Trusts are proliferating, but advisors are focusing on protecting wealth, not on the interests of beneficiaries. This increases the likelihood that resentful beneficiaries will cause an enormous increase in trust litigation. But this can be avoided by learning to appreciate the beneficiaries. And by that I mean everything from merely considering the beneficiaries' point of view to actually engaging them in the planning process.
Boomers in the United States are worried that their wealth will harm the next generation, robbing them of initiative and spoiling them. The solution? Restrictive trusts and incentive trusts.
Around the world, wealthy families want to protect their fortunes from risk, including unstable political environments. The solution? New trust laws in Dubai, Bahrain and China.
Advisors tell clients: Protect your wealth by leaving it in a trust, and carefully choose the trust's terms and situs. When left out of the process, beneficiaries tend to assume: My parents didn't trust me with the money.
So, here's a caution: in the rush to protect fortunes — don't forget the beneficiary's perspective. The core concept of a trust, after all, is to give the management of property to a third person “for the benefit of” the beneficiary. If the intention is to protect the wealth from the beneficiary, and not for the beneficiary, two outcomes are likely. Either the trust will be upheld and the beneficiary will settle into a dependent, “trust fund baby” role, or the dissatisfied beneficiary will attack the trust, resulting — at a minimum — in costs and disruption, and in the worst cases, in publicized family feuds and trusts that are set aside.
How can advisors help families avoid these disasters? How can advisors help families design trusts that are imbued with an appreciation of the beneficiaries?
Avoid some classic mistakes by understanding these three principles:
- Top-down planning does not work
Traditional estate planning has consisted of planning by the senior (wealthy) family member with the advice of his estate-planning professional. The beneficiary is not in the room and has no voice in this discussion. Trusts are created “to take care of” the beneficiary. The planning is unilateral and top-down.
The result: the beneficiary is unlikely to appreciate or even understand the trust. Recipients of this kind of planning sometimes say that a trust was created for them because they weren't trusted. Living as a beneficiary of a unilaterally created trust causes many adult children to feel their parents didn't think they were competent.
One trust beneficiary in his seventies complained that he was thoroughly tired of the trust his parents had created. He felt he was mature enough to manage the assets on his own. If he had been included in discussions with his parents, he might have seen the lifelong trust as a positive protection of the wealth for him and for his children. Instead, he hired a lawyer to have the trust terminated.
Another wealthy client, who felt he had been forced to live a dependent life as a trust beneficiary, decided to leave his large estate outright to his young adult children. He added language in his will explaining his decision: “I am not creating trusts for my children, because I have complete confidence in their judgment.” Unfortunately, the outright repudiation of trusts throws out some valuable arrangements.
- “How much is too much?” is the wrong question
As everyone knows and seems to admire, financier Warren Buffett set the modern test, saying that he wanted to give his children “enough so they can do anything, but not so much that they can do nothing.” Bill Gates agrees with this philosophy and has emphasized that he wants his children to learn “the value of a dollar.” In the United States, this assumption that too much money is harmful was memorialized by Andrew Carnegie, who wrote in his Gospel of Wealth, “[T]he parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.” The result of thinking (again unilaterally) that too much wealth will harm the recipient leads directly to an increased (and unilateral) use of trusts. Trusts then are used to withhold wealth from beneficiaries.
Interestingly, this is not an issue in Europe. There, children have a legal right — from birth — to a large share of their parents' assets. In those same countries, the law has traditionally not recognized the concept of trustee ownership (requiring instead “unity of ownership.”) What this means is that parents do not spend time worrying about how long to withhold wealth from the children (that is to say, ruminating about what are good ages for trust distributions) or how much to give to them (this has been predetermined.) In some countries, even the lifetime gifts to others are pulled back into the estate to determine the child's share
- Incentive trusts cannot be trusted
Today, there is a great deal of attention on how to ensure that children/beneficiaries are raised with the “right” values. A corollary to the idea that wealth will harm beneficiaries' character development, incentive trusts are a way to use trust funds to encourage the “correct” way of living. Distributions are based on the success or failure of the beneficiary to meet certain predetermined goals or standards.
But, think: Who are the targets for an incentive trust? Usually, it's a wealthy client's children. Yet, most incentive trusts go into effect upon the parents' death and the objects of the trust are likely to be well past their formative years. In fact, given how long settlors are living now, the beneficiaries are probably going to be approaching retirement age.
