TOTAL RETURN TRUST
by John R Lolio, Jr ,
Estates and Trust Dept.
A. Introduction
Traditional trust planning has called for the trustee to "hold the principal" and "pay the income" to a current beneficiary. This "income" includes interest and dividends, but not capital gains. With dividend yields at historic lows, many equity investments which produce growth in value, pay little or no dividends. Fixed income investments, which yield greater current income, produce little or no growth in value. Furthermore, interest rates have been declining and are at their lowest levels in three decades.
Thus, the current beneficiary of a traditional trust may receive less than he or she needs, and growth of the trust may be sacrificed to produce higher income yields. By investing for total return, however, an investor can expect to really profit after taxes and inflation. A decedent who wishes to create a trust to benefit his or her family, take advantage of total return investing to maximize returns for the trust and its remainder beneficiaries while providing an adequate income to the current beneficiary may want to use the Total Return Trust.
B. Issues Associated With Traditional "Income Rule Trusts"
- Where a current beneficiary's need for income is high, the trustee must invest in a higher proportion of fixed income investments, sacrificing growth potential.
- When dividend yields and interest rates decline, the current beneficiary's "allowance" will go down even when the value of the trust increases.
- During times of interest rate volatility, income distributions will fluctuate, making planning difficult for the current beneficiary.
- If fixed income investments represent a large portion of the trust's investments portfolio, the current beneficiary may not be adequately protected from inflation.
C. The Total Return Trust and How It Can Help Address Common Trust Dilemmas
- The Total Return Trust is a form of private unitrust which distributes a percentage of the total value of the trust assets rather than just income.
- Because annual distributions are related to the trust's market value, as the market value of the trust grows, so does the payout to the current beneficiary.
- Total return investing takes advantage of the tax benefits of low capital gains tax rates and the use of the cost basis of securities to increase distributions by regularly monitoring equity holdings.
- The trustee satisfies its fiduciary duty and the beneficiaries' risk to tolerances by investing in an appropriate asset allocation because the composition of the return to the trust (income and appreciation) is irrelevant.
- The current beneficiary is able to plan better since the annual distribution is calculated and known at the beginning of the year.
- The provisions of a Total Return Trust may provide certain safeguards which reduce volatility in the size of a beneficiary's distribution from year-to-year, particularly in years that the portfolio may decline due to market conditions.
- The interests of the trustee, the current beneficiaries and the remainder beneficiaries are united by the same objective - to invest and grow the trust principal, i.e., to maximize total return of the trust.
- The total return objective is designed to provide greater inflation protection over the long term because, if the trust's assets grow, everyone's trust interest grows.
D. Considerations for the Use of Total Return Trusts
- What are the family's objectives? Are the needs of the current beneficiary (or beneficiaries) the most important? How important is it that the distributions to the current beneficiary keep up with inflation? Is growth of the trust an important consideration?
- What assets (trust size) will be working for the family after taxes and expenses?
- What payout rate (percentage of trust's market value) is suitable and appropriate?
- Should the trustee be permitted to change the payout rate?
The provisions of a Total Return Trust may allow for a "cap" on the percentage distribution to the current beneficiary.
