Just 20 years ago, a sophisticated family plan might have employed a single trust, subdivided into two or perhaps three sub-trusts. A sole individual or bank served as the family's trustee. Today, popular planning strategies involve multiple trusts, numerous trustees and other advisors, fragmented trustee roles and investment vehicles sponsored and controlled by families. Tax and planning strategies requiring complex trust structures are recommended to and adopted by families of only modest wealth. These intricate arrays serve a variety of purposes, but underlying them all is the goal of giving a family maximum control over its own wealth, especially wealth held in trust.
Unfortunately, too many families — and, let's be candid, too many of their advisors as well — don't realize that creating a suite of trusts, like composing a symphony, is only the first step. A symphony requires an orchestra of musicians to transform a score on paper into a fully realized concert. Even virtuosos who know their parts require a conductor to set the tempo and bring each performance in where the score requires. Today's trusts also may involve dozens of performers in specialized roles who require direction and supervision. A family that creates such an ensemble without likewise providing direction and supervision is courting failure.
The new generation of sophisticated trusts has been the subject of exhaustive attention — not all of it positive. As often as not, reports of new stratagems run side-by-side with cautionary tales about earlier configurations that didn't fulfill expectations, usually because they were not managed as their drafters intended.1
In a period spanning barely more than a decade, trusts and estates counsel have allied with state legislatures and uniform laws draftsmen to remove many significant legal barriers to a family exercising control over major aspects of its own trusts. But these statutory initiatives also have aided and abetted the less-welcome trend toward complexity. The three most significant changes have been:
- the 1994 Uniform Prudent Investor Act's default authority for trustees to delegate investment responsibility to third parties; 2
- preemptive authority under the Uniform Principal and Income Act (1997) for trustees to rewrite the relationships among current and contingent beneficiaries;3 and
- the constellation of powers in the Uniform Trust Code (2000), which ratifies the parceling-out of the trustee's role to delegates and “mini-trustees” such as trust protectors and advisers.4
With these legal building blocks, families can control their wealth — and their destinies. But even states with the most progressive trust regulations have not repealed Murphy's Law. Absent effective handling of decentralized trust structures, that adage's newest corollary will be, “If you build it…they will mess it up.” Recognizing this, tax and planning advisors should help families finish what they start. If a planning objective is important enough to justify an arcane configuration, then it's worth the expense and inconvenience of adding a prudent management program to ensure it works.
Starting in the early 1980s, the single trust has been progressively supplanted by separate trusts for each generation and even each descendant, along with an alphabet soup of specialized trusts, often with acronyms revealing an origin in financial product foundries. Frequently added to an already intricate mix are charitable trusts and organizations, with their special rules and requirements.
Families are forced to find a number of individual and corporate trustees willing to administer their proliferating trusts. Increasingly, a trustee from a state far from the family's residence also is needed (to forum-shop for the best trust laws and/or lowest state income taxes). The jobs of these trustees are made ever more difficult not only by the need to coordinate among themselves, but also by multiple trusts having significantly different beneficiaries and purposes, which require trustees to vary their actions to respond to each trust's unique circumstances.
Other developments, also grounded in the desire of families to take charge of their wealth, add to the management challenge. For instance, private investment vehicles such as family limited partnerships and insurance trusts are now common. With family members as general and limited partners, managers and even investment advisors, these vehicles propel families into the investment services business.
Today, many families create so-called “open-architecture trusts” in which fiduciary roles are parceled out among directed trustees, protectors, advisors, power-holders and committees. The purpose is to put advisors into positions best suited to their expertise and family members where their special sensitivities to the family's needs and desires are invaluable.5 These benefits led many families to begin splitting up the trustee role even before uniform laws commissioners and states got into the act. Families relied on informal agreements among co-trustees, language in trust instruments and on a settlor's authority to overcome common law and statutory delegation barriers.
Multiple trusts, investment vehicles and roles for family members and others mean that a wealthy family's trust arragement will often involve as many performers as a chamber orchestra. A typical wealthy family's trust can easily involve some 20 different roles:
- three major types of clients (trusts, charities and individual investors);
- five additional participants with the authority to make discretionary decisions (individual trustees, corporate trustees, protectors, power-holders and a distributions committee);
- four types of investment entities (operating companies, family limited partnerships, common trust funds and third-party investment funds);
- three levels of investment advisors (an investment committee, allocation advisor and investment advisors); and
- five kinds of administrative or professional service providers (the family office or a family audit committee, custodians, brokers, attorneys and accountants).
