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The Total Return Unitrust
By Robert L. Moshman
wave of information and legislation about total return unitrusts (TRUs) is breaking over the state legislatures, the professional literature, and the public's general awareness.
Perhaps the wave will break over us and wash away, failing to make any lasting change. Yet there appears to be some basis for thinking TRUs are here to stay. The total return philosophy of investing has been with us for years and it dovetails nicely with the unitrust. In fact, it is possible that TRU features will dominate the design of trusts for many years to come. Let's have a closer look at the TRU.
The Unitrust Context Develops
Unitrusts are not new. They have been around since 1966 and have been used primarily in the context of charitable giving. But for several decades, there was little attraction in departing from the basic annual income format of personal trusts.
When the stock market was in a slower path, there was no compelling reason to keep trust funds invested in riskier investments or growth stocks with unpredictable returns. Instead, having a more dependable source of income was preferred. Income would be generated...and then paid out annually. Capital gains would ultimately benefit the remainder beneficiary. That was the traditional and prevailing approach to trusts and was reflected by trust accounting rules and fiduciary investment standards.
But over the past several decades, people have gotten familiar with IRAs, 401(k)s, mutual funds, and other vehicles to take charge of their investments. Passive investing is passé. In the 1990s, the rapid growth of the stock market made it clear that investment portfolios (whether in trust or not) cannot remain competitive unless they take full advantage of the long-term growth of the stock market.
What's So Great About Unitrusts?
A unitrust is able to channel the benefits of long-term growth to the income beneficiary by basing the annual payment on the value of the trust rather than the income generated.
Example: A conservatively invested portfolio of $1 million produces exactly 5% annual income ($50,000) which is entirely distributed while the remainder beneficiary's interest remains at a static level. The lifetime beneficiary can count on exactly $50,000 annually. Unfortunately, this amount will not rise when the market rises and will not rise over time because the portfolio itself is barely growing in value. In fact, such an arrangement can't even keep pace with inflation.
Moreover, this example illustrates the classic friction between income and remainder beneficiaries. The remainderman wants the value of his interest conserved if not cultivated. In this day and age, if you have an interest in $1 million and someone allows
it to sit around for 20 years only to hand you the original $1 million, you know that something has gone terribly wrong. A portfolio should not favor the income beneficiary at the expense of the remainderman.
By comparison, a unitrust with a growth portfolio of equity stocks might not experience growth every single year, but if it increases by 12% on average over many years, then it could afford to pay out 6% income ($60,000) to the lifetime beneficiary while the corpus of the trust increases by 6% ($60,000) as well.
This approach benefits everyone involved. The income beneficiary gets a higher payout right off the bat. The remainder beneficiary's interest grows instead of remaining flat. As the value of the trust grows, the amount of income generated grows as well, and the income and remainder beneficiary both benefit from this as well. And the fiduciary administering the investments can concentrate on investment-oriented decisions without decisions being dominated by the need to avoid favoritism toward one beneficiary at the expense of the other.
The Sustainable Unitrust
Although the unitrust concept is easily understandable, fiduciaries don't like to jump into murky waters of indeterminate depth. One issue that needed to be resolved was whether the TRU would work in practice. What percentage of income can be paid out without depleting the trust?
Before the dot.com bubble burst and sent the economy reeling, there were three years in a row when all the major stock market indexes (Dow, S&P, Nasdaq, etc.) were exceeding 20% returns every year. Those were lovely, heady, champagne times, but we have seen
how quickly such times can end.
Example: A trust is set up while the glow of a 26% annual return is still in the air and the draftsman and the grantor anticipate that the trust could be funded with $1 million and pay out a minimum of $75,000 a year. They express this as the greater of 7.5% of the trust's annual value, or $75,000. No sooner is that trust executed than the market drops and for the first year of the trust, the assets lose 60% of their value, leaving a portfolio valued at $400,000, from which $75,000 is then paid, leaving $325,000. Over the next three years, the assets just barely hold their value. Yet the trust keeps paying out $75,000 a year, eventually leaving a portfolio of $100,000 at the start of the fifth year. Even if the market roars back to life, and produces 30% returns, it can never catch up with the annual
payouts of 75%. The trust will be exhausted.
To be successful and fair, the unitrust has to equitably allocate returns between the current and remainder beneficiaries. As a practical matter, there appears to be a consensus that a unitrust return of between 3% and 5% would be sustainable.
Terms of Art: Although sudden market declines still pose a threat, one can avoid having a beneficiary's source of income cut off by utilizing a three-year averaging approach. This "smoothing" technique averages a truly bad year with those of the preceding years.
