A Professional's Simplified Guide to TRUs

Stephan R. Leimberg

TABLE OF CONTENTS

INTRODUCTION........................................................................................................................ 1

WHAT'S WRONG WITH WHAT WE'VE GOT NOW? ............................................................ 2

TIME FOR A REALITY CHECK  ............................................................................................... 4

ENTER THE TOTAL RETURN UniTRUST (TRU) ................................................................ 5

ARISING TIDE INVESTMENT PHILOSOPHY ........................................................................ 6

TRU ADVANTAGES ................................................................................................................... 6

PRUNING:   NOT JUST FOR TREES...................................................................................... 8

BUT HOW IS THE TRU IN DOWN MARKETS?...................................................................... 8

THE MOST IMPORTANT BYPRODUCT!.................................................................................. 8

ARE TRUs THE PERFECT TRUST?........................................................................................ 9

WHAT'S THE ARIGHT PAYOUT RATE?................................................................................... 9

CAN EXISTING TRUSTS BE CONVERTED INTO TRUs?.................................................. 10

CONCLUSION............................................................................................................................ 10

WHERE CAN I LEARN MORE?................................................................................................ 10              

TOTAL RETURN UNITRUSTS
THE NEW CAPITAL NEEDS FULCRUM

INTRODUCTION

The threat of repeal or significant modification of the transfer tax system should be sufficient warning that Athe times they are a changen.  Although I predict that estate liquidity will remain an important reason for the purchase of large amounts of life insurance, I strongly suggest that regardless of whether there is repeal or modification in the transfer tax system, planners begin to place more focus on other needs-based planning as well.

One way to do just that is to illustrate how much it really costs to live and how little income - net after taxes, inflation, trustee's fees, and turnover (securities sales costs) -  is produced by the assets in today's often antiquated trusts. 

That's right!  The capital necessary to maintain the high standard of living that many folks now want their families to have will cost much more than they expect. 

And all too often, the type of trust they have isn't helping one bit.

It's time for many of our clients to consider a new type of trust, one which will eliminate or minimize many of the shortcomings of the old style trusts and maximize the trust's total return.  Attorney Bob Wolf of Tener, Van Kirk, Wolf & Moore, P.C., Pittsburgh, PA. and I have named this trust for the new millennium the TRU.  That stands for Total Return UniTrust.  We feel that, among other things, it's a model which could provide greater returns for both the current and remainder beneficiaries.

WHAT'S WRONG WITH WHAT WE'VE GOT NOW?

Before we get into what the TRU is, how it works, and why it's essential that every financial services professional understands its pros and cons, let's examine the types of trusts many of our clients have right now. 

The odds are high that most of your clients' trusts are Aincome rule trusts: It is an income rule trust if the document essentially provides:

ATo my wife (husband) for life, then (at her/his death) to my children. 

In such a trust, the surviving spouse receives all (but only) the income while the remainder (capital) passes at her/his death to the next generation, a class called the remaindermen.

Now imagine you are the trustee of this very typical trust.  Your client has died.  There's a million dollars of cash in the trust.  And you have to invest it.  The matrix below shows the typical Agame plan:

As trustee

Do you make the surviving spouse happy - by purchasing assets such as bonds which will produce the maximum possible current income (but essentially no growth)?

Do you make the remaindermen happy - by purchasing stock which will produce the maximum possible long-term growth (but produce essentially no current income)?

Do you try to make both parties happy - by purchasing - half stock and half bonds (which cut the income in half and cut the growth in half)?  

This is exactly the nightmare many investment decision-makers face daily:   Restricted by the old style so-called Aincome rule trust document, today's trustee has a Hobson's Choice: invest to maximize income - and by doing so alienate the remainder beneficiary who seeks the largest possible capital growth or 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.  Of course, the trustee could try the third approach, try to please both by a more or less middle-of-the-road approach which typically results in insufficient income and mediocre and unsatisfactory capital appreciation - which pleases neither party. 

