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Slowly but surely trust law is catching up with Modern Portfolio Theory, although by the time it does, the theory
may not be "modern" any more. "Modern Portfolio Theory" as most all advisors know, is based on the idea
that the most important consideration in portfolio management is "total return", which includes dividends,
interest, capital gains (short and long term) and investment appreciation (or depreciation). This approach
became popular in the decade of the 90's because of stock market appreciation.
Trust Accounting. Historical trust accounting has been cost and cash based. Assets are valued at cost (or
value when the trustee takes title), not current market value. Trust investments are treated as "principal",
"Income" is usually interest and dividends actually received. This concept of "income" is carried over into the
tax law, particularly as it relates to the taxation of trusts and trust beneficiaries and qualification of particular
trusts for the Marital Deduction. Beneficiaries who are entitled to receive "income" from trusts, were often
dissatisfied in the 90's when trust assets were appreciating in value faster than the interest and dividends
being received, and are even more unhappy with current interest rates at historically low levels.
Trustees, over the years, have had to pay attention to what is "income" for the benefit of the income
beneficiaries and what is "principal" , benefitting the remainder beneficiaries. They have also had to be
mindful of allocation of expenses between income and principal to make sure that the trust document and
trust laws were being complied with. Naturally, trustees felt a divided loyalty between these classes of
beneficiaries, selecting investments that showed promise of capital appreciation versus investments which
paid high current interest and dividends, but offered little or no prospect of appreciation. For example, a ten
year government bond may yield a current return of 4.4%, but at the end of ten years, the trust has only the
principal remaining. If the entire interest is distributed to the income beneficiaries, the principal remaining at
the end of the ten years, after inflation, will have declined in real value.
Enter the Total ReturnTrust. A logical solution to these contradictory forces has been the "Total Return Trust"
by which the current distribution to the so-called "income" beneficiaries is framed in terms of a fixed
percentage of trust assets (specified by the trust document), or a distribution within a range to be selected by
the trustee, according to market conditions and the total return of the trust portfolio.
Legislation has been passed in several states defining how the "current return" will be determined, usually
establishing a range to be selected by the trustee. For example, this may permit the trustee to distribute 3.5%
of the trust principal per annum, depending on the total returns of the trust portfolio. The objective is to
preserve the after tax and inflation value of the principal, while at the same time providing a reasonable return
to the "income" beneficiaries.
In some states this legislation has permitted trustees to retroactively designate the selected payout as
"income", within the terms of the existing trust, without the necessity of a court order or trust reformation.
Michigan has not yet adopted a "total return" statute, but a revision and update of the Uniform Principal and
Income Act is now under active consideration here in Michigan.
Dollars and Sense. This is not an academic problem. It impacts all trusts and beneficiaries. It can affect the
dollars in a beneficiary’s pocket (or lack thereof), which is enough to get and keep their attention. Trust
drafters have often thrown the decision making on to the trustee, forcing the trustee to balance investments
between income producing and growth investment. This can lead to a lot of arguments and lawsuits.
Michigan has gone part-way with the Michigan Prudent Investor Rule, which requires trustees to follow a
process in analyzing a total portfolio in terms of risk tolerance, expected return and the balancing of the
interests of various beneficiaries. A "total return" trust makes that job easier.
Solution. The solution to the dilemma of trust investments and allocation of trust return between the current
beneficiary and the remainder beneficiary is really a specification of what is a reasonable, annual payout to an
income beneficiary, considering preservation of the value of trust principal. If inflation is 2.5% per year on
average, that amount of appreciation in principal value would be needed to protected the interests of the
remainder beneficiaries. On the other hand, should the current living budget of the income beneficiary be
impacted by wide swings in trust distributions? The solution is specifying an annual percentage distribution
to the income beneficiary, or permitting a trustee to select such distribution within a range, for example, 3.5%
-5% per annum, depending on the trust’s total return.
Is This a Real Problem? Many Marital and Family Trusts are drafted to last for years. A surviving spouse may
live 20 years or more after the first spouse dies. The children may wait a long time for their inheritance. If the
surviving spouse is the parent of the children, there is more likely to be harmony and understanding.
However, if the surviving spouse is a step-parent, or if the surviving spouse remarries, the situation is
different. As we live longer and second, third or even fourth marriages become more common, you will see
more and more arguments about trust investment and administration. Do what you can to make sure that
your clients give these matters serious thought and anticipate the challenges that come from changes in the
investment climate, tax laws and personal needs.
©BRANDT, FISHER, ALWARD & ROY, P.C.
This newsletter is provided for informational purposes and should not be acted upon without professional
advice.
| WEALTH CONSERVATION: PROFESSIONAL ALERT Brandt, Fisher, Alward & Roy, P.C. |
| September 2003 TOTAL RETURN TRUSTS by James R. Modrall III, J.D., C.P.A. |
| If you would like to receive future editions of the monthly Wealth Conservation Newsletter directly to your e-mail account, please e-mail our office using the following link: Estate Planning Newsletter |
| Brandt, Fisher, Alward & Roy, P.C. Attorneys at Law |