Decades ago, trust officers had a pretty good idea of what to do with money: They stored assets in bonds juiced up with a high cash yield. This gave the first beneficiary (perhaps a wife or a parent, or the grantors themselves) the fruits of the trust in a steady income stream while leaving the trunk of the tree behind for others.

Modern financial strategists, like many second-generation beneficiaries, have always blanched at such a strategy, though most trusts still are set up this way. Though modern portfolio strategies can be written into new trust documents, they often aren't. State legislators, however, have begun to come around to the idea that setting up a trust with two separate investment goals-both high-income payouts and principal growth-is a misbegotten strategy attempting to marry two irreconcilable goals that ultimately erodes the value of money over time.

As dividend and interest yields have fallen, these income strategies often have turned trust grantors' survivors against one another. Those drawing steady income from the trust during their lifetime want to boost their payouts (traditionally taken from dividends and interest), while the remainder beneficiaries want the principal to grow-making the gift keep on giving. Trust officers are thrust into the role of referee, trying to serve many masters and often satisfying none.

What's worse is that trustees get mixed signals from trust documents, paradoxical statements demanding high payouts and optimum growth at the same time. There are also vague mandates to pay for the primary beneficiary's "maintenance," though this is a highly subjective term to the person getting the short end of the stick. Shout it mean, after all, that the second wife gets a yacht?

Such questions are going to make the trust area a field ripe for lawsuits.

"Trusts are going to be the new hotbed of litigation," says John Schuman, an estate-planning attorney with Budros & Ruhlin in Columbus, Ohio. "A lot of that is because there is going to be more money put in trusts as the baby boomer generation dies. The other reason is that you don't have as many bank trustees [as individual trustees]." These individuals are more likely to fail to fulfill their fiduciary duties, he says.

The result is that, as the laws continue to change, many fiduciaries are going to go running to financial advisors for help, lest they be unmercifully sued.

State Law Changes

Several states have begun recently to tweak their laws to make the job of a trustee less hairy. The first dose of medicine was the Prudent Investor Act, which gives independent trustees new latitude to invest in a number of different securities-tilling the investment field for seedlings once considered too risky, like venture capital, oil and gas, etc. The law also allows trustees to delegate their authority to financial advisors (within certain limits).

Now various state legislatures are wrangling over part two of the plan-changing the rules that determine what is principal and what is income in a trust.

Taken in conjunction with the prudent-investor rules (already on the books in most states), the Uniform Principal & Income Act (UPIA) gives trustees discretion to allocate principal (which includes realized gains and unrealized gains) to income, and vice versa. This way, trustees have a great deal more freedom to actually implement total-return strategies in a way they couldn't before, says Edward C. Halbach, professor of law at the University of California at Berkeley. So far, 23 states plus the District of Columbia have passed some form of the UPIA.

The change in the law, Halbach says, frees up trustees to be more impartial.

"They can do a better job of investing if they can disregard the need to provide a traditional level of income productivity to the income beneficiary," he says. This allows them to take from principal and add to yield. "Or, if you invest it all in bonds, hold back some of the income [from interest], so the principal doesn't take too much of a beating," he says.


Not everyone likes the new law, however. A few states have added their own provisions or dropped the one that allowed adjustment of principal and income. Trustees have cried foul about the liabilities they could suffer under the new rules if some beneficiary determines that he or she is not being paid enough.

The bill was tabled in Florida this year after accountants raised their own objections. Though they concede that the revised UPIA is necessary, they also think it's flawed.

"Had we not stood up, a very deficient law would have been passed," said Lloyd "Buddy" Turman, executive director of the Florida Institute of Certified Public Accountants.

"The centerpiece was the power to adjust," says Florida CPA Gordon Spoor. "That means the rest of the law was extraordinarily weak. It didn't address the proper handling of basic fiduciary issues."

Florida law currently provides a minimum 3% of fair market value of assets under the underproductive-property rule, Spoor says. The revised UPIA didn't have such a provision-because it relies on a trustee's power to adjust to make up inequities. For those without power to adjust (those with an interest in the trust themselves), there is no longer any protection. Beneficiaries are now left powerless to do anything but sue.

"The main source of income is gone, and you have to sue to get it back," Spoor says.

