Often, when establishing a trust, it is desirable to have the trust make payments to one person for a period of time (called a “lifetime beneficiary” or a “payment beneficiary”) and then after that to give what is left to another person (called a “remainder beneficiary”). Two common examples: make payments to my spouse for the rest of her/his life, then split what is left equally between my kids. Or, make payments to my kids for the rest of their lives and then give the balance to my grandkids. There are numerous advantages to such a plan, which are discussed elsewhere. This is about how to do it. And historically, the payment beneficiary would receive “income” from the trust or, if that was thought to not be enough, income plus a certain amount.
But when payments are being made like this, there is an inherent tension between the interests of the current payment beneficiary and the remainder beneficiaries. The payment beneficiary wants aggressive investing, to yield (at least, potentially) the maximum growth and therefore the maximum income. The remainder beneficiary doesn’t get the income, so he or she doesn’t care about growth, safe investing is what counts. This generally provides less income but helps to ensure the maximum corpus being left to them (because significant investment losses are unlikely).
Enter the Unitrust. The Unitrust varies the traditional model by stipulating that, rather than making the payment beneficiary’s payment based upon trust income, the payment beneficiary receives a payment each year that is a set percentage of the trust balance (technically the Net Asset Value (NAV)) on a given day of the year (usually January 1st) Of course, though the payment is calculated on an annual basis, it could be (and usually is) set up to be paid quarterly or monthly.
So, for example: The trust specifies payment to the surviving spouse of 5% of the NAV annually, remainder to the children. The trust has $500,000.00 on January 1st of a given year. The surviving spouse would get a payment of $25,000.00 ($2,083.00 per month) that year, and the trust might well actually grow over the course of the year (if income less expenses is greater than 5%). This means that the spouse would get a greater payment next year. Meanwhile, the trust balance cannot be lost to nursing home care, creditors, changes in estate planning, or anything else, and may actually grow depending upon the payment level chosen by the person forming the Trust and investment choices made by the Trustee.
Now the payment beneficiary and the remainder beneficiary are both benefited, at least to some degree, by trust growth and harmed by trust loss. Both have an incentive to monitor trust investments and the activity of the financial planning of the Trust. There is still a tension between the payment beneficiary and the remainder beneficiary. But the tension is now reduced to the percentage that the payment beneficiary is to receive, and this is set by the person forming the Trust.
So what should the payment be? That will depend upon your circumstances and goals, but a common starting point for the discussion is 6%. That accomplishes a number of objectives:
1. 6% of the NAV will usually, over the course of time, cause costs and payments to the payment beneficiary to match the income generated from a balanced portfolio. (Balanced portfolios are desirable methods of insuring that the trustee is properly discharging its fiduciary duty to both the income and remainder beneficiaries.) Of course, this depends a little on costs (tax prep, paying investment advisors, etc.) and depends upon market conditions (hence, ‘over the course of time’).
2. The trustee is freed from the artificial restraints of having to invest for income or growth and can follow both the “Prudent Investor Rule” and “Modern Portfolio Theory” which means that a diversified portfolio is created based on a predetermined appropriate risk tolerance, which minimizes the risk of losing value to inflation or to market declines, and lessens exposure on the part of the Trustee.
3. Both the lifetime and remainder beneficiaries are hoping for the same result, an increased portfolio value, because the larger the growth, the greater the 6% payout becomes and the greater the remainder becomes.
4. This is a really important concept in those cases where a lifetime beneficiary can be expected to live (and take payments) for several years because over that length of time an interest oriented portfolio would, in times of modest inflation, see the value of the income decline dramatically. But the Unitrust naturally keeps up with inflation with increasing annual payouts while the principal also grows.
Of course, it may be desirable to direct more of the trust balance to the payment beneficiary (at the expense of the remainder beneficiaries) or to preserve more for the remainder beneficiaries (at the expense of the payment beneficiary). An additional consideration is whether or not the Trustee has discretion to make additional payments to the payment beneficiary if the payments are not adequate at some point (often done if the payment beneficiary is a surviving spouse or disabled). So, yet again, the key to estate planning is the planning, but the Unitrust is a very useful (and greatly under-utilized) tool and this a good starting point for the discussion.