Each of the roles in a family financial plan may be performed by many individuals or entities, yielding a total number of participants that often is a multiple of the total number of roles.
It's well-known that a heightened risk of making mistakes inheres in intricate systems involving many moving parts and players. A variety of disasters can and have resulted from inadequate management.
In one instance of management gone AWOL, a family failed to promptly replace a fired family office executive with a new trustee. When another trustee suddenly died, the family's wealth fell under the complete control of a competent but hostile trustee with the power to choose his own successor.
Other examples include numerous cases of family members asserting inappropriate, although usually inadvertent, control over trust assets or family limited partnerships, generally with disastrous tax consequences.
Sometimes a trustee or committee legally charged with authority takes action without documenting the action or the reasoning behind it. Or an action fails to include any of several co-trustees whose votes are required. The result in either case can be an otherwise defensible action leading to a beneficiary gaining the right to impose a surcharge on the trustees if a loss ensues.
Another frequent mistake: adoption of a “family investment policy” for all trusts, instead of policies adapted to the unique requirements of each. See “What Can Go Wrong?” page 42, for a variety of ways in which the risk of costly mistakes or omissions can be magnified in convoluted trust structures.
These pitfalls are well-known in the industry, but many an expert's palliative is to exhort trustees and mini-trustees to become better informed about their responsibilities, trusts and beneficiaries — in other words, to do their jobs better. This advice may have a subtext: “Don't try this at home. This is a job for an institutional trustee.”6
Turning the job back to the institutional trustee, though, would undermine the main purposes of unbundling the trustee's roles: maximizing the family's ownership of its wealth and assuring that those most in tune with the family are performing the critical tasks.
Other solutions must be found.
Educating the beneficiaries about their responsibilities would be helpful,7 but not the complete solution. Neither is informal coordination among participants. Rather, a well-thought-out system for effective supervision and direction of all the players and their fiduciary and investment roles is needed.
Only through such a system can a family ensure that each role is not just understood but also performed and monitored, that every participant has the resources he needs, that the organization will respond to changes in the law or in family circumstances as they occur, and that ineffective or retiring players will be replaced with capable successors.
Of course, effective administration also requires effective people at the top. Whenever possible, the family office can and should play the central role in shepherding the family's financial plan and the trusts created to implement it. Unfortunately, these intricate schemes are not formed or recommended only to families who have such offices or the ability or desire to create one.
Absent a family office, a professional with the necessary skills should be given the authority to execute a multi-faceted, potentially risk-laden blueprint. Good candidates exist, including cooperative or commercial “multi-family offices.” But if no one can be found at an acceptable cost, adopting a strategy requiring such complexity should be reconsidered.
The most important word in “risk management” is not “risk” — it is “management.” Losses rarely occur in a multi-party trust apparatus just because its managers lacked black boxes spewing the results of algorithms with names like “Sharpe Ratio,” “Monte-Carlo Simulation” or the dreaded “Black-Scholes Option Pricing Model.” Instead, they usually occur because there was no manager — or the managers lacked the authority and resources to supervise and direct professional and family participants.
The vital elements of risk management for an elaborate trust configuration are straightforward and intuitive. Every element is too reasonable and inexpensive to neglect. What's more, there are only three:
- Assign management of the system to the family office or someone else able to perform this role.
- Give that manager the necessary authority and resources.
- Require the manager to follow basic risk management procedures.
These fundamentals, thoughtfully applied to even the most involved trust package, should yield a system that will operate as intended and provide a family an appropriate level of protection from participant mistakes and omissions.
A family office is an excellent candidate for the role of manager, but it must be able to fully perform the role. Most family offices have two self-imposed limitations on their ability to adequately supervise a multi-faceted financial services organization: First, they seldom have actual authority to supervise and direct the participants. Second, they usually lack the resources and systems necessary to do so.
Instead, family offices often operate according to an “ostrich risk management plan.” This approach has real strengths: a concerted effort by the family to employ capable, honest and dedicated officers and employees, and the hard work of those officers and employees to get ahead of the escalating needs of a growing family adopting ever more elaborate trusts.
But it deserves its “ostrich plan” label because that same family — recognizing that the complexity and magnitude of its trust arrangements have outgrown seat-of-the-pants risk management — has nevertheless put off instituting the formal risk management they know they need. Consequently, families in this situation lack the three fundamentals of effective administration and all the program components that would have been derived from them.
