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Terminating an income trust: A suggested approach

Trustees face ethical issues when beneficiaries seek to terminate

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  • By  Jerry Reiss
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Terminating an income trust: A suggested approach
 By Jerry Reiss. Originally licensed by the Department of Labor (and the IRS) to do valuation work under ERISA (1983), and by the Society of Actuaries, Reiss has carried the ASA designation (Associate of the Society of Actuaries) since 1983. Reiss is listed in Best Experts in America in Family Law and Employment Law. He has written over a dozen state bar journal articles (and others) on valuation topics. He also publishes newsletters in family law and employment law. Principal offices: Fort Lauderdale and Orlando. This email address is being protected from spambots. You need JavaScript enabled to view it.

With the economy sluggish and likely to recover very slowly over the next few years, you can bet that many beneficiaries of income trusts will request that their trusts be terminated. This article will explore the ethical obligations that the trustee faces when confronted with this request. It also will offer the methodology and assumptions that will accomplish this liquidation and how they can maximize the chances for agreement amongst all of the beneficiaries.

An income trust becomes irrevocable upon the death of the grantor. The trust automatically pays income to current named beneficiaries on specific sums of money or share interests bequeathed to them. The trustees have discretion to pay principal from those specific sums or share interests and such payment is usually conditioned on proof of specific need. There are often successor beneficiaries who obtain the rights to automatic income and discretionary principal upon the death of the current beneficiary. The current and successor beneficiaries may receive their interest individually or jointly with the right of survivorship. Upon the deaths of all beneficiaries to each specific sum or share interest bequeathed the balance can go to named charities. Terminating these trusts after the benefactor dies can seldom be done without the consent of all current, successor and residual beneficiaries, as well as the trustees. These are also among the most complicated trusts to terminate and should never be undertaken without the assistance of an actuary.

An estate trust attorney is an integral part of the termination process because the trust cannot be terminated without court approval. Such approval can be routine when all the beneficiaries consent to a proposed distribution showing the amount of distribution that each party gets and the way that that determination was made.1 Problems result when the methodology is flawed because the proposed distributions will then reveal inconsistencies that lay people can readily see. Many proposed terminations contain obvious flaws because estate trust attorneys, skilled in construction of these trusts, fail to understand how the termination process affects the measurement of future distributions. A perfectly acceptable method for measuring today’s value of future distributions with an ongoing trust is no longer valid once the trust terminates. Very few attorneys understand this. Attorneys can also represent only some of the beneficiaries. This can lead to suggested methodologies that introduce bias that favors their clients. This should cause the trustee concern because that trustee has a duty to all the beneficiaries equally. This gives the trustee a vital interest in the process and who is retained to do the calculations.
 
Because consent of all interested parties is the best way to proceed, a proposal setting forth methodology and assumptions should be created before doing the major work. This determines whether such consent can be obtained before the trustees commit to spending the bulk of the money.

Direct Methodology & What is Wrong With It
Most proposed terminations will be done with a direct approach. Assumptions are made with respect to the income the trust will produce in the future, the interest rate that should be used to discount the future income stream to a present value amount, and the amount of discretionary principal that will be paid in the future. The methodology of the direct approach is the preferred method of most estate trust attorneys. This is very problematic for a number of reasons:

First, too many assumptions must be employed. The assumptions are either based on history or they are not. When they are not, there is no justifiable reason to support them. Even when they are, the assumptions are useful in predicting what the future income would be if the trust continued, not what earnings should be considered with a discontinued trust.

