Keeping the Peace Between Trust BeneficiariesMarch 2014
Trust beneficiaries with differing financial needs often face an inherent conflict of interest regarding the investment management goals of their trust. This conflict has been exacerbated over the past five years by the persistent low-yield environment, which has reduced the level of traditional income that trust portfolios have been able to generate.
Our Fiduciary Trust Forum members discuss how beneficiaries’ competing goals may be addressed by exercising the ‘power to adjust’ distributions between income and principal.
Q. Why are many beneficiaries facing conflicts of interest over the investment management goals of their trusts?
Gail: The investment goals of a trust can have a significant impact on all beneficiaries. Many trusts are structured so that current income beneficiaries receive the income generated from a trust, and the remainder beneficiaries ultimately receive the principal and any capital appreciation at the end of the trust’s term.
This structure often creates an inherent conflict of interest among beneficiaries since income beneficiaries typically have expectations for generous current income, which, in more normal times, could be secured with a heavier weighting of higher income-producing investments such as bonds. Remainder beneficiaries often have expectations for maximum asset appreciation through a high allocation to growth securities, regardless of the income they generate.
These conflicts can be aggravated by the terms of the trust or family dynamics. For example, we have experienced situations where the income beneficiary and the remainder beneficiaries were not related and had not formed strong relationships with one another. In one case, a step-parent was the income beneficiary and step-children were the remainder beneficiaries. The step-parent wished for the trust to be invested to maximize income, with little regard for the growth of capital. The step-children, on the other hand, preferred the trust to be invested for growth at the expense of current income. Trustees have a fiduciary duty to balance these competing interests.
Q. How has the low interest rate environment intensified this issue?
Ron: The income available from bonds has been considerably below historical levels since the credit crisis began in 2008. For instance, in the decade preceding the credit crisis, a 2-Year Treasury bond yielded approximately 4.0% and a 10-Year Treasury bond yielded 4.8% on average. Even with the slight rise in rates since 2013, both the 2-Year and 10-Year Treasury bond yields still stand considerably below their historical averages, at about 0.3% and 2.7% today. It has therefore been very difficult for trusts to generate the same level of income that beneficiaries have been accustomed to receiving prior to this dramatic decline in rates.
Q. Can the ‘income versus growth’ conflict be resolved?
Gail: There is a solution available under the current trust law that can help trustees better manage this ‘income versus growth’ conflict. Trustees in most states have the ability to exercise a discretionary ‘power to adjust’ the distribution between principal and income to provide income beneficiaries with an appropriate level of income, while preserving and growing the principal for the remainder beneficiaries. The income needs of the income beneficiaries are met because their distributions represent a combination of income, principal and capital gains, rather than income alone.
Ron: This approach can be a win-win for both parties. It allows the trust to be managed with a much greater degree of flexibility to invest for the highest overall returns without the need to produce a certain amount of income. Trustees can take advantage of the full range of investment opportunities available in today’s market while still fulfilling their fiduciary duty to balance the interests of both the income and remainder beneficiaries.
Q. How can the ‘power to adjust’ trust distributions between principal and income benefit beneficiaries?
Mackin: Since the current law allows trustees to distribute principal to meet beneficiaries’ cash needs, a trust portfolio can be invested for growth. In the current low-rate climate this means constructing a portfolio that is primarily equity. Over time as the trust principal grows, so will the amount that a trustee may distribute within the rules of each state and prudent investment practice.
As an example, consider a $10 million trust with a balanced asset allocation of 50% equities and 50% fixed income. The current income beneficiary is the surviving spouse; the remainder beneficiaries are her children. Our expectation from this 50/50 allocation would be that the portfolio would have an annual income yield of 2.6% on average and appreciate on average at 4.4%. Eight years later, after taxes and any fees were paid, the spouse would have received a total of $2.2 million in income. The trust’s value at the end of the eight-year term would have been $11.9 million, which would ultimately be passed to the children.
Consider the outcome if that same trust had instead been invested for growth, with 80% of its assets allocated to equities and 20% to fixed income. The income yield expectation would be less, just 2.2%, but the appreciation expectation would be much higher, 7.2% annually, on average. The trustee can use the ‘power to adjust’ to reclassify a portion of the principal as income, so the annual distribution totals 3% of the value of the trust for example, even if only 2.2% was technically derived from investment income. The expected outcome is significantly better for both parties: eight years later, the income beneficiary would have received $2.7 million, $500,000 more than with a 50/50 portfolio, and the trust’s market value would have grown to $13.2 million, providing $1.3 million more for the children than in the other scenario.
Using the ‘power to adjust’ has allowed what were once competing interests to be aligned, since both the current and remainder beneficiaries can meet their goals with a growth-oriented portfolio.
Fiduciary Trust Company International and subsidiaries (doing business as Fiduciary Trust International), and Fiduciary Trust Company of Canada are part of the Franklin Templeton Investments family of companies.
This communication is intended solely to provide general information. The information and opinions stated are as of March 1, 2014, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process.
IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction of matter addressed herein
FIDUCIARY TRUST FORUM
and General Trust Counsel
Vice Chairman and
Chief Investment Officer
Executive Vice President and
Director of Fixed Income Strategies
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