The income rule trust (as common as it is) all too often creates a diametric opposition, an antagonistic tension that by definition threatens to put the key parties to the trust - the current beneficiary, the trustee, and the remainder beneficiaries, at each other's throat.  An all too common result is the frequent mistrust, acrimonious communication, discharge, or attempted surcharge of the fiduciaries and investment team, and a polluting of the investment climate.

TIME FOR A REALITY CHECK 

I'm going to use Arough and Arounded numbers here to make it easy to illustrate my point:  Interest rates and dividend yields have continued to hover at near their lowest points in history; 30 year Treasury notes are currently producing only slightly better than roughly 5.8 percent; while the average dividend yields are currently at around 1.2 percent. (Statistics courtesy FaxNet: 610-527-5216 and are also archived at leimbergservices.com.)

Assume a trust with $1,000,000 of investable assets and of that $650,000 is invested in equities and $350,000 in 30-year Treasury Bonds based on the traditional 65/35 investment mix.  Think about what this produces:  The $650,000 in equities is likely to produce less than $7,000 (1.2% X $650,000 ' $7,800 reduced further by trustee's fees and income taxes).  The T Bonds - after trustee's fees and taxes - will generate much less than $20,000 (5.8% x $350,000 ' $20,300), a total of SPENDABLE INCOME OF  SIGNIFICANTLY LESS THAN $30,000 A YEAR! 

Stated another way, under the classic trust approach and today's market conditions using the traditional investment mix, each unit of $1,000,000 will generate not even $30,000 a year of truly spendable income!

Worse yet, the more bonds in this portfolio, the less growth - and the less purchasing power the portfolio will have over a long period of time.  Bob Wolf's 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.

The more equities in the portfolio, the less income. For example, if the entire $1,000,000 is invested in equities, the current beneficiary would receive about $12,000 gross - but after payment of trustee's fees and income taxes closer to $10,000! This analysis would cause many  current beneficiaries a heart attack.  If the entire $1,000,000 is invested in fixed income assets, the current beneficiary could receive around $58,000 but that's gross -  before trustee's fees and taxes - and would totally sacrifice long-term growth. 

There's another factor to consider.  Under state trust law, a trustee has a fiduciary duty of impartiality toward current and remainder beneficiaries.  So it's not really likely that a trustee would invest the entire amount in either bonds or stocks.  To be truly impartial,  given the impossibility of finding an Aideal investment mix (one generating  both adequate income and reasonable growth), the trustee would have to purchase approximately equal shares of both bonds and stocks.  And although this may seem impartial, it's more than a little impractical - since it solves neither class of beneficiary's problem.

What we know in real life is that (a) most trusts are intended to last for a term of more than 10 years, (b) many trusts are intended to last for one or more lives, (c) some trusts are created to last for a dynasty, and (d)  the longer the investment horizon, the more likely common stocks will out-perform other investments.

Yet another but almost invisible problem is the disparity between how the income and remainder beneficiaries are treated for tax purposes.  Income generated by interest, dividends, or rents paid to the income beneficiary is taxed at rates of up to 39.6 percent.  Capital gains, when trust assets are sold and the principal is distributed to the remainder beneficiaries, is  favored with a maximum rate of only 20%.

So in every respect, the classic trust design - the one that so many clients (including most of your clients I'd bet) have - is flawed.  Trustees are thwarted by this Ahold the principal and Apay the income investment constriction from investing in the best interests of both classes of beneficiaries and maximizing the full tax and financial utility of every dollar of trust assets.