The earnings achieved are related to inflation, the risk taken, and the skill of the trustee in imputing prudent risk into the investment vehicle. Conventional thinking holds that prudent risk produces a 3% rate of return, plus the rate of inflation. But the skill of the trustee investor is a wild card that affects what rate of return can be achieved. A terminated trust can neither pay for the return produced by the skill of the trustee, nor for the pure 3% for the prudent investment, because both require future work effort to produce the result. As the trust is terminating neither will be realized. Thus the only component left in the income is the rate of inflation. This is always at work in the rate of return because even when principal is not touched the present day value of future principal is much less valuable today. Inflation is always at work eating into what those future dollars will buy. For that reason the inflation component of earnings can be viewed as distribution of principal masquerading as a portion of the rate of return. It also will be much easier to predict future inflation than future earnings and it will be much less subject to error.
 
A uniform assumption of earnings and discretionary principal produces larger results for the younger beneficiaries over the much older ones. This creates dissatisfaction for the older beneficiaries who may have much greater need for discretionary principal based on health problems or need for long-term care. It also produces results that appear to be age discriminatory, particularly when older people start with larger share interests bequeathed to them. Use of uniform assumptions can also liquidate the entire share interest for a younger person leaving a negative balance, and this can be achieved using historical earnings and historical principal. The trustees can never pay more in a termination than the remaining allocated share interest. If the trustee liquidated beneficiary interests based on historical earnings this could also be extremely unfair to the successor beneficiaries and charities. If the trust continued to operate it could pay actual earnings without touching principal. But as demonstrated before, realization of those earnings required the trustees’ investment skills at work well beyond the termination of the trust. As a result, a direct approach to termination involves too many assumptions, which viewed as a whole, are entirely unsupported and cannot be realized.

Indirect Methodology (Implicit Assumptions)—the Preferred Method
The indirect approach employs implicit rather than the explicit assumptions used in the direct approach. No one implicit assumption need be realistic or supported by historical evidence. The implicit assumptions look at the way each assumption is related to the other assumptions used and how they are impacted by each other. Valid implicit assumptions work in concert to produce a correct result.

In order to arrive at proper implicit assumptions note that no assumption need be made on the investment return during the years that the trust operated. All current income beneficiaries shared the investment return. It was then allocated to each one on the basis of their percentage share interests and if no discretionary principal was paid the principal remaining for that share interest remained constant. This then becomes the foundation for the implicit assumptions or backdoor approach.

Start first with this foundation. Then note the following obvious result: if all discretionary principal of the share interest is paid to the current beneficiary then it matters not what interest was earned on the principal, or what rate should be used to discount it to present day value. As the opening balance is distributed to each beneficiary, the present value of the future income, plus the present value of future discretionary principal disbursements must equal the opening principal balance. Understanding this identity theorem is crucial because the trustees work to produce a good result with the funds they invest. They never guarantee a result like an insurance company does. Thus the methodology used must be able to relate the distribution amounts to what one starts with and a methodology that does not produce suspect results. Under the indirect approach, neither an investment rate or rate of discount for present value purposes has been assumed, nor has one been assumed for payment for discretionary principal. If the entire principal has been disbursed, the result of the above theorem is accurate even though we will not be able to allocate it between earnings and discretionary principal.

Of course, the identity theorem above is not sufficient to do the work itself because the assumption that all principal will be paid to an individual beneficiary defeats the authority that the trustee has in deciding whether to make a discretionary principal payment in a given year. Keep in mind, however, that all principal will be distributed pursuant to the termination, but that it will be allocated between the beneficiary and any successor beneficiary, with the balance paid to the named charity or residual beneficiary. Also keep in mind, even if no discretionary principal is paid to a given beneficiary, that the lifetime right to future income has a present day value associated with it and this will reduce today’s value of current principal. Where it comes from and how it is paid and related to the current principal is the key to unraveling how to use the above identity theorem in supporting a proposed distribution.

Valuation Procedure—Three Steps
Return to the normal operation of the trust for evaluating how the current income is related to the future untouched principal. Monetary funds are a unique form of investment, because whether the investment itself is stock, bond, or real property, the investment, which throws off income generally improves over time and this improvement protects it from the erosion of inflation. But with actual funds, which is the only investment at work with in a terminating trust, part of the income it throws off is a portion of the present day value of principal lost while inflation eats at the foundation of the future value of that untouched principal.

