What impact could the worldwide economic crisis have on trust clients? Plenty. GRATs may bust. IDITs may not have sufficient cash flow to meet required note payments. Unhappy trust beneficiaries may file lawsuits against fiduciaries, whom they blame for plummeting trust investments. Disputes may erupt over the scope of trust investment policy statements.
What’s a wealth advisor to do?
Here’s a to-do list for these turbulent times.
Attention all trustees:
• Update investment policy statements—Trustees and clients serving as trustees should be reminded that, to meet their fiduciary obligations, they should have a current investment policy statement (IPS) in place and that it should be updated to reflect recent economic developments. Compliance with the Uniform Prudent Investor
Act (UPIA) is process-oriented, not result-oriented. The trust’s portfolio can decline without liability to the trustee, so long as the trustee has developed a reasonable asset allocation model and monitored investments in light of that plan. The recent market declines will likely breed suits: Was there a plan? Was it documented in an IPS? Were the plan and/or documentation reasonable and appropriate? Will check-the-box applications with brokerage firms (for example, documenting investor experience, time horizon, risk profile, investment goals, etc.) suffice to constitute an adequate documentation of a plan? Angry beneficiaries with the benefit of hindsight may bring cases testing the definitions and applications of the UPIA as never before. Trustees should be advised to meet with counsel. If there are gaps in documentation, it’s unclear what impact currently documenting the previously existing plan will suffice, but like chicken soup, it can’t hurt.
• Update distributions projections—Trustees should have the trust accountant and/or a financial advisor/wealth manager prepare projections of how the stock market declines (or economic impact on other trust assets) might affect distributions to current and remainder beneficiaries. They should then consult with you to decide whether, and if so how, the likely bad news should be communicated to the beneficiaries. Even if communication is not required, it might be advisable to do so to minimize conflict with beneficiaries whose expectations may vary dramatically with the new economic reality.
• Review the terms of the trust—Too few fiduciaries engage in periodic meetings with counsel to review the terms of the trust under which they’re serving. The recent economic earthquake certainly warrants such a review. Take a fresh look at the governing document and determine if there are any other measures that should be taken.
• Assess responsibilities in directed trusts—If you’re dealing with a directed trust, look at just how much responsibility the trustee has over the investment advisor providing the direction. Considering the language of the trust agreement and applicable state law: Must or should the trustee exercise care over the investment advisor directing investments? What standard of care should be exercised? Must or should the trustee periodically review the agent’s actions? If so, when was this done last, if at all?
Calling all trust protectors, distribution committees, investment advisors and other such fiduciaries:
• Review your roles and responsibilities— Even if you think you know what’s required of you, now is the time to check again. The use of a bevy of fiduciaries, along with trustees (for example, an institutional administrative trustee, an individual co-trustee, etc.) creates a host of inter-relationships between the different roles. Exactly what degree of responsibility does the trust protector, institutional administrative trustee, individual co-trustee and investment advisor have, if any, for the investment management of the trust assets? What is the responsibility of each of these fiduciaries for the others? If there are overlapping responsibilities, who trumps who? Develop appropriate plans in light of current market conditions. Determine what to communicate, if anything, to beneficiaries.
• Examine assumptions—Directed trusts with family or other friendly investment advisors have been used to hold family business interests. While it may have been clearly understood by all that these family business or real estate interests were the purpose of the trust and would be held no matter what the economic climate, has the recent cataclysm changed that? Do the terms of the governing document mandate the retention of the family business interest? Perhaps they merely authorize it subject to certain stated goals or considerations. Might it be advisable, or perhaps required, to document the appropriateness of that objective?
Estate-planning lawyers and wealth managers:
• Calm clients’ fears about their short-term rolling GRATs—Grantor retained annuity trusts (GRATs) come in many flavors. A common flavor has been a short-term, typically two-year GRAT designed to capture upside market volatility. The annuity paid to the grantor would be set high enough so that the GRAT would have a nominal value for gift tax purposes (a post-Walton zeroed out GRAT). The result of this approach is that a substantial portion of the assets of the GRAT (principal plus the 7520 mandated return) would be paid back to the client/grantor.
Market returns above the mandated federal interest rate, would inure to the benefit of your client’s heirs (or a trust for their benefit provided for under the GRAT). This would result in your client having to re-GRAT the large distribution received in each year of the GRAT to a new GRAT. That’s why the technique of using repetitive short-term GRATs has been referred to as “rolling” or “cascading” GRATs. You undoubtedly explained to your clients the concept of re-GRAT’ing each year’s distributions to a new GRAT. But it may be worth reminding them of this point now.
The problem is, now, instead of earning more than the mandated interest rate, your clients’ GRATs are worth 20-plus percent less than what they initially transferred to it. Such GRATs will bust—resulting in no assets inuring to the intended remainder beneficiaries. All the assets will be distributed to your clients with nothing left for their heirs.
What should your clients do?
Make lemonade out of this lemon.