Lifetime incentive trusts are rare because few parents are willing to pay a gift tax on any trust transfers in excess of the relatively small $1 million. And few parents are worried about the harmful consequences of a mere $1 million.
If incentive trusts are aimed at grandchildren, a number of intrinsic conflicts are created. Who should be parenting these little beneficiaries? Surely, it should be the parents and not the grandparents? Also, how can the grandparents be wise enough to anticipate the conditions in which their grandchildren will be raised? Ironically, though, grandparents do not usually have the same angst about the effect too much money might have on their grandchildren.
Another concern is that no matter how tight and detailed the drafting is, circumstances may change. One incentive trust that turned out sadly was drafted to match the income earned by each of two adult children: one was a successful investment banker; the other, a teacher (a profession she chose after the parents died.) Not only were the distributions quite uneven (and not needed by the investment banker), but also the teacher had an accident resulting in loss of income, diminishing the already small distribution to her. With internal family conflict, her sibling would not agree to assist her. Obviously, the parents had not intended this result.
Clearly, then, there are core difficulties with the whole idea of the incentive trust. And this is apart from the endless drafting issues: (For education: Should it be a grade point average of X? Does the major matter? Does the difficulty of the school matter? Must they finish within X years? For work choices: Should the paycheck be matched by the trust? Should pay excesses over X be matched or doubled? Should nonprofit pay be tripled? Should childcare time be compensated? For drug use: Should tests be administered quarterly? Prior to each distribution? Should they lose their beneficiary status after X failures? Should their family line be excluded?)
To expect a posthumous trust to shape a child's values is misguided. To use money to alter a child's choice of life can only cause resentment, and possibly litigation. Parents must instead trust themselves as parents and believe that their children will develop values as they grow and observe the values practiced in their families.
SHOW ME THE WAY
Now that we've thrown out the old way of doing things, what new approaches can we adopt? Here are three suggestions:
- An informed beneficiary has the greatest chance of success
Let's define “success” from two related perspectives. First, success is when the wealth continues to be held in accordance with the intentions of the settlor of the trust. Second, success is when the beneficiaries are appreciative, because the trust funds assist them in creating meaningful, fulfilling lives.
How are such goals achieved? Communication is key. Ideally, the settlor speaks with the beneficiary when planning to create the trust. Those conversations include the reasons for the trust, explanations of how the trust is intended to benefit the beneficiary and advice about how to make the best use of the funds. Particular care should be given to beneficiaries' opinions about the selection of the trustee, or of any protector.
Fortunately, most of the wealthy clients needing advice currently are Boomers, and as a generation, Boomers tend to support inclusiveness and consensus building. So, advisors: instead of waiting until the client possibly asks if children should or could be told about the trust — why not suggest it? Clients are likely to be receptive and appreciate the concern you've shown. I recently had parents who on their own initiative not only explained to the children the terms of a trust they were planning, they also distributed balance sheets to their children. Another wealthy parent confided that if the lawyer does not suggest including the children, the parent assumes the lawyer would disapprove of the idea, so it never gets mentioned. Advisors can raise the subject and be proactive.
Obviously, the beneficiaries' age greatly affects their level of involvement. But even young beneficiaries can be given simple explanations. I remember when my parents explained in my teen years that some of my extra expenses would be covered by Trustee Ray. Their explanation made the trust seem favorable, even approving of me. As children get older, their parents are likely to amend their trusts. At each age, parents could discuss the trust alternatives with their children in more detail.
Second best are conversations between the trustee and the beneficiary. The trustee can ask to meet with the beneficiary to explain all of the trust's terms and, if there are several trusts, provide clear outlined summaries of each. In these cases, the parents have usually died, so the only conversations the beneficiary can have are with the trustee.
Some trust companies are considering offering education programs to teach beneficiaries about trusts in general: what trusts are and how they work. A few family facilitators, who work as consultants with wealthy families to address wealth-related issues and family governance issues, understand that the terms of a trust play a large role in family dynamics. These facilitators help to explain how trusts work and what options there might be for changing a trust.
The worst scenario is when there is no communication and the existence of a trust comes as a surprise when the settlor dies. When that happens, beneficiaries often feel as if they weren't deemed worthy of information.
