Traditional income trusts have placed the trustees, who have a fiduciary duty of impartiality towards all beneficiaries, in the middle of the inherent conflict between the income needs of the income beneficiaries and the growth needs of the future beneficiaries. Historically, the only devices available to affect income distributions have been asset allocation, which determines almost all of the investment total return, or in limited circumstances, broad discretionary powers granted to a trustee to invade principal.
The potential problem of asset allocation as the mechanism for establishing an adequate payout to income beneficiaries is that a portfolio that emphasizes income over a long period of time, such as the life span of a trust which can last for over 100 years, is likely to under perform a portfolio that utilizes a long-term investment horizon to focus on growth. This is because growth portfolios focus on equities while income portfolios tend to hold a higher concentration of fixed income securities. The longer the time horizon, the more likely equities will outperform other forms of investments. To resolve this issue, some income trusts have granted trustees broad powers of discretion to allow payouts from interest and principal to meet desired income levels.
While empowering a trustee to determine which assets to liquidate and how much of an income distribution to make can effectively balance the needs of the income beneficiaries and the future beneficiaries, there are also potential pitfalls with this strategy. Income or future beneficiaries could object to a payout that they feel is arbitrary and to their detriment which would, at the very least, cause disharmony. Another potential problem lies in the mere need to have a trustee rely on "discretionary" powers on an ongoing basis to balance the needs of all beneficiaries. The constant exercise of this balancing act could create timing issues that subject trust assets to reinvestment and market risk because of the lack of a pre-established liquidation strategy.
So what is the solution? The answer that may well satisfy both income and future beneficiaries can be found in the Delaware Total Return Unitrust legislation, signed back in June 2001 by Delaware's Governor Minner. This law allows for conversion of an existing irrevocable trust to a Delaware Total Return Unitrust that may provide greater returns for both the current and the future beneficiaries.
A Delaware TRU is a trust intended to fairly balance the interests of the current income and the future beneficiary. The way the Delaware TRU accomplishes this is by allowing a trustee to invest for total return while eliminating the conflicts of interest between the current income needs of the life beneficiary and the future distribution needs of the future beneficiary. The trustee can choose a fixed payout (between 3% and 5%) while striving to invest for maximum after-tax returns and long-term capital growth. Also, since the Delaware TRU does not rely on discretionary powers to establish a systematic payout, distributions can be easily defended as appropriate, hence increasing the harmony between income and future beneficiaries.
How does a Delaware TRU work? The Delaware TRU requires a payout of a fixed percentage at least once a year to the current beneficiary. The payment is calculated as a fixed percentage of the fair market value of the trust's assets (revalued at least annually). To "smooth" the payments, the annual revaluation may be based on a rolling historical period. In most situations, if income is greater than the percentage amount that is required to be distributed, it can be accumulated for the benefit of both current and future beneficiaries. Similarly, if current income is insufficient to make the required payments, the trustee is empowered to invade principal to make payments.
In short, the Delaware TRU is intended to bring together the interests of the current beneficiaries, future beneficiaries, trustees, and investment managers by providing a predictable distribution scheme for the current beneficiaries, which in turn promotes investing trust assets using modern portfolio theory.
Certain administrative tasks may be necessary or appropriate to carry out the conversion of a non-Delaware income trust to a Delaware TRU. If you are looking for a way to increase the harmony between income and future beneficiaries through increased payouts, increased remainder values, and a structured distribution program, consult with your financial advisor to see if a Delaware TRU conversion is the right alternative for you and your family.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.