Independent Thinking^®

Finding the Balance

Trust beneficiaries and their trustees face a dilemma. Yields on a balanced trust portfolio, at 2.6% after taxes, fees and inflation, are about half of what they were in the 1970s, arguably lower than their grantors ever envisioned.
 
What is the reasonable distribution that beneficiaries can seek from their trusts?
 
Determining how much is enough is complicated, for families and their advisors. Trustees must first consider the intent of the grantor but also the needs of the current and future beneficiaries. Is the primary purpose of the trust to provide for a surviving spouse, for the next generation or for the family as a whole, including grandchildren and future generations? Depending on the terms of the trust document, a trustee should be able to determine a sustainable level of distribution without materially harming the interests of subsequent beneficiaries.
 
In every situation, the trustee under the Prudent Investor Rules, as Evercore Wealth Management Portfolio Manager Jay Springer discussed in the previous edition of Independent Thinking, must diversify assets and strive for the best possible risk-adjusted total return, just as we do for all investment portfolios.
 
That means careful consideration of the consequences. The top federal capital gains rate of 20% and income tax rate of 39.6%, combined with the Medicare surtax of 3.8%, kicks in at just $12,300 for a trust, compared with $413,200 for an individual taxpayer. State taxes further complicate matters, especially in high-tax jurisdictions such as New York and California. Trustees need to consider whether income should be distributed to the trust beneficiaries to be assessed a lower income tax, and whether this makes sense for the family as a whole and in the context of the purpose of the trust.
 
Of course, it can work the other way too: Income in excess of need can be retained and added to the principal, and then saved for future beneficiaries in an estate tax-free vehicle.
 
As illustrated on the following page, the more an income beneficiary takes from the trust, the less is left for the future beneficiaries. Take too much and the value of the trust will deteriorate. However, if the income beneficiary does not have a taxable estate, is at a lower income tax bracket than the trust, and, although this is unusual, is able to accumulate the remittance in an investment portfolio, the family may come out ahead. The tax considerations for trusts can be complex, and families should consider their options in close consultation with their wealth advisors.
 
Assuming a balanced portfolio allocation, we can expect a trust to grow at approximately 6.1% over time, or 2.6% after taxes, fees and inflation. If the trust distributes 3% or less, it should reasonably be able to maintain its purchasing power over time. Market values can fluctuate dramatically, however, and beneficiaries can see big swings in their remittances if a fixed percentage of the market value is withdrawn each year. For that reason, trustees should consider a rolling three-year market value of the trust in calculating the fixed dollar remittance, to smooth out the proceeds year over year.
 
When we serve as our clients’ trustee through Evercore Trust Company, N.A., our first responsibility is to carry out the wishes of the grantor – to exercise our judgment through his or her lens. We take care to counsel beneficiaries that the interests of the subsequent beneficiaries – often their own children – could be impaired by invasions of the trust, and we look to the intent of the grantor of the trust. Each family situation is unique, of course, and there are many cases in which accessing the principal makes sense and is within the intent of the grantor. In those cases, we work with the current beneficiaries and exercise our discretionary authority to make distributions of income and principal.
 
It’s important to note that some states have adopted an alternative solution, a unitrust conversion. This permits the trustee to pay out a specific percentage of the trust, a sum that is recalculated annually. However, clients are generally better served by trustees who, where allowed, exercise the power to adjust principal to income. These trustees, ourselves included, can accommodate for changes in the prevailing market conditions and the individual needs of the beneficiaries.
 
It is in the best interests of all the trust beneficiaries, as well as the trustees, to determine an equitable solution for the whole family.