position of Vice President and Manager
of the Personal Trust Department in a Lancaster, Pennsylvania
bank for more than four years. Since 1996 she has headed Spencer
Law Firm, which specializes in estate planning, probate, taxation
and closely-held business issues. When requested to serve,
Ms. Spencer acts as Private Trustee and/or Executor for informed
clients. Ms. Spencer also works as a consultant to other attorneys
and financial professionals, bringing to them extensive expertise
and experience in estate planning and taxation matters.
Adam R. Clark, paralegal, graduated
summa cum laude from the University of Maryland at the same
time he finished a 26 year career in management with PECO Energy.
Mr. Clark has numerous and varied responsibilities at Spencer
Law Firm including the overseeing of office technology, preparation
of tax returns, legal research, and document preparation. He
frequently assists Ms. Spencer in the preparation and delivery
of seminar presentations.
The information contained in these materials
is based upon sources believed to be accurate and reliable.
Reasonable care has been exercised to assure the accuracy of
the information. However, no representation or warranty is
made as to such accuracy. Readers should check primary sources
where appropriate and use the traditional legal research techniques
to make sure that the information has not been affected or changed
by recent developments.
TOTAL RETURN TRUSTS
Table
of Contents
I.
Statement of the Problem
II. The Solution.......
III Modern Portfolio Theory.........
IV Developments in Trust Law.............
V What to do?
VI What’s the number?......
VII Fees, Taxes and Turnover....
Sample Form - The Total Return Trust
I.
Statement of the Problem
A.
Much has changed in the world of trusts -
1.
Flooded with acronyms: QTIP’s, CRAT’s, QPRT’s, QSST’s, QDOT’s
and ILIT’s, much has changed
2.
Uniform Management of Institutional Funds Act
3.
Prudent Investor Rule - Third Restatement of Trusts
4.
Principal and Income Act
5.
Modern Portfolio Theory
B.
One thing hasn’t changed - Trustees are directed to hold the
principal and pay the income.
1.
Sometimes discretion to pay principal for minors
2.
Or sometimes principal discretion limited to an “ascertainable
standard” for health, maintenance and support.
3.
Depression era advice - “don’t spend the principal”
C.
Current trust drafting follows old rules, continues old conflicts,
and reduces returns
D.
Duty of impartiality to life beneficiaries and remaindermen
1.
“Yield” is considered to be current return, not including principal
appreciation
2.
Trustee is compelled to decided between higher yielding fixed
income investments, where neither the income nor principal is
likely to grow over the life of the trust, or equity securities
(stocks or mutual funds) with much lower current yields but
much greater long term returns both in principal and in income
3.
“[M]ost corporate fiduciaries are reluctant to invest less than
one-half of their long-term trust portfolios in equity securities,
simply because of the duty of impartiality and the historical
truth that fixed income investment yield dramatically less in
total return over long periods of time. With a 50/50 mix as
between stock and bonds, one is able to generate a net 3.9%
[1]
return currently, not enough to satisfy the income beneficiary,
and yet not enough of an equity mix to provide truly favorable
returns when compared with the Standard & Poor 500 average
over longer periods of time.”
[2]
4.
Unfortunately, income beneficiaries measure trust performance
by the amount of income received, and remaindermen measure performance
by the amount of principal appreciation. Consequently, BOTH
are often disappointed, “Leading to the conclusion that trust
funds do not do well, almost as if they were a separate form
of investment itself. As a result of the fact that beneficiaries
have these expectations, which are divergent and contradictory
from the point of view of the trustee, their expectations are
often disappointed and this, rather than any absolute performance
standard will be the measure of the success of the trust in
the eyes of the income beneficiary and the remaindermen.”
[3]
a.
Income beneficiaries compare to certificates of deposit or bonds,
remaindermen compare to the S&P 500 - both have to
be disappointed
b.
Small company stock
(1)
over long periods of time have significantly outperformed large
company stocks - from 1926 to 1995 with a compound annual growth
rate of 12.5% compared to large company stocks at 10.5%
(2)
same stocks which produce lower dividends - literally squeezing
them out of the trust investment portfolio because of income
beneficiary needs
E.