What's a better alternative? To start with, families should document in writing the responsibilities of each trustee, mini-trustee, committee, advisor and power-holder with discretionary decision-making authority. Families also should appoint a family office or an outside service provider as manager, formally charged with making the system work. That manager will be responsible for:
- committing to support all who hold trust powers, primarily by calendaring, recording and implementing each decision required of them;
- confirming that all key actors have the information required to make prudent decisions;
- monitoring and assessing the performance of each power-holder, custodian, accountant, attorney, broker or other outside provider of administrative services;
- correcting any mistakes or omissions and taking steps to assure they will not recur;
- recommending successors for participants or service providers who retire, resign or are ineffective;
- preparing and communicating policies and procedures necessary to operate the complex trust structure and updating and revising them as necessary;
- notifying all participants and service providers of changes in the law, family circumstances or policies and procedures affecting their roles
- identifying and obtaining the resources (people and systems) necessary to do all of the foregoing;
- auditing compliance with procedures to assure that all critical functions are performed well.
The manager of even the gnarliest trusts need only embrace these basic components of risk management to be in an excellent position to protect the family.
If the family eschews creating a family office to perform these functions, and instead turns to an unrelated entity (such as a multi-family office), it should at least appoint a “family audit committee” of selected family leaders and its most trusted advisors. That committee should be charged with selecting the manager and monitoring how it performs its vital role of managing the family's wealth and, therefore, its future.
- Douglas Moore, “Trustees Under a Microscope,” Trusts & Estates (July 2003) pp. 44-49; C. Thomas Mason III and Lawrence M. Elkus, “Sue or Be Sued,” Trusts & Estates (February 2003) pp. 32-38; Ian A. Marsh, “Trustees for the Wrong Reasons,” Trusts & Estates (May 2003) p. 72; Owen G. Fiore, “Communicate — or Be Held Liable,” Trusts & Estates (November 2002) pp. 23-25; Roy M. Adams, “Trustees Delegating Investments,” Trusts & Estates (June 2003) p. 80; Richard L. Harris and Russ Alan Prince, “Paralyzed Over Split Dollar,” Trusts & Estates (March 2003) pp. 28-29; Richard L. Harris and Russ Alan Prince, “The Problems with Trusts Owning Life Insurance,” Trusts & Estates (May 2003) pp. 62-64.
- The National Conference of Commis-sioners of Uniform State Laws (NCCUSL) Uniform Prudent Investor Act (1994), has been adopted in varying versions by a large majority of the states.
- The NCCUSL Uniform Principal and Income Act (1997), already has been adopted by a significant minority of the states. Also, many states have adopted, separately or in addition, a “unitrust conversion” act with similar aims.
- The NCCUSL Uniform Trust Code (2000), has been adopted in a handful of states thus far, but other states, such as South Dakota and Delaware, have had similar provisions in effect for several years.
- John H. Lahey, “Open-Architecture Trusts: The Wiser Choice,” Trusts & Estates (August 2003) at pp. 44-45 (“Open-Architecture Trusts”).
- Consider articles cited in note 1 above.
- Ibid, “Open-Architecture Trusts,” at p. 45.
WHAT CAN GO WRONG?
The more people involved with a trust, the greater the possibility of error
Trusts are about as self-implementing as symphonies are self-performing. Even simple trusts run by a single trustee can go awry. Trustees can make bad investment decisions, fail to follow the provisions of the trust instruments, communicate poorly with beneficiaries, steal or negligently lose assets, and otherwise fail to perform their fiduciary duties.
But complex trust configurations create greater exposure to some types and magnitudes of risks. Potential problems include:
- some trustees not participating in a crucial decision;
- uncertain scope of a mini-trustee's duties;
- trustees not recognizing when they need to act;
- lack of clarity as to who should implement a decision;
- participants who don't document and communicate their decisions;
- a delegation that was not authorized or documented;
- inadequate due diligence by trustees or mini-trustees on service providers;
- delegated performance not monitored and delegate retention not reviewed;
- lack of coordination of multiple parties' participation in decisions or implementation;
- no one assuring that actions of donors and beneficiaries and their related or subordinate persons are consistent with applicable legal limitations;
- capable successors to trustees and mini-trustees not sought ahead of time;
- confidential trust and beneficiary information not kept to a “need to know” basis;
- self-dealing and other conflicts of interest among participants.
— John P.C. Duncan