Accountants in Florida also disagreed with provisions that treated short-term capital gains as income. "The revised act wanted to make them income because the IRS taxes them as income rather than capital gains. That's a silly reason."

He cites the example of a charitable remainder trust in which a wealthy person wants to turn off income, and yet has short-term gains in a tax-inefficient growth stock being allocated to an income stream she doesn't want.

Halbach says that he, too, thinks the law has some flaws. "I disagree with the rule that deals with annuities," he says. "This would include [situations] where pension benefits are being paid into a trust-that you allocate 10% of payment to income. That's awfully low." He says this might significantly cut down benefits to a spouse, money that can't be salvaged by a readjustment.

Responding to states' objections, the National Conference for Commissioners on Uniform State Laws has created at least one new provision that a trustee's decision to readjust income and principal cannot be changed by a court unless it can show an abuse of power.

Drafters who want to avoid readjustment issues sometimes create unitrusts, which give income beneficiaries a fixed percentage of assets each year. Though the conference doesn't support it, at least three states-New York, Delaware and Missouri-allow a trustee to convert a trust to a unitrust. Many planners consider unitrusts useful tools that can serve both the interests of the remainder and income beneficiaries by letting both benefit from a growing pie.

"From the time of Richard the Lion-Hearted until today, income meant dividend and interest, and capital was capital," says David Arcella, senior vice president with Bessemer Trust Co. in New York. "Now, if a trustee [in New York] wants a unitrust regime, it's going to be 4% regardless. You couldn't do that before. The only way to do it was to write it into the trust agreement."

Not everyone is thrilled. "We oppose the unitrust conversion rather strenuously," says John McCabe of the national conference. "The issue is that we can turn trusts into something like captured mutual funds to which we don't have to devote resources."

Advocates And Peacemakers

The changes are not going to solve every problem or satisfy everybody's demands. Many trusts, as written, send mixed signals to trustees about their responsibilities. Financial advisors can help in two capacities-as advocates and as peacemakers.

As an advocate, a financial planner can stand up for one beneficiary who may or may not be getting as much as he or she has a right to. It may not be part of the job description, but it will win a planner a lot of good will, says Mari Adam with Adam Financial Associates in Boca Raton, Fla. "You have a lot of trustees who are not experts at administration," says Adam. "You have a lot of beneficiaries who don't know which way is up."

Mary Sue Donohue, an estate-planning attorney with Buckingham Doolittle Burroghs in Boca Raton, Fla., says there are several things that trust officers often don't tell beneficiaries. Individual trustees are supposed to provide information, for instance, that they are taking over as a trustee, but they often don't. Also, the income and remainder beneficiaries are entitled to an annual accounting. Very often, individual trustees will not tell a beneficiary how much time they have to object to the accounting.

Nor, she says, will banks tell a beneficiary about things like income minimums. Florida, for instance, requires that a surviving spouse receive a minimum of 3% per year.

It helps to write a letter to the trustee, Donohue says, "asking what are the rules or the limitations as to what the beneficiary is entitled to. What are the minimums and maximums? Be aware of the current value of the trust and have a good sense of what the level of payout is. That's the important thing, to stay on top of reports from a trustee."

Like Adam, Schuman says that one of the biggest roles for the financial planner is going to be as the person who can go to the trustees without the threat of litigation and remind them of their obligations to the beneficiaries. Trustees, though they have the power to adjust between principal and income, will not always know how much.

This is where they can turn to help from total-return strategies, says Jay Shein of Compass Financial Group in Lighthouse Point, Fla. Many attorneys and trustees remain in the dark about various strategies, such as total-return unitrusts, total-return annuity trusts, total-return QTIPs and total-return income trusts.

But once they have outlined these modern portfolio strategies, planners and attorneys also will have to take on a more unpleasant task: explaining to an income beneficiary the need for a smaller yield from the trust. Shein says that most income "bennies" expect a return of 5% to 6%. But a trust that's invested for long-term growth probably can't pay out more than 3% to 4.5%.

"The whole trend toward liberalizing investment rules means lawyers and trustees have to get informed about the realistic rate of return," agrees Halbach. "It's going to be a hell of a jolt to clients."

Where the 1997 Uniform Principal & Income Act Has Been Adopted

District of Columbia
New Jersey
New Mexico
New York
North Dakota
South Carolina
West Virginia

States That Allow Trustees To Create Unitrusts

New York