Advise your clients that, when the final GRAT assets are repaid to them, they should continue the plan. Nothing has really changed. Volatility was the rationale behind the GRAT in the first instance, and that is exactly what the client experienced. Clients need to be reminded that, just as with rebalancing their portfolios during market upswings and declines, assets should be re-GRAT’ed to new GRATs. If, in fact, the markets are at a low enough point now, the new GRATs will remove the market recovery from their estates.
So, give your client some Tums, then help them establish a new GRAT and re-gift the assets remaining to that new GRAT. This was the plan when the client undertook the rolling GRAT structure. There is no need to change now.
Indeed, if the markets get sufficiently hammered, this may be the ideal time to contribute depressed assets to a new GRAT. The fact that the client is depressed along with the assets won’t help GRAT performance, but will present a hurdle for practitioners in keeping the GRATs rolling. Encourage clients to stick with the discipline. If the asset class contributed to the GRAT rises within two years, they’ll have made GRAT lemonade.
Practitioners might wish to consider having the trustees execute a short acknowledgement that the GRAT has been terminated with a final payment to the grantor, so that there is an obvious record in the files of what happened should a question arise in future years. This might be especially helpful if the GRAT distributes all of its assets prior to the intended termination date (for example, a high payout two-year GRAT that has declined to less than 50 percent of its value before the first annuity payment will bust in year one, not the intended termination date in year two.)
• Reconsider long-term rolling GRATs—The mathematical superiority of short-term rolling GRATs over long-term rolling GRATs has been documented. But none of these analyses take into consideration the changing political environment. So, let’s do that.
(1) What is the likelihood of the next administration making the estate tax tougher or eliminating GRATs? If the next President wants to raise revenues from the wealthy, he could leave whatever estate tax exclusion he chooses in place, perhaps the $3.5 million, just so he can say, “Read my lips, no new taxes.” But this exclusion could be coupled with an elimination of discounts on related-party transactions, elimination or restriction on Crummey powers, repeal of GRATs (gee, was it really fair that “heads the taxpayer wins, but tails the taxpayer doesn’t loose?”), and a few other choice changes that the media and public will barely notice or comprehend. The result will be a substantial enhancement of estate tax revenues without the appearance of a tax increase. If GRATs are legislatively eliminated, the cascading GRAT strategy might be fodder for the next GEICO caveman commercial.
(2) Some wealth managers say the recovery from the current market decline could take five-plus years.
(3) The safety of relying on a power to substitute assets was reaffirmed in a recent ruling.
(4) Interest rates remain at historic lows.
Considering these factors doesn’t change the fact that the short-term rolling GRAT is a better strategy, but it does mean your clients may not have enough time to make it work for them.
Perhaps a safer long-term strategy might be to create a series of long-term GRATs. If the GRAT technique is repealed, completed GRATs are more likely to be grandfathered. The client/grantor can use the power to substitute to lock in that particular GRAT’s gains. Perhaps at that point the portfolio of the particular GRAT can be invested in a diversified portfolio with consideration to the termination date of the GRAT.
For example: A client establishes a series of 10, $1 million 10-year GRATs— each for a different asset class. One of the 10-year GRATs experiences a substantial gain in year one, doubling in value. Under the rolling GRAT paradigm, this would have been a two-year GRAT, not a 10-year GRAT. The client would have been advised to substitute Treasury bills (T-bills) for the $2 million in the GRAT, thus locking in the large gain. This strategy won’t work well in a 10-year GRAT, because no investor would retain T-bills for the nine remaining years. However, a two-year GRAT won’t work either if GRATs are repealed next year or it takes three-plus years for that asset class to recover. Instead, while clearly less advantageous, the 10-year GRAT might prove the only practically effective technique.
There are several approaches to consider. The client could substitute a diversified portfolio with a nine-year time horizon for the $2 million appreciated GRAT property. While clearly not as secure as locking in the gain with T-bills on a two-year GRAT with one year remaining, it will be more secure for purposes of retaining that gain than perhaps the client’s long term overall asset allocation. Assume that the client generally has a 20-plus year investment horizon and an overall asset allocation consisting of 60 percent equities, 25 percent bonds and 15 percent alternatives. Perhaps the nine-year remaining GRAT might be given as substitute property a more conservative allocation designed to minimize downside risk of giving up the $1 million initial gain, but still consider the long nine-year time horizon and the need for growth inside the GRAT.
The client’s wealth manager might recommend 40 percent equities, 45 percent bonds and a 15 percent alternative strategy. Perhaps option techniques can be used to hedge the downside risk in the highly successful GRAT while leaving some upside potential for growth in light of the nine years remaining.
While that strategy will come at a cost that will reduce the upside, it can perhaps be viewed as insurance on preserving the large gain in year one. Such a portfolio might be believed to be far less risky, thus locking in as best as feasible the large gain realized in year one. But, with nine years remaining, substituting all T-bills for the large gain property would leave too many years of mediocre performance to even pace inflation.
Long-term GRATs are not the homerun that a successful series of short-term GRATs can be. But the budget deficit that the next administration will have to address, the uncertainty of whether GRATs will survive, and the unknown timing of market improvements, make it worth reconsidering them.
• Think about sales to intentionally defective irrevocable trusts (IDITs)—IDITs and sale transactions to them can take various forms. Each of these approaches raises issues that may require careful consideration in light of recent economic developments.
