Skip to Content

Total Return Trusts

March 1, 2004 Articles Trusts & Estates

Should there be a Total Return Trust in your future? Trusts as we know them have been around for a long time. Trusts were developed in England in the 1500s to provide a way of managing what was the only form of wealth in those days, land. Land was treated as what we would call principal today, and crops were treated as what we would call income today. This model persisted until 1915 when the Federal Estate and Gift Tax was imposed in order to pay for W.W.I. With income taxes and estate taxes came a new trust, the estate planning trust, this new trust was designed to get the best income tax treatment and the greatest estate tax savings. The estate planning trust has served us well for almost 100 years but now we, as estate planners and advisors, are beginning to formulate a third model of trust; a new trust which incorporates new ways of looking at the function of long-term trusts.

Provisions in today’s trust agreements should reflect the changes that have occurred in the financial markets in the world. The trusts should be designed to facilitate the long term financial success of investments and the long term goals of both the income beneficiaries and the remaindermen. This new type of trust is called the Total Return Trust.

The Total Return Trust is designed to provide a fixed percentage set in advance which is payable to the income beneficiary. It usually does not provide that the income beneficiary is to receive all of the income except for certain special types of trusts required by Federal tax law. The fixed percentage may be distributed either in cash or in-kind on a monthly, quarterly, semi-annually or annual basis. The trustee is charged with the responsibility of obtaining the best return on the investment without regard to the competing interests of the income beneficiaries and the remainder beneficiaries.

This is a significant step forward over the current model of the trust. Too often the current type of trust creates an inherent conflict between the income beneficiaries and the remainder beneficiaries. The income beneficiaries want more income. They want the trustee to invest in income-producing assets such as bonds and CDs. The remaindermen want more capital appreciation. They want the trustee to invest in assets such as stocks that have high appreciation potential rather than bonds or notes. The trustee is caught in the middle of these two competing interests. Will a trustee invest for more income and satisfy the income beneficiary or invest for more capital appreciation and satisfy the remaindermen? The result is that the trustee, being caught in the middle, invests a portion of the portfolio in income-producing assets and a portion of the portfolio in assets with capital appreciation potential. The result is, too often, that the investment portfolio is a compromise resulting in the mutual dissatisfaction of both the income beneficiary and the remainderman.

A trust with a million dollars of investable assets shows the problem well. Assume that the generally well-accepted investment mix of 60% stocks and 40% bonds were used, and using a blend of 10-year Treasury notes, corporate bonds and an S&P 500 index fund, a trust would yield today about $25,000 per year. Deduct the customary trustees’ fees and deduct taxes. The result is that the income beneficiary has actual spending money of $15,000 on a million-dollar investment. This is a disappointing result using the traditional trust. 

The same million dollars in a Total Return Trust with a 4% payout figure would yield the beneficiary close to $25,000 after expenses and taxes.

What are some of the other advantages of a Total Return Trust? Beneficiaries find it easier to forecast what they are going to get. They can do the arithmetic of multiplying the fixed percentage times the value of the trust and know what their distribution is going to be. There is not a lot of arguing with the trustee over what is income, what is principal, and who gets what; it is just simple arithmetic.

Even more important, now the income beneficiary and remaindermen are not in conflict as in the more traditional type of trust. They have a shared interest. Investment return has not been sacrificed, rather, it has been enhanced. The trustee is now able to invest for the best possible return on the money. The rising tide raises both boats. Asset allocation has been restored to achieve the greatest return. Conflicting goals between income beneficiaries and principal beneficiaries have been avoided. This can be especially true in situations of a second marriage, where family unity can be a bit shaky at times, particularly after the death of the grantor of the trust.

Anyone who has been in the stock market for even a short period of time knows how volatile the stock market has become. Whether it is because of program trading or day trading or other economic forces, the stock market and, to some extent, the bond markets, have become very volatile. We have seen the disasters that occurred in the early 70s, the euphoria that occurred in the late 90s, and the train wreck that occurred starting in the year 2000 because of the hyper-inflated expectations of people investing in tech stocks with nothing but hope backing them up. The Total Return Trust can avoid many of these peaks and valleys which can be so distressing to the income beneficiary, particularly if he or she is living on what is generally referred to as fixed income. The Total Return Trust smoothes out the peaks and valleys of income through a smoothing mechanism. To provide a smoother flow of distributions, a three-year averaging mechanism is used which causes the year-end values of the last three years of the trust to be averaged together rather than just the last year’s value. This average is then used to calculate the distribution. This reduces the stress on the income beneficiary and smoothes out the distributions. Finally, because the markets have been so volatile, it is also possible to provide that the distribution to the income beneficiary shall not be more than 120% of the previous year’s distribution nor less than 80% of the previous year’s distribution, thus providing further assurance particularly to the unsophisticated income beneficiary who relies on this money to get him or her through the last years of life.

What is the best percentage? Anyone with a well-operating crystal ball can answer that question. For those of us who have not been so fortunate to have an accurate forecasting instrument for the future in the financial markets, we can only look at history to give us guidance. Many models have been created. Computer technology has permitted us to play many different kinds of “what if” scenarios but the final answers seem to be that a total return of around 3-1/2 to 4-1/2% is right. Now before people say that seems awfully low, it is worthwhile to go back and remember what the income beneficiary of the typical trust scenario above was receiving-$15,000 after taxes. Dividend rates are about 1.5%. Bond rates are 4%. Put that in a 60/40 bonds stock mix and the income beneficiary would be receiving 2.5%. I have seen Total Return Trusts with three times that payout percentage. I hope those folks are right for all of us but, personally, I am afraid that is going to turn out to be too high.

While Total Return Trusts seem to be the wave of the future, they do not work well in some specialized applications. Total Return Trusts do work well for stocks and bonds but should not be used if real estate is a high percentage of the trust’s return. Remember, the trust has to make a distribution each year. If the real estate is a high percentage, it may be difficult to find liquid assets to make the distribution. Similarly, closely-held businesses can be awkward assets in a Total Return Trust because of the competing needs of the business for cash and the trustees need to make distributions. Credit shelter trusts where the surviving spouse is the beneficiary can, under some circumstances, be a good candidate for a Total Return Trust but in other instances, it may not be a good candidate. If the surviving spouse has plenty of money in his or her own right, then the Total Return Trust, mandating a distribution, will cause funds to flow from the tax sheltering trust to the taxable estate of the surviving spouse. Better in the credit shelter or estate tax shelter trust to invest in capital appreciation which will not be subject to estate tax. The dynasty trusts may not be good choices for Total Return Trusts if the intervening generations after your children’s generation are likely to have significant assets of their own. Remember the Total Return Trust will be distributing out assets but the purpose of the dynasty trust is to preserve assets inside the tax shelter trust so that they are not taxed on the death of the younger generations. The distributing out of assets is in conflict with the desire of the dynasty trust to hold holds assets inside the trust. However, if the younger generations are likely not to be subject to significant estate taxes, then a Total Return Trust makes good sense because of the double benefits of avoiding conflicts between income and remaindermen and giving the trustee the ability to invest with the greatest possible return regardless of the otherwise competing interests of the income and remaindermen beneficiaries.

The Total Return Trust is a new idea. Though a bit complicated, it may turn out to be the way trusts are intended in the future.