Introducing the “Total Return” Trust

The fundamental purpose of most trusts is to create a plan of financial protection for more than one beneficiary, often beneficiaries in different generations. “All the trust income to my surviving spouse, with the balance to be divided among our children at her death” might be used in a marital deduction trust, for example (provided the necessary “QTIP” election is made). This would give the surviving spouse cash to live on during the life of the trust, and the substantial resource of the trust principal would be available to the younger generation in the future.

But what is “income” in a trust? Under traditional trust accounting, income includes interest and dividend payments. Capital gains and losses, in contrast, would be charged to trust principal and so would affect what the future beneficiaries receive.

An implicit conflict

These trust accounting rules mean that the interests of the current and future beneficiaries may be at odds when it comes to investment management decisions. The future beneficiaries will favor investments with the highest potential for capital growth, usually stocks. Some stock market investments are advisable for a trust, so that the value of the principal is not eroded by inflation. The future beneficiaries may want to give the stock portion of the trust’s investment portfolio even greater weight.

The trouble is, stocks don’t yield much annual dividend income these days. In recent years, a $1 million portfolio invested in the S&P 500-stock index would have provided less than $20,000 in dividend income to distribute to the income beneficiary! What’s more, a growing number of companies have been reducing or eliminating their dividends, in part because many investors prefer to receive lightly taxed capital gains to dividends, which are taxed at federal rates of up to 39.6%.

To boost trust income, and to make that income more reliable and predictable, the trustee needs to invest a portion of the trust assets in bonds to generate interest payments. That same $1 million portfolio invested in safe, long-term government bonds would have generated more than $50,000 annually for the income beneficiary in recent years. Still, excessive reliance on bonds in the portfolio exposes the trust principal to inflation risk.

Possible solutions

Several strategies have been advanced in recent years to resolve the potential conflict among beneficiaries that investment strategies may pose.

Inflation-indexed income. The income beneficiary can be protected by establishing a base dollar amount of income, then providing for inflation adjustments each year. This frees the calculation of the distribution from the traditional definition of income earned by the trust. One potential problem is that, if stock prices don’t keep up with inflation (as has occurred at times in the past), the trust could be depleted by adhering to this formula.

The “total return” trust. In the world of charitable trusts there is something called a “unitrust.” In this trust “income” is defined as a fixed percentage of the value of the trust, recalculated each year. If the value of stocks held by the trust goes up, the income payments rise, regardless of changes in dividend payouts. Should the trust assets fall in value, the income falls also. Thus, this approach does present some variability of cash flow for the income beneficiary. Estate planners have begun exploring using the unitrust for noncharitable situations. When trust income is defined as a percentage of trust assets, the trustee is free to invest for total return instead of a given income target—hence the name “total return” trust.

If a trust will play a role in implementing your estate plans, it may be wise to take a closer look at how the investments will be managed to balance the interests of all beneficiaries.