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TOTAL RETURN TRUSTS

Trusts in the New Millennium

Presented to

Pennsylvania Institute of Certified Public Accountants
Estate & Personal Financial Planning Conference

November 11, 1999

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.

[1]            6.5% + 2.0%/2 = 4.25% less .35% trustee's income compensation.

[2]            Robert B. Wolf, "Defeating the Duty to Disappoint Equally - The Total Return Trust",  ACTEC Notes, Volume 23, No. 1, Summer 1997, p. 47

[3]            Ibid.

[4]            Ibid at 48.

[5]            Ibid.,  p. 56.

[6]            Ibid., p. 57.

[7]            Gary Brinson, Brian Singer, and Gilbert Beebower, Determinants of Portfolio Performance, Financial Analysts Journal (July/August, 1986).

[8]            Gary Brinson, Brian Singer, and Gilbert Beebower, Determinants of Portfolio Performance II: An Update, Financial Analysts Journal 40 (May/June, 1991).

 
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