Format—The sale could be for a note, a self-canceling installment note (SCIN) or a private annuity. If a sale was made for a note, when the transaction was structured the expectation was that the growth in the assets sold to the IDIT would far outstrip the interest cost on the note plus the costs and risks of the transaction. Time to check if this expectation is still valid. If it isn’t and the note can be prepaid, what would the consequences of prepaying be? Also, note that recent mortality data indicated an increase in life expectancies. This increase in life expectancy might further exacerbate the negative results triggered by the economic downturn in say, a sale for a private annuity (if there are no health issues).
Payment—The financial aspects of the transactions can be structured in a myriad of ways. These could include the intent to pay the note or annuity amounts from cash flow, or the expectation that equity interests sold to the IDIT will be re-transferred back to the seller to cover the required payments (in part). But all these options have the expectation of substantial post-sale appreciation.
It’s time to evaluate IDIT sale transactions to determine whether current economic conditions impact the buyer’s/IDIT’s ability to make timely payments on required due dates. If cash flow will be insufficient because of stock market declines or because business is reduced due to the economic downturn, plan to meet required distributions in advance. While a business might borrow to fund distributions, this option may not be viable. Third-party lending to a closely held business owned in significant part by an out-of-state trust may be difficult in normal circumstances; it might be impossible in the current lending environment. That leaves borrowing from a related party, or planning a distribution of equity to the seller, if appropriate for the transaction. A distribution in-kind will require a new appraisal for the interest being distributed back to the seller. In many cases, meeting distribution requirements will require advance planning so that the distribution can be made on a timely basis.
Security—Some practitioners insist on seed money, some even claim there is a biblical mandate for not less than 10 percent seed capital in an IDIT. Other practitioners structure transactions without any seed money. Some practitioners will incorporate various types or levels of guarantees to support the sale transaction. Sometimes the nature of the guarantees correlates inversely with the amount of seed money (the more seed money, the less significant the guarantees).
Guarantees for the repayment of the note may have been made by an IDIT trust beneficiary, or perhaps another family entity. If the beneficiaries had sufficient net worth at the time the sale transaction was closed, what is their financial status after the recent market swings? If it was believed that the guarantee was an important component of the plan at the time, and the child/IDIT-beneficiary’s net worth is half what it was when the transaction was consummated, what does that mean to the viability of the guarantee? How should that be addressed? What would an unrelated commercial party do in such a situation? If a family’s irrevocable life insurance trust (ILIT) guaranteed a tier of the IDIT note, what is the ILIT’s current financial status? Is the issuing insurance company financially sound? What about the value of the insurance policies held by the ILIT? If the policies were variable policies that took a pounding in the market decline, what is the worth of the ILIT’s guarantee? If the guarantee was based on the possible sale value of the insurance policies, how have recent developments affected that value?
• Take a hard look at GRATs and IDITs funded with real estate and business assets—Selling real estate or business interests to an IDIT or gifting them to GRATs are common estate-planning techniques. I’ve mentioned several possible implications the recent economic and market developments may have for these types of transactions generally. But there may be additional problems when closely held businesses or real estate are involved.
The key to some of these transactions’ success is that the real estate or business interests generate sufficient cash flow for the trust to pay the note or for the GRAT to make its periodic annuity payment. If economic developments have cast doubt on the trust being able to make payments out of cash flow, advisors must take steps to ensure these payments will be made. Audits have concentrated attention on fiduciaries’ complying with the formalities of maintaining the transaction. Therefore, meeting payment requirements should be given considerable care. If the result is that the GRAT or IDIT will have to distribute back part of the equity of the underlying real estate or business interests, an appraisal will be required of those assets. Given current market conditions, three negative results are possible:
(1) If the business or real estate is valued lower than when the transaction was initially consummated, a larger percentage interest may have to be repaid.
(2) Making a note (annuity) payment using interest in the real estate or business assets held by the IDIT (GRAT) could be further exacerbated by discount whipsaw. Assume that your client’s appraiser determined a 35 percent aggregate discount on the 40 percent interest in a limited liability company sold to the IDIT or given to the GRAT. Since the real estate or business cash flow is inadequate to make the note (annuity) payment, the IDIT (GRAT) will have to make a payment in-kind. A higher discount may apply to the much smaller, say 2 percent real estate or business equity interest that must be distributed back to your client as a result of the business or real estate not generating the cash flow that had been expected. The argument would be that a higher discount would apply to a 2 percent interest than applied to a 40 percent interest.
(3) Some appraisers have speculated that current economic conditions and volatility actually justify greater discounts. Perhaps they are seeking to encourage clients to engage in transactions now while greater discounts imply more leverage. But the danger of these transactions now is discount whipsaw. The discount on the equity interests that has to be distributed back to the grantor or note holder could now have a third level of negative leverage.
All wealth advisors take note:
• Be careful out there—The economic turmoil, real estate bubble and stock market meltdown have likely impacted every existing trust, and will affect planning for every type of trust technique. I’ve endeavored to identify a number of the possibilities and steps that can be taken to help clients plan through the tumultuous period we now face.