Step 1
Understanding the relationship between inflation and the present value of future earnings allows simplification of this complex termination with a backdoor approach. First, a decision must be reached whether any discretionary principal is paid, or whether the full discretionary principal not eaten by inflationary forces will be paid to the residual beneficiary, who is often a named charity or charities. Before discretionary need can be assessed, the economic holdings of the beneficiaries must be evaluated, along with any historical requests for discretionary principal, and the age and related health of each beneficiary. Rather than do this evaluation and classifications individually, group classifications, based first on age, then break it down by economic factors. This might support as many as four separate classifications or as few as two, depending on the demographic data.

If there are beneficiaries in their eighties and older and then quite a few much younger, separate anyone with additional substantial economic means regardless of age. Then create another group, if applicable, those that have good long-term nursing care insurance from those that do not. More often than not no one will fall within this group because good insurance is very expensive. Two additional groups can be created for age: generally those over age 80 have a much greater chance of experiencing the need for long-term care than those under age 75. Look for a natural break based on the data rather than create an artificial one.

Step 2
Once the breakpoint has been identified, use the 20-year nursing care study published by the Society of Actuaries for determining the probability of incidence of accident and illness necessitating long-term nursing care confinement.2 Multiply the published rate by the average annual cost for confinement and do so for all future years for everyone in that group. Because only those who actually become sick or have an accident will require nursing care, determine the average for the group rather than have a cost for each such beneficiary, most of whom will not require the service in the future. From this total, divide the accumulated amount by the accumulated future years of the group to determine an average annual percentage of withdrawal applicable to everyone in that group.

Thus work with two distinct cost rates for the two different groups rather than work with different rates for every beneficiary. Also use any historical information available to establish averages for discretionary contributions and then average this within the group and apply that single average to the entire group rather than for the single individual. Add the two for a composite average for the group. When done this way the discretionary add-on percentage for the request for discretionary principal unrelated to nursing care confinement is kept as a very low number.3 This also smoothes out a very large one-time discretionary payment made to a beneficiary based on one-time need.

Step 3

For the final step, determine the aggregate present value of future principal and income disbursed as the actual amount of principal disbursed by using zero percent interest in the process. This follows simply by relying on the foundational principal enunciated at the beginning: the present value of future principle, plus the present value of future income, equals the opening balance. One need make adjustments only when the entire principal is not distributed. This is because the foundational principal works only when the total principal is disbursed. The income earned on the partial disbursement could not possibly implicitly be recognized on the principal that was not disbursed. But as the only income on principal for a terminating trust is the portion of the principal from which inflation has eaten into it over time, we need only to adjust the earnings for that inflation. Thus, for a given income beneficiary, if 20% of that share interest paid is discretionary principal, valued at zero percent interest, that 20% principal has an implicit component for the present value of future earnings on the disbursed principal and the 20% amount is unallocated between the two. What hasn’t been included in that 20% amount is the income earned over the beneficiary’s lifetime for the 80% principal left. That too can be implicitly and much more accurately determined by present valuing it using the rate of inflation as the rate of present value discount. The adjustment for earnings is the discount achieved by using the rate of yearly inflation to present value the future principal balance.

The payment to the primary beneficiary becomes the principal disbursement, plus the adjustment for earnings on the balance left. That adjustment reduces the opening share interest for the successor beneficiary and the process is repeated for the successor beneficiary as a future income beneficiary, with the successor beneficiary’s balance left to the residual beneficiary or the charity. This methodology avoids all of the problems and criticism of a direct approach.

1 However, the trust can also be terminated if certain statutory conditions can be met.
2 Society of Actuaries, Long Term Care Experience Committee Intercompany Study 1984 –2004 (November, 2007)
3 If there are only a handful of beneficiaries it might make better sense to use one rate for historical discretionary withdrawals and individual rates for welfare-based need.

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