Traditional drafting - no instructions to Trustees as to how
much income to be produced: “Is it the trust document rather
than the investment manager, dictating investment returns?”
[4]
II
The Solution
- Modernize the dispositive provisions of trusts.
III
Modern Portfolio Theory
I
Total Return investing = investment of funds for maximum
return regardless of whether that return is in the form of accounting
income or appreciation in principal
A.
Need to preserve capital and income stream over a long period
of time has always been with us. Inflation, however, has not.
1.
1926 - 1940 – deflation
2.
1941 - 1947 - significant war-time inflation
3.
1950 - 1965 - very little inflation
4.
1965 - 1973, 1973 - 1975, and 1978 - 1981 - periods of inflation.
B.
Because of inflation, no longer sufficient to preserve the principal
value of a trust. It became important to preserve the “real”
value (after inflation) of assets. Studies of long terms returns
showed that only assets which represented ownership interests
in assets and income-producing property kept pace with inflation.
Hence, despite the volatility in the equity markets, equity
securities and real estate came to be favored as investments.
IV
Developments in Trust Law
A.
Third Restatement of Trusts - first stated the Prudent Investor
Rule
“227. General Standard
of Prudent Investment.
1. The trustee is under
a duty to the beneficiaries to invest and manage the funds of
the trust as a prudent investor would, in light of the purposes,
terms, distribution requirements, and other circumstances of
the trust.
a.
This standard requires the exercise of reasonable care, skill,
and caution, and is to be applied to investments not in isolation
but in the context of the trust portfolio and as a part of an
overall investment strategy, which should incorporate risk and
return objectives reasonably suitable to the trust.
b.
In making and implementing investment decisions, the trustee
has a duty to diversify the investments in the trust unless,
under the circumstances, it is prudent not to do so.
c.
In addition, the trustee must:
(1)
conform to fundamental fiduciary duties of loyalty (§170) and
impartiality (§183);
(2)
act with prudence in deciding whether and how to delegate authority
and in the selection and supervision of agents (§171); and
(3)
incur only costs that are reasonable in amount and appropriate
to the investment responsibilities of the trusteeship (§188).
d.
The trustee’s’s duties under this Section are subject to the
rule of §228, dealing primarily with contrary investment provisions
of a trust or statute.”
2.
Differences from prior law - Prudent person standard
a.
Prior law judged each investment separately, not on a portfolio
basis
b.
Duty to diversify is clearly stated.
c.
Delegation of investment and other functions is permitted so
long as done reasonably
d.
Cost control is required - argue against spending to try to
increase returns by timing or security selection
3.
Uniform Prudent Investor Act was adopted by the National Conference
of Commissioners on Uniform State Laws on August 5, 1994. Has
been adopted in Pennsylvania, New York, Massachusetts, Illinois,
Florida, Maryland, Virginia, Rhode Island, California, and some
others.
B.
Uniform Principal and Income Act - power to adjust between
income and principal - has been approved by the Uniform Commissioners
July 1997. (Last one was in 1962 and not adopted in PA). Purpose
is to update to take into account new forms of investment and
to reflect modern portfolio theory - to allow fiduciaries the
means to make the best investment decisions parallel with the
Prudent Investor Rules in the restatement and the Uniform Prudent
Investor Act
C.
Gives trustee power to adjust between income and principal.
Section 104:
1.
“(a) If a trustee who invests and manages trust assets
as a prudent investor determines that the trust instrument does
not contain discretionary powers of administration that are
sufficient to permit the trustee to comply with the duty to
pay due regard to the interests of income and remainder beneficiaries,
the trustee may adjust between principal and income to the extent
the trustee considers it necessary to administer the trust impartially
based on what is fair and reasonable to all of the beneficiaries
or to administer the trust to achieve the settlor’s intent if
the terms of the trust clearly manifest an intention that the
trustee shall or may favor one or more of the beneficiaries.”
2.
Many tax concerns
a. preserve marital deduction and gift tax exclusion
which are dependent on trust accounting income
b.
do not want to make trustee or grantor subject to grantor trust
rules
c.
do not want to give trustee power of appointment
d.
trustee would be permitted to release the power completely or
for a term
e.
