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Making Trust Funds Do Double Duty


Until recently, trust funds could become a painful financial crowbar between generations. Dad would leave a nice package of assets--stocks, bonds, and real estate--in a trust. Mom got the income to live on, and when she died, the kids got the capital. The problem was that an investment strategy that best served Mother's needs for a comfortable and steady income often did little to boost the value of the children's inheritance. The earnings all got paid out, and there was no incentive to invest in hot-growth stocks such as Microsoft that appreciated like crazy for years but paid no dividends. That put whoever was managing the trust's assets in a bind. The two generations' interests were diametrically opposed.

But new trust-conversion laws passed in four states--starting with Delaware last summer--give those who are struggling to balance opposing interests an alternative. Trustees in Delaware, Missouri, New Jersey, and New York can--with their beneficiaries' consent--convert old-style irrevocable trusts into "total return trusts," which pay out a fixed yearly percentage of the whole trust, interest income and principal included. Those from other states have to wait until their state allows conversion, or go to court, where the outcome has been mixed, to seek permission to alter the trusts. All 50 states and the District of Columbia now allow the creation of new total return trusts.

The total return concept frees trustees to invest in a mix of assets that produce both capital appreciation and income. Switching to a total return trust can boost an income beneficiary's yearly take-home to anywhere from 3% to 5% of the trust's value, depending on the state the trust calls home.

That's clearly a better deal for whoever is getting the income. A fixed percentage each year provides stability that can't be matched. "Historically, the fluctuation can be very dramatic" on traditional trust payments, says Joan Bozek, a senior fiduciary consultant at Merrill Lynch. And there are tax advantages for total returns trusts: The capital-gains portion of the trust's payout is taxed at a lower rate than conventional trust payouts, which are taxed at the ordinary income rate.

Converting to a total return trust is not without risk, however. The danger, according to critics, is that making fixed payouts can, in the long run, shortchange all the beneficiaries. According to research done by J.P. Morgan Private Bank, a trust that pays out 4% or more of the trust's assets every year over a 20-year period has a 60% chance that it will lose value over time. "Even in a bull market, it takes out so much principal that a declining amount goes to the income beneficiary," says Joanne Johnson, a managing director at J.P. Morgan Private Bank. Another potential disadvantage: The conversion to a total return trust is binding in some states, so there's no turning back if the switch turns out to have been a bad move.

Instead, Johnson advises her clients to take advantage of "power-to-adjust" statutes that are on the books in more than two dozen states and the District of Columbia. The power-to-adjust provisions give the trustees discretion to dip into the principal in order to provide a larger payout to an income beneficiary. Cash-strapped income beneficiaries can, of course, lobby trustees to make adjustments, but any responsible trustees should be considering adjustments each year anyway.

The power to adjust allows a trustee to supplement the income with capital gains during a bull market. In a downturn, the trustee can revert to an income-only payout to conserve capital. "It gives a lot more flexibility in terms of timing and amount," Johnson says.

The downside is that adjusting the annual payment each January brings greater risk of family strife. If Mom wants a bigger payout than her kids agree to, the whole matter could end up in court. But no trust statute can prevent that. As anyone who has ever divided a deceased parent's belongings among siblings knows, inheritance disputes bring out the worst in everybody. But a total return trust can go a long way to keeping such acrimony at bay. And that's a pretty good return in itself. By Brian Hindo


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