ENTER THE TOTAL RETURN UniTRUST (TRU)

You already know the model upon which the TRU is based.  It's called the CRUT, Charitable Remainder UniTrust.  As you know, the CRUT is sort of a growing - or shrinking - pie. There are two parties to the CRUT, the annuitant and the remainder beneficiary.  The annuitant receives an annuity which grows (or shrinks) according to the value of the whole Apie:  For example, if you were a 5% beneficiary and the trust was worth $1,000,000 in year one, you'd receive 5% of $1,000,000, or $50,000.  If the trust value was $500,000 in year two, you'd still receive 5% - so you'd receive 5% of $500,000, or $25,000.  If in year three the trust was worth $2,000,000, your 5% annuity would pay you 5% of $2,000,000, i.e., $100,000.  When you die, the CRUT pays the remainder - whatever it's worth - to the designated remainder beneficiary, a charity.

The TRU's basic operating formula is similar (but without all the complex and harsh CRUT minimum and maximum payout rules.  The current beneficiary receives an income not based on what the assets in the trust produce, but based on a percentage of the value of the trust.  So when the trust increases in value, the payments to the current beneficiary increase - as does the value to the remainder beneficiaries.

The TRU is an express non-charitable UniTrust. The design of the TRU is intended 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.  The TRU requires a payout at least once each 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. 

Typically, to Adampen and smooth out the impact of a Adown or Aup year in the market, the TRU will base its payout on a three-year period.   Bob Wolf calls this a three-year Asmoothing provision and, as noted, it enables a TRU to eliminate or dampen the impact of temporary dips in the market and the consequent volatility of the amount paid to the current beneficiary from year to year. 

Note that the TRU is required only to pay out the specified percentage.  Unless the TRU is also a marital trust (which it can be and in which case is required to pay all income, annually or more frequently), it is not required to distribute all the income it earns.  This means that in a year in which the income produced by trust assets is greater than the percentage amount that is required to be distributed to the current beneficiary, the excess can be accumulated.  This accumulation has the long-term effect of benefitting both current and remainder beneficiaries.

ARISING TIDE INVESTMENT PHILOSOPHY

The TRU follows the modern portfolio theory that 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 that benefits both current and remainder beneficiaries by placing both parties in the same investment boat.  Both sets of beneficiaries benefit from an increase in the overall value of the trust - and neither cares about the source of that good fortune.  This makes it easier for the investment advisor to invest for total return.

TRU ADVANTAGES

A TRU provides many advantages to all parties:

$                   Both classes of beneficiaries quickly see why a Atotal return  investment philosophy (i.e., maximizing income plus growth in the overall long-term value of the trust's assets) benefits them.

$                   It is easier to make investments since both key parties have similar interests.  This allows the trustee to base investment decisions on the needs and risk tolerances of the beneficiaries, and  restore asset allocation to its proper place in investment planning.

$                   The potential for bickering and acrimony between the current and remainder beneficiaries (and both parties with the trustee) is significantly diminished, and impartiality can co-exist with maximization of total return.

$                   In a Adiscretionary trust one where the trustee is given absolute and total discretion to Aspray capital and Asprinkle income among beneficiaries, and 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.  (It is possible to give a TRU trustee discretion over and above the mandated TRU payout and thereby introduce an additional layer of flexibility and protection for the current beneficiary.)

$                   A fully discretionary trust can not be used where the marital deduction is required because of the requirement that the trust MUST mandate the payout of all income annually or more frequently to the surviving spouse..  One the other hand, as noted above, the TRU can be structured to qualify for the marital deduction.

$                   A TRU reduces both 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 as well as 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.

$                   Current beneficiaries find it easier to plan because they can calculate, at the beginning of each year, their cash flows.  This leads to more effective financial planning.

PRUNING:   NOT JUST FOR TREES

Bob Wolf, in his comparison of the tax impact on beneficiaries of the classic trust with the TRU realized that, through a process he called  Apruning and I call Acherry picking, that he could save thousands of tax dollars for the current beneficiary. 

Pruning (cherry picking) is supplementing current yield with the judicious sale of a sufficient number of shares of an equity security to match the desired payout to current beneficiaries.  In other words, suppose a TRU was mandated to pay out 4 percent of its $1,000,000 value.   Assume the TRU actually produced only $3,000 of Aincome.  Bob Wolf suggests that the $1,000 shortfall be made up by selecting and selling off a small portion of the trust's stocks, preferably high basis assets. 