§104(f) provides that the adjustment power would apply “unless
it is clear from the terms of the trust that the terms are intended
to deny the trustee this power of adjustment”
V
What to do?
A.
Do nothing?
“It is difficult
to make fundamental changes in the way documents are drafted.
Anything really new creates anxiety for the drafter. Trust
and estate lawyers being a rather conservative (some might say
stodgy) crew, they may well do nothing and continue to draft
as they have. If they do, though, they will destine many beneficiaries
and their families to disappointment. All the trustee can do
is to try to fulfill the duty of impartiality by disappointing
income and remainder beneficiaries equally.”
[5]
B.
Discretionary trusts
Allow trustee to
invest for total return and use discretion to invade principal
to pay a reasonable return to the income beneficiary. This
does not give direction to trustee on how to exercise discretion
nor give beneficiaries any basis for their expectations.
C.
Indexed Payment Trusts
Not workable because
inflation does not have a correlation with return. During a
period of high inflation, stock and bond markets adversely affected
and payout requirement goes up.
D.
Total Return Unitrust.
1.
Specific direction for an amount of payout removes the difficulty
of the duty of impartiality.
2.
Trustee can invest for total return
3.
The expectations of the income beneficiary in the first year
will always be met.
VI
What’s the number?
How to arrive at the percentage to be paid out.
A.
Smoothing Rule is needed
1.
Consider using a three-year rolling average to reduce volatility
of payout
2.
See Robert B. Wolf discussion
[6]
:
Assume trust created 71 years ago
- with same returns as S&P 500, with assumed 5% payout.
If 5% payout is simply 5% of fair market value at end of year,
there are 23 years in which there is a reduction in the distribution
and 14 years in which the reduction was over 10%. A beginning
market value of $100,000 grew to $4,800,464.
3-year rolling average produces a
smoother stream of distributions. There are only 13 years in
which there is a reduction in the distribution and only 7 with
a decline greater than 7%. Market value at the end is $5,217,253.
A 5-year rolling average
did not produce fewer years with a decline.
A 10-year rolling average did not
produce fewer years with a decline and substantially lowered
the payout to the beneficiary.
B.
Need to give trustee ability to change the rate if circumstances
change
C.
Tax aspects
1.
Marital Deduction
a.
Add language to make sure that the distribution is at least
all of trust accounting income.
b.
Add language to permit surviving spouse to direct conversion
of unproductive property
2.
Stock pruning and capital gains tax
a.
In early years - with recovery of basis, very low effective
rate of tax. Eventually would approach the long term capital
gains rate - 20%
b.
Equities generally tax favored. Even if have to sell at the
end of the trust. (If a marital trust includible in the surviving
spouse’s estate, the gain is never taxed.) See 3 spreadsheets
on following pages.
c.
Treas. Reg. §1.643-(a) - 3(a) ordinarily excludes gains from
DNI - but permits their inclusion if allocated to income under
the terms of the instrument. There is a ruling request pending
on this issue.
VII
Fees, Taxes and Turnover
- all reduce returns in the real world
VIII
Modern Portfolio Theory II
A.
Diversification
1.
Central concept = a particular investment is valued as a function
of its risk and reward.
2.
Risk is defined as variability of total return (both income
and principal appreciation or depreciation). The volatility
is the frequency and amplitude of return variation.
3.
In general, the higher the risk, the higher the return because
the investor sees volatility as a negative that must be balanced
by a higher reward.
4.
Diversification - create lower risk without necessarily lowering
expected return.
5.
Modern portfolio theory looks at an investment in the context
of the whole portfolio, as it may increase return or decrease
risk for the whole portfolio. This has not been the historical
approach of fiduciary law, where each investment is looked at
on its own.
6.
Individually risky investments may in combination actually lower
the overall risk of a portfolio - many investments show a negative
co-variance.
B.
Asset Allocation
1.
The overwhelming contribution to return performance related
to the allocation of the assets to particular classes, and specifically
to the portion of the portfolio allocated to common stocks.
[7]
2.
In an update to their article, they conclude that 91.5% of the
variation in quarterly return is due to investment policy reflecting
overall asset allocation in the portfolio, with only a few relatively
small percentage points attributable to stock selection or active
portfolio management.
[8]
3.
