A Case Study

The Total Return Unitrust

By Joseph T. Buxton III, J.D., C.E.L.A.*

Revocable living trusts (“RLT”) are one of today’s most popular estate planning tools. Most RLT’s provide that upon the Grantor’s death the net income of the trust, (that is, the dividends, rents and interest) shall be paid to the surviving spouse, with discretionary power to distribute principal for health, support and maintenance. Upon the spouse’s death, the principal would be paid to the remaindermen, usually the couple’s children.

On the surface, the typical net-income trust appears to protect all parties, the life beneficiary (the surviving spouse), the remaindermen (the children) and the trustee. The net income approach is commonly used by many attorneys as standard boiler plate language because of its simplicity and apparent conservatism. And in most cases, a net income trust would operate satisfactorily where the surviving spouse is the trustee and, as trustee, is working within a traditional family made up couple’s own children. However, in cases where there is a widow or widower and step-children involved, an adversary environment often develops between the life beneficiary (surviving spouse) and remainder beneficiaries (stepchildren).

In the above scenario, the task of the trustee to equitably meet the legitimate claims of each class of beneficiaries becomes problematic, particularly in an economy plagued with inflation, poor income yields and low stock dividend payouts. This situation immediately puts the income beneficiary and the remaindermen at odds. Neither the life beneficiary, nor the remaindermen, enjoy any reasonable expectation regarding future payouts from the trust. This puts the trustee of such a trust in a difficult position, where the trustee is unable to adjust investment strategy satisfactorily to meet the demands of the life beneficiary, or the remaindermen. The situation can be particularly difficult where the surviving spouse is the Trustee. Here is an example of one such case.

In 1990, Dr. Howard Jones, PhD, then living in South Carolina, created an intro vivos or living trust for the benefit of himself and his spouse. He served as his own Trustee. The trust provided that upon Dr. Jones’ death the net income of the trust, (that is the dividends, rents and interest), would be paid to his widow with discretionary power to distribute principal. Upon Mrs. Jones’ death, the principal would be paid to the remaindermen, his three daughters by a previous marriage.

The Trust documents provided in Article IV.,

“If upon the death of the Settler, the Settler’s wife, Ruth Jones, survives him, all income of the Trust shall be distributed to the wife as follows:

(1) Commencing with the date of the death of Settler, Settler’s wife during her lifetime shall receive all the net income from the Trust in convenient installments, but no less frequently than quarter-annually. Any accrued and undistributed income at the death of the Settler’s wife shall be paid to her executors and administrators.

(2) In addition, the Successor Trustee may pay to or apply for the benefit of the Settler’s wife such sums from the principal of the Trust as in its sole discretion shall be necessary or advisable from time to time for the medical care, support and maintenance in reasonable comfort of the Settler’s wife, taking into consideration to the extent the Successor Trustee deems advisable, any other income or resources of the Settler’s wife known to the Successor Trustee.

(3) The Settler’s wife may at any time by written notice, require the Successor Trustee either to make any nonproductive property of this Trust productive or to convert such nonproductive property to productive property within a reasonable time.”

Dr. and Mrs. Jones were married in 1980. It was his second marriage. His three adult children were by his first marriage, which had ended in an acrimonious divorce. In the early 1990’s, the couple moved to Virginia. In 1997, Dr. Jones amended his trust agreement to provide for the continued management of the trust. He hired a security firm as his portfolio manager and he named its affiliated trust company and his wife, Ruth, as co-successor trustees. He intended that his wife succeed him and continue to work with the financial advisor to continue his investment strategy for her benefit. The amendment gave Mrs. Jones the right to make all decisions regarding the “management of the investments of the trust funds.” If she died, resigned, or became incapacitated, the co-trustee trust company became sole trustee. The trust portfolio was made up of approximately 70% bonds and 30% equities and the couple lived on the income. During the last two years of his life, Dr. Jones was severely disabled and Mrs. Jones became his caretaker.

In 1999, Dr. Jones died at their home in Virginia. His widow left the investment portfolio much as it was at his death as it provided the major part of her income and permitted her to maintain the lifestyle she enjoyed while her husband was living. In March 2000, the remaindermen filed suit to have their step-mother removed as trustee for failure to invest the trust assets “to provide for growth for the benefit of the remainder beneficiaries” and sought monetary damages. This suit came at the peak of the stock market boom of the 90’s.

To settle the case, Mrs. Jones resigned in favor of the corporate trust company as trustee and agreed to modification of the portfolio to allocating sixty percent (60%) stocks and forty percent (40%) bonds. By 2003, Mrs. Jones’ income from the trust had dropped by over fifty percent. She was having a difficult time making ends meet. The Trust company refused to make any changes on the portfolio or to distribute principal to relieve Mrs. Jones’ situation. At the same time, the Remaindermen were seeking greater growth. The Trustee was in a “no-win” situation. Mrs. Jones felt she had no choice but to bring suit to compel the Trustee to increase her income or in the alternative to have the corporate trustee removed.

Virginia has adopted the Prudent Investor Rule . The Prudent Investor Rule is based on the modern portfolio theory. In the past, trustees were required to avoid speculative investments in favor of safe investments. The new rule requires the trustee’s investment and management decisions to be “evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy, having risk and return objectives reasonably suited to the trust.” The idea is that by using a wide range of investments to build a portfolio more closely resembling the overall investment market, higher returns are possible. Obviously, modern portfolio theory is a marked departure from the traditional “safe” investments philosophy of prior law.