Another practical matter is how the annual payout will be accomplished with a portfolio that is not designed to produce much income. A "pruning" technique can be used to liquidate assets based on factors such as capital gains, diversification, and projected future performance.
During the late 1990s, there were several individuals calling attention to unitrusts, but one of the most influential was probably Robert Wolf, an attorney in Pittsburgh who used computer modeling techniques to demonstrate the viability of total return unitrusts. Many of the terms of art that have become associated with TRUs (such as smoothing and pruning) appear to have originated with his articles.1
Wolf's calculations help prove what investors already know about stocks and bonds. Over time, stocks will prevail over bonds. In fact, stocks have outperformed bonds over every 20-year period since 1926-a total of 54 consecutive periods.
The IRS and State Variations
In February, 2001, the IRS introduced a set of proposed regulations that addressed the concepts of the modern portfolio, total return investing, and discretionary adjustments by the fiduciary of income and principal. This removed another major unknown that had troubled fiduciaries about the TRU.2
With the IRS taking a leading role instead of enacting regulations long after the fact, a planner can be confident that a trust involving the use of principal to provide income when needed will work.
Numerous states are now enacting or contemplating TRU legislation. New York has had a committee actively pursuing TRU legislation for more than three years. Legislation reached the Governor of Pennsylvania, but before he could reach for his pen, the Governor of Delaware managed to have his state get the title as the first in the nation to have TRU legislation. Missouri followed promptly and more statutes are in the pipeline in Iowa, Maryland, New Jersey, and other states.3
Of course, it is possible to have a unitrust in most states already. An Ohio practitioner noted that he began using TRUs for his clients more than a year ago. He found that clients with second marriages or spendthrift situations found TRUs useful. In one situation, an existing income trust was being judicially reformed as a TRU and both the income and remainder beneficiaries of the existing trust were cooperating fully-both stood to benefit from having a total return approach.
Nevertheless, Ohio, like many other states, is contemplating TRU legislation. States without any legislation may be somewhat disadvantaged insofar as the Treasury's proposed regulations state that a TRU's concept of income must not be a fundamental
departure from existing state laws to be considered for federal tax purposes. A TRU must be based on some state statutory authority or it will place the marital deduction at risk. In the absence of a state statute, the TRU would have to be drafted to distribute the unitrust amount or income, whichever is greater. Attempting to give the trustee power to adjust income using principal would require some state statutory basis as well.
Moreover, not all of the state statutes are identical. There is a competitive rivalry among the states to attract and retain assets. That may explain why Delaware not only moved so quickly to be first, but also included a provision to extend TRU powers to any trust that is relocated to the state. Other state approaches vary in how much discretion a TRU trustee will have.
Modern Portfolio Theory Limits
While modern investment theory works fine in a given portfolio, it has gotten tripped up in the context of trusts. Income and remainder beneficiaries have been at cross purposes for hundreds of years. The traditional definitions of income and capital gains leave little common ground to satisfy these competing ambitions. The total return unitrust may just be the timely answer to this age-old dilemma. With the IRS and state legislatures clearing up remaining questions, the TRU appears poised to make its mark in the world of financial planning.
Technical References
1 Robert Wolf has authored many valuable articles on the subject: "Defeating the Duty to Disappoint Equally-The Total Return Unitrust," 32 Real Property, Probate & Trust Journal 45 (Spring, 1997); "Total Return Trust-Can Your Clients Afford
Anything Less?" 33 Real Property, Probate and Trust Journal 1 (Spring, 1998). Wolf noted that the value of his research articles was in quantifying the benefits of TRUs over the alternatives. Another leading figure in the TRU area is William Hoisington, a California-based attorney. See, Hoisington, "Modern Trust Design: New Paradigms for the 21st Century," 31 U. Miami Hecklering Institute on Estate Planning, Ch. 6 (1997).
2 A discussion of the societal shift in preference toward equity-based investments is discussed in, What is "trust income" in 2001?, The Estate Analyst (April, 2001). As modern portfolio theory developed, the prudent man standard was replaced by the prudent investor standard that is included in the Restatement (Third) of Trusts of 1992. The total return theory of investing is further reflected by the Uniform Principal and Income Act of 1997, which allowed for greater fiduciary leeway in allocating
income and principal-even allowing the fiduciary to recharacterize principal as income. See, Keister and McCarthy, 1997 Principal and income act reflects modern trust investing, 26 EP 3, p. 99 (March, 1999); and, Cline and Jory, The Uniform Prudent Investor Act: Trust drafting and administration, 26 EP 12, p. 451 (Dec., 1999).
3 Having taken a prominent role in the TRU area, Robert Wolf now fields inquiries from states contemplating TRU legislation. More than a dozen states now have TRUs under consideration.
© 2001 R. Moshman
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