Stocks - since 1926 have highest average returns of any asset
class
This Sample Form is taken from Robert B. Wolf,
“Defeating the Duty to Disappoint Equally - The Total Return
Trust”, ACTEC Notes, Volume 23, No. 1, Summer 1997
Sample
Form - The Total Return Trust
II.
I give the residue of my estate to my trustee to hold as the
Residuary Trust under the following provisions:
A.
During Spouse’s Life. My trustee
shall pay the distribution amount set forth below to or for
the benefit of my ___________________ during h___ life, in quarter-annual
installments.
B.
B. Distribution Amount.
The trustee shall pay to my______________ in each tax year of
this trust during h___ life an amount equal to five (5%) percent
of the average of the fair market values of the trust as of
the close of the last business day of the trust’s three previous
tax years (or such lesser number of tax years as are available
for the first three tax years of the trust). In the case of
a short tax year, the distribution shall be calculated as set
forth in subparagraph C below. In the case of contributions
to or distributions from the trust, including the initial funding,
the distribution amount shall be determined as set forth in
subparagraph D below.
C.
C. Short Year. For
a short tax year, the distribution amount shall be based upon
a prorated portion of the distribution amount set forth above,
comparing the number of days in the short tax year to the number
of days in the calendar year in which the short tax year is
a part.
D.
Contributions and Distributions.
In a tax year in which assets are added to or distributed from
the trust (other than the distribution amount)(hereinafter an
“adjustment year”), the distribution amount shall be increased
(in the case of a contribution) or decreased (in the case of
a distribution) by an amount equal to five (5%) percent times
the fair market value of the assets contributed or distributed
(as of the date or dates of the contribution or distribution),
multiplied by a fraction, the numerator of which is the number
of days from the contribution or distribution to the end of
the calendar year and the denominator of which is the days in
the calendar year. Further, the year end values for the two
tax years preceding the adjustment year shall be increased by
the amount of such addition, or decreased by the amount of such
distribution, for purposes of determining the distribution amount
for years following the adjustment year.
E.
[Insert for QTIP and re-letter subparagraphs.] If in any tax
year of the trust the net income of the trust exceeds the distribution
amount, such excess net income shall be distributed to my _____________________
at least annually.
F.
Computing Fair Market Value. All
computations of the trust’s fair market value, or the value
of any contributions or distributions as set forth above, shall
include accounting income and principal, but no accruals shall
be required. If the trust includes assets for which there is
not a ready market, the trustee shall adopt such method of valuation
as the trustee deems reasonable in its discretion under the
circumstances.
G.
Estate Income Prior to Funding Trust.
In addition to the distribution amount as determined above,
the net accounting income earned in my estate and allocable
to the residue shall be paid to the trust, and distributed to
my ________________ in addition to the distribution amount set
forth above.
H.
Source of Distributions. The distribution
amounts from the trust shall be paid first from net accounting
income, next from net realized short term capital gains, then
from net realized long term capital gains, and as necessary
from the principal of the trust.
I.
Discretionary Distributions.
In addition to the distribution amounts as set forth above,
my trustee shall distribute such additional amounts, if any,
of accounting income, capital gain, or principal to my said
___________________ as the trustee deems advisable for my_________________’s
health, maintenance, and support in h____ accustomed standard
of living, taking into account other income or assets which
are available to h___. (Comment: Discretionary distributions
may be advisable for the same reasons as they are in any trust.)
J. Death of a Spouse. On
the death of my ___________________, the trustee shall distribute
the balance in said trust to my then living issue, per stirpes,
subject to the trust continuation provisions hereinafter.
K.