A trustee now has a duty under the rule to balance risks against total returns, duty to diversify, and duty of loyalty and impartiality to treat the beneficiaries impartially. In this context, the rule recognizes that income production is more a function of the portfolio’s overall productivity than the productivity of an individual investment. Therefore, the trustee must balance the demand for maximum yield against the demands for maximum growth. Therefore, the trustee must recognize the need for investment strategies that increase and not merely preserve the trust corpus. The rule also recognizes the authority of the trustee to delegate, in this case to the professional financial advisor as Dr. Jones did. Furthermore, the prudent investor also needs to be aware of costs incurred in the management of the trust and must consider such expenses in the light of efficient market principles and justify such costs as outside advice, investment fees, commissions, other brokerage charges, and capital gains taxes against the prospective increase returns. These costs, of course, can be mitigated by the use of pooled funds, mutual funds and index funds.

The Prudent Investor Rule increases the liability of the trustees. The rule now measures a trustee’s liability by comparing the portfolio’s total return, whether positive or negative, with what the portfolio reasonably could expect to earn under appropriate investment program. In this case, a court can use a recognized securities index as a benchmark when comparing a given portfolio’s total return. It appeared the Trustee under the rule had the discretion to increase Mrs. Jones’ annual payout; however, to do so would have undoubtedly brought an adverse reaction the Remaindermen.

Under a net income trust, the trustee will have great difficulty meeting the requirements of the rule. However a new avenue to resolve this dilemma is found in a 2004 modification of the Virginia Uniform Principle and Income Act, the Total Return Unitrust. Under this provision of the Act, an independent trust can establish the fair market value of the trust, at least annually, and determines a unitrust amount of no less than 3% nor more than 5% which shall thereafter be the reasonable rate of return from the trust. The Trustee must take into account the intentions of the Grantor as expressed in the governing instrument, the needs of the beneficiaries, the general economic conditions projected, and current earnings, appreciation of the trust and projected inflation and its impact on the trust when involving this option. The unitrust amount shall then be considered the “income” of the trust for the purposes of determining the amount that the trustee shall pay to the beneficiary.

The trustee must, however, adopt the total return trust by a written policy and provide notice to all beneficiaries. They have the right, within sixty (60) days, to object to such conversion. If the trustee refuses to establish such a trust, the beneficiary’s exclusive remedy shall be to obtain an order of the Court directing the trustee to convert an income trust to a total return unitrust in accordance with the provisions of the Act.

From the date on which the corporate Trustee took over the Jones Trust, it appears that the trustee may have failed to fully carry out their fiduciary responsibilities not only to the income beneficiary, but to the remaindermen. They refused to consider conversion of the trust to a total return unitrust for the benefit of the income beneficiary, likely because prior to the 2004 amendment to the Uniform Principal and Income Act, the authority to do so was not explicit. Nor were they in the position to adopt a more prudent investment strategy to protect the overall trust for the benefit of the remaindermen, without further jeopardizing the life beneficiciary’s income.

However, with a “Total Return Unitrust”, the expectations of the income beneficiary could be fulfilled, and the remaindermen could be protected to the extent properly managed, through the overall growth of the trust principal. In this case, the widow and step-children would be on the same team, and the trustee would not be caught in the middle trying to meet the conflicting demands for income and growth at the same time.

At the trial of Mrs. Jones case, the Court brought all parties (the widow, their counsel, the Trust officers, and the portfolio manager) into Chambers for an informal discussion of the positions of each. The Plaintiff’s attorney had asked that I be prepared to testify as an expert witness on the fiduciary duties of the Trustee and the advantages of converting the Trust to a Total Return Untrust. The Judge request that I give the Court and the parties present an overview of the situation they found themselves in and explain the option of converting the trust.

It was clear the widow needed more income, but the remaindermen were resisting, claiming they were entitled to more growth. The Trustee stated they were ready to convert if the parties could agree to do so and set the unitrust amount. The portfolio manager explained that if the Trust were converted he would move into some small capital investments away from bonds. He felt he could increase the overall growth of the trust corpus. The widow’s counsel stated that conversion to 4% unitrust amount would increase Mrs. Jones income substantially. I explained that to convert would be truly a win-win situation. The remaindermen would have the expectation of reasonable growth, the widow’s income would immediately increase, and, if the total trust grew over time, she would enjoy increased income with some protection from inflation, the corporate trustee would be freed up to employ modern portfolio theory in managing the Trust to more closely reflect the historical growth in the market.

After several hours of discussions, side conferences, and encouragement from the Court, the parties came to an agreement without the necessity of a trial. The step-daughters and the widow stipulated to permitting the Trust to convert the trust to a 3.25% total return unitrust. The date for the annual review was set to value the Trust for each year. The widow’s income thereafter would reflect 3.25% of the total corpus of the Trust as established annually. The income beneficiaries would have reasonable expectations of certain income and the Trustee could manage the trust for growth. Everyone was a winner….

While the revocable living trust forms utilized by many attorneys often adopt the net income approach and reflect little or no concern for the potential conflict between the trustee, the income beneficiary and the remaindermen, these developments in the law in Virginia now provide both the grantor and the trustee useful tools to mitigate against these apparent conflicts between the beneficiaries.
*Certified Elder Law Attorney by the National Law Foundation.

Revised 11-07-05