The result is that more of each payment to the current beneficiary will consist of capital gains and to some extent non-taxable return of cost basis rather than the ordinary income that income beneficiaries of traditional trusts must report.  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-taxable payments from the classic trust.

BUT HOW IS THE TRU IN DOWN MARKETS?

Bob Wolf's computer modeling has shown that the TRU is viable even in Adown markets, and can actually increase returns by making a more favorable asset allocation possible, and by dollar averaging in bull and bear markets.  His computer simulations start at the worst possible time in modern history, January 1, 1973, the beginning of the longest bear market since the Great 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 increased its distribution every year for 21 straight years and end the year 1997 with twice the market value and twice the payout of a 60/40 income rule trust.  By smoothly and automatically reducing the payout, the TRU protects the trust from excessive damage in an extended bear market, an important protection.

THE MOST IMPORTANT BYPRODUCT!

Bob Wolf's computer modeling showed me the future - and the nexus of TRUs and sophisticated capital needs planning.  Through his modeling, it will soon be possible for  planners to 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 - and vastly underappreciated cost of trustee's fees, transaction costs, and portfolio turnover as well as taxes and inflation. Most professionals have not begun to realistically net these costs out and take them into consideration when assessing a client's capital (and therefore life insurance) needs. All too often, whether or not a trust is used, the real financial security - and future living standard of the survivors of today's high income client--is no where near what either the planners or the client thinks it is!

Wolf's computer modeling of historical markets and portfolios should also make it possible to customize and 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 multiple of scenarios properly focuses new attention toward the satisfaction of the human needs of clients, and away from the single-minded obsession of practitioners on the minimization of death taxes.  This is a very important aspect of the shift in paradigms!

ARE TRUs THE PERFECT TRUST?

Of course, TRUs are not a trust for all seasons - or all clients.   Like every other tool or technique, they have downsides and costs.  Typically, they are not indicated if the sole asset to be placed into the trust is unproductive real estate or a family business.  And because TRUs are not common, we don't have sufficient cases to understand fully how IRS and the courts will treat them.

In many cases, TRUs will not replace but rather serve to supplement and compliment other types of trusts. In fact, having broken the mold, planners should regularly think in terms of mixing and matching trusts to accomplish a number of objectives for a given family unit.

WHAT'S THE ARIGHT PAYOUT RATE?

Bob Wolf's 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.  Combining what I've learned from him and the other authorities in this field (you'll find a number of articles and a sample TRU document at http://www.leimberg.com), my feeling is that a rate of 3.5% to 4.5% will work well in many situations. 

I suggest a higher payout rate be considered if the client's primary objective is to favor the current beneficiary (e.g. a spouse), while a lower payout rate should be considered where the client's  primary objective is growth and the financial enrichment of remainder beneficiaries is a priority.  For example, a 2.5 to 3.5% payout might be indicated in an ultra-large dynasty trust.  A rule of thumb for planners is that, the more conservative (less stocks) the investment mix, the less the trust can payout and keep pace with inflation!

New York's 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 Aincome for future trusts if the trust instrument does not define it differently. 

CAN EXISTING TRUSTS BE CONVERTED INTO TRUs?

Some states are now adopting 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 percent depending upon the needs and goals of the trust.

CONCLUSION

The TRU enables an investment policy which increases a trust's 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 Apruning ability afforded 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 nontax objectives of the grantor-client - will be met.

WHERE CAN I LEARN MORE?

You'll find extensive free information on this most important trust development at http://www.leimberg.com on the far right hand side under TRUs.  There are extensive articles and outlines by attorneys Mark Edwards, David Diamond, Michel Nelson, and Bob Wolf and myself as well as links to articles by reporters James Dam (LAWYERS WEEKLY) and Carrie Coolidge (FORBES).  Information on other types of trusts can be found in THE NEW NEW BOOK OF TRUSTS (610-924 0515).