Goals of Trust; Trustee’s Power To Alter Distribution
Rate. The goal of this trust is to provide
a relatively smooth flow of distributions to my _____________,
which distributions over the anticipated term of the trust may
maintain to the extent practicable their real spending power
after inflation. A second goal is to maintain the real spending
power of the principal of the trust for the remaindermen. It
is my intent by using this total return trust, which does not
distinguish in investment goals (or distributions) [DELETE
FOR QTIP] between the production of income and short and long
term capital gains, to eliminate any conflict which the trustee
might otherwise experience between attaining the two goals set
forth above. I have set the distribution rate at five (5%)
percent based upon my hope that over long periods of time this
distribution rate can be maintained and still have the distributions
increase sufficiently to offset inflation. If this goal is
achieved, the principal of the trust will also have maintained
its value. I recognize that these goals will not be attainable
every year, and may not even be attainable over the term of
the trust. I accept that the setting of the five (5%) percent
distribution rate is my own decision and recognize that the
two goals set forth above may not be attainable even if my trustee
acts with reasonable prudence. As a further safeguard, if the
trustee becomes convinced that the goals as set forth above
cannot be attained as a result of substantial and long term
changes in the investment marketplace because of inflation,
deflation, or other secular economic change which would make
advisable a change in the percentage distribution rate used
for determining the distribution amount, then my trustee shall
have the discretion to modify such rate as my trustee may deem
necessary. Such a change in rate will be within the sole discretion
of my trustee given the investment and distribution goals for
this trust. My trustee shall not be held accountable for such
discretionary act by any party provided that the trustee has
acted in good faith. [N.B. Trustee must be independent to
insert this power.]
VI.
Executors’ and Trustees’ Powers. In addition
to the powers conferred by law, my executor with respect to
my estate, and my trustee with respect to any trust, shall have
the following powers, to be exercised in their absolute discretion
without the necessity of application to any court, in the capacity
to which such powers may be applicable; [optional] except
that they shall have no power as to the Marital Trust which
would disqualify it for purposes of the marital deduction:
[CUSTOMARY
PROVISIONS OMITTED]
*
* *
__To invest in any type of investment
that plays an appropriate role in achieving the investment goals
of the trust, which investment shall be considered as part of
the total portfolio. It is my specific direction that no category
or type of investment shall be prohibited. I specifically do
not wish to limit the universe of trust investments in any way
other than is dictated by the trustee’s exercise of reasonable
care, skill, and caution. In connection with the trustee’s
investment and management decisions with respect to this trust,
the trustee is specifically entitled to take into account general
economic conditions, the possible effect of inflation or deflation,
the expected tax consequences of investment decisions or strategies,
the role which each investment or course of action may play
within the overall trust portfolio which may include the financial
assets, interests in closely held enterprises [NOTE - CONSIDER
VALUATION PROBLEMS HERE] tangible and intangible personal property,
and real property; [NOTE - VALUATION PROBLEM] the expected total
return from income and the appreciation of capital; other resources
of the beneficiaries, the needs for liquidity, regularity of
income and preservation or appreciation of capital, and the
asset’s special relationship or special value, if any, to the
purposes of the trust or to one or more of the beneficiaries.
Nor shall my trustee be limited to any one investment strategy
or theory, including modern portfolio theory, the efficient
markets theory, or otherwise, but my trustee should be free
to consider any appropriate investment strategy or theory under
all the circumstances.
__ Delegation. The trustee
may delegate investment and management functions which a prudent
person of comparable skills would properly delegate under the
circumstances. Should the trustee delegate such function, the
trustee shall exercise reasonable care, skill, and caution in
selecting an agent, establishment the scope and terms of the
delegation consistent with the terms and purposes of the trust,
and periodically reviewing the agent’s actions to monitor performance
and compliance with the terms of the delegation. Should such
delegation occur as set forth above, the trustee who complies
with the requirements for delegation shall not be liable to
the beneficiaries or to the trusts for the decisions and actions
of the agent to whom the function was delegated, but by accepting
the delegation of a trust function by the trustee of this trust,
the agent submits to the jurisdiction of the courts of this
state. [Insert for QTIP] Should the trustee invest in property
that is unproductive, my spouse shall have the right to require
the trustee to convert the same into productive property within
a reasonable time.
(Comment: Note that much of the foregoing comes
from the Uniform Prudent Investor Act.)
*
* *
__ The corporate trustee, acting
alone and in its sole discretion, shall have the power to reform
this instrument, with or without court order, to make any changes
necessary so as to preserve and make the best use of the
marital deduction for federal estate tax purposes and the exemption
from generation-skipping transfer tax. Any provisions of
the will shall be interpreted or reformed so as to preserve
these benefits wherever possible, provided that such interpretation
or reformation does not do violence to my primary intent to
provide for my spouse and my children.
