Can You Trust a Trust or Its Trustee?
By Henry K. Hebeler
Like many people who have savings in retirement that are likely to be subject to estate taxes, the wills of my wife and myself call for a bypass trust that will be generated at the death of the first spouse. This allows us to take advantage of the estate tax exemption for both of us instead of only the second person to die.
Also, like many people, we have each been married before and wish to protect part of our estates so that our children can benefit from our savings. Therefore our wills call out another kind of trust that will be generated on our death, a Qualified Terminable Interest Property, or QTIP.
Both of these trusts have provisions that would allow the surviving spouse to invade the principal, that is, draw out more than the dividends and interest that are the normal distributions from the trust. To do this, the survivor must show the trustee that there are insufficient funds elsewhere to maintain a standard of living comparable to some kind of a standard. This likely is going to be very difficult to prove, either to an institutional trustee available only by phone or to a trustee or person who may ultimately benefit from the trust and therefore wants to minimize distributions. As an example, is a significant gift to someone or a charity a necessary expense?
After a while itís easy to develop an image of sour-faced trustees with green eye-shades, pince-nez glasses and ice-water veins. Perhaps itís hard to blame them because multiple requests for additional money are tiresome both the trustee as well as the surviving spouse. Wills may provide for the surviving spouse to be able to change to a more cooperative trustee or even be the trustee. However, this may end up in a lawsuit from disgruntled beneficiaries (in cases which we hope wonít be like ours) because the reason to set up the trust in the first place was to provide an inheritance for the beneficiaries.
Another major controlling factor is the allocation of investments within the trust. A portfolio that is dominated by stocks or stock funds may provide precious few dividends which may be key to the surviving spouseís standard of living. The stock dominated portfolio offers the greatest growth opportunity for the beneficiaries. Often the spouse would prefer a portfolio dominated with fixed-income securities such as bonds or CDs. That maximizes the spouseís current income, and if the bonds are tax-exempt, offers ax-free income. So the constituency of the trust securities may also be a major point of contention.
Many people turn their trusts over to a financial institution, particularly when there are no family members that want to be a trustee. You can understand this better when you consider the large responsibility the trustee has to try and resolve these conflicts as well as the fact that the trustee has to know something about investments and be able to interpret the surviving spouseís real need to invade principal. Financial institutions can be particularly inflexible and impersonal.
I have talked to a number of widows who live largely on trust income. They have another complaint. The costs of trusts are very high. They have to pay a fee to the trust institution that provides the trustee. They have to pay an accountant to do the tax return. They have to pay a financial planner to help determine the allocation of securities. They have to pay a lawyer to communicate with the trustee when principal draws are required. And they have to pay a broker and/or mutual funds for the costs of maintaining their securities. To add insult to injury, tax rates on undistributed trust income are more brutal than on personal income. These widows say precious little income is left to them. The professionals, financial industry, and government can get more than the widows.
After some of these conversations, I thought it was high time to include provisions for trusts in my retirement planning program, the Retirement Decision Assistant. Needless to say, the results were shocking. If your wills call for testamentary trusts on your death, youíd better do an analysis that accounts for them.
The two major concerns are the costs and whether the trusts will really give up capital when required. If you have an extraordinarily low cost trust and a very cooperative trustee, the trust may be transparent such that your ordinary planning tools will suffice. However, the more I learn, the more unlikely I think this may be in most situations.
There is another situation that bears special planning tools. My wife and I both provided trusts to help our parents in their old age. My wife was the trustee for my folks and vice-versa. These trusts only provided income to the parents, not part of the capital. That was intentional because when these were set up many years ago we did not know what our own need for capital might be after our parents died. These had low cost funds and were relatively easy to administer. I even learned how to do the tax returns myself because it was simpler just to fill out the trust tax return than to provide the data to my accountant. We used an accountant only in the first and last year of the trusts, and, of course, we needed a lawyer when we set them up initially.
So here were some simple trusts without high costs, no means to invade the principal, and cooperative trustees, namely us. Still they illustrate the point that even if a trust for a spouse had these same benefits, it takes a special kind of planning program to cope with the repositioning of the assets to fund the trust and the fact that the income may vary considerably depending on the security allocation.
Another kind of trust that has similar requirement is a charitable remainder trust, or CRT. There are many people, who in their old age, decide to give a substantial part of their wealth to a charity in exchange for some income until they die. These can offer substantially different patterns of future income anywhere from being like a fixed annuity to a payment plan that extracts a certain percentage of the assets each year. Depending on whether the percentage withdrawn is more or less than the prevailing market conditions, that income might grow or reduce over the years, but certainly it is not likely to be constant. So once again we have a trust where value must be extracted from other investments to fund the trust, and income can be far from the traditional planning assumption that income will increase with inflation until death.
But getting back to my own personal case with two testamentary trusts in each of our wills, Iíd like to give you an idea of the staggering difference between plans with and without the trusts. Understand that I have a very substantial fixed pension and large deferred tax accounts in addition to taxable accounts that would be used to fund the trusts. Therefore, I felt that the trusts would have almost a trivial effect on, say, my wife if she survived me. Iím now age 69, and if I assumed that I would die at age 85 and my wife at 100, my initial results showed that for my surviving wife to have the same income after I died, we would have to cut our spending and gifting now by almost one-third! It got worse if I assumed Iíd die before 85! Lots worse.
Of course, this was based on taking no capital from the trusts. We got poorer quickly and our heirs got substantially more than we otherwise planned. I could moderate the results with different investment patterns and assumptions of lower costs, but as long as she couldnít invade the principal, there was still a large difference in what we could afford to spend before my death.
The Retirement Decision Program is set up so that two retirement planning programs run simultaneously side-by-side. (This program, including the trust provisions, is available from www.analyzenow.com.) Then I set up a case where the trusts were essentially transparent so that there was complete flexibility to withdraw any needed amount each year. In this latter case, the only difference from a conventional retirement plan is that the costs for the trust part necessarily were higher than otherwise. If this was truly a possible scenario, the difference between my plan without trusts and this one with transparent trusts was evident, but still relatively small. But the difference between these two cases and the case with an inflexible trustee were huge.
Now neither of these trust scenarios is likely to happen. The results probably are going to be some place in between the inflexible trustee and the completely cooperative trustee. Itís largely a judgmental call how much capital it will be possible to draw out of the trusts as a practical matter. Certainly our children will not be happy seeing what started out to be mouth-watering retirement potential for themselves turn into paltry sums on my wifeís death. Nor would that be a likely outcome with an institutional trustee who would feel some obligation to protect the trust capital.
I thought that once I had paid large sums to an estate planning lawyer that I could forget about what would happen after I died because my will would take care of everything. Now I know better and face a lot of work trying to reach a compromise between trust and a trustee as well as more detailed allocations and withdrawal considerations in the will. These may well be a lot more important than what will happen to the details of estate tax rates.