One independent trust advisor, Irina Shea, based in the New York metro area, strongly encourages communicating with the beneficiaries during the planning process. She assures clients that — even if they are uncomfortable disclosing actual dollar amounts — they still can have fruitful conversations about the conceptual framework of the trust they're creating. They can share the thinking about the pros and cons of trusts, and the various drafting alternatives.
Recently, for example, Shea worked with a widow, herself the beneficiary of a number of inflexible trusts, who felt she would just give everything outright to her adult children. Shea suggested that the widow ask her children what they preferred and helped her draft a letter describing potential trusts. The children were able to consider their families and businesses, then make informed choices that were integrated into their mother's estate plan. In fact, they chose to have a number of trusts. The children were glad to be included in their mother's plans. The mother was relieved to be unburdened from making this decision on her own. (Sample letters can be found on Shea's website at www.irinashea.com.)
- Portfolio education eliminates trust fund babies
The oft-repeated warning that wealth goes from “shirtsleeves to shirtsleeves in three generations” describes a cycle in which the first shirtsleeves generation, the creators of the wealth, don't have a solid understanding of wealth management. They assume their children will also not understand wealth management, so they rely on trustees. At its worst, a trust can reinforce this lack of understanding by treating beneficiaries like babies; someone else, the trustee, is responsible for taking care of all of the beneficiaries' needs.
One very wealthy father recently boasted that he's a born caretaker; he gives his young adult children the money they need, upon each specific request. Unfortunately, he hasn't taken care of them all. What he does is continue to infantilize them and stop them from developing any real understanding of wealth management. His children have never even had allowances, a critical key to learning basic cash management.
A trust can provide an excellent opportunity to impart financial education. Instead of sending the children to financial boot camp or an annual week-long meeting, why not use the trust as an integrated tool for financial education? The trustee can have regular meetings with the children to review the investment performance and use that time to teach.
The educated beneficiary can also make life easier for the trustee. As Elizabeth Mathieu, who headed several trust companies and a multi-family office, said to me recently, “If a beneficiary has a solid understanding of long-term financial wealth management, he will understand what limits on distributions are necessary to ensure that the trust corpus lasts for as long as the trust is intended to last — generally at least for one if not several lifetimes. He will not pressure a trustee to make inappropriately large distributions or investments in ventures, which are not properly vetted. Also, a trustee who works with an informed beneficiary will be more apt to listen to his suggestions and engage in a productive dialogue, strengthening their partnership and the beneficiary's education.”
As the beneficiary's wealth management education increases, the trustee can provide opportunities to participate in, or at least comment on, the asset allocation decisions and general portfolio management. Lessons learned with the trustee will benefit the beneficiary in managing non-trust investments, and even with understanding nonprofit investments as a board member. Finally, as Mathieu noted, an educated beneficiary will be able to evaluate the inevitable investment requests he receives from friends.
- Beneficiaries can collaborate with their trustees
In managing trusts, trustees have distinct duties: investments, reporting and making distributions. Beneficiaries can participate in any or all of these areas. With investments, beneficiaries can be given the right to choose or confirm the selection of money managers and the asset allocations and long-term strategies used. With reporting, beneficiaries can request the format and timing of reports, which can include comprehensive cash flow projections from all sources.
And there are numerous creative collaborations possible for trust distributions. One multi-generational family of beneficiaries has created distribution committees at each generation level. Those committees consider individual requests and agree upon a recommendation to the trustees. Another family ensures that at least one family member is always named in the trust agreement to concur with trust distributions. In one case, the trustee for grandchildren was required (at the request of the second generation prior to the trust drafting) to consult with the parents of the beneficiaries prior to making any distributions to them. This was to prevent the possible awkwardness of having the young children become wealthier than their parents as a result of the trust, and was also intended to honor the role of the parents in overseeing wealth management by their children.
The Iroquois and Ojibwe have a saying: “In our every deliberation, we must consider the impact of our decisions on the next seven generations.” With the use of dynasty trusts, planning for seven generations is quite possible. And planning for seven generations can inspire families to break through the “shirtsleeves to shirtsleeves in three generations” cycle of failure.
When drafting the trust in a collaborative manner, build into it an assumption that each generation will be actively involved in changing the terms of the trust and in selecting new trustees. By keeping the trust as flexible as possible and having the current generation involved, the odds increase that the trust can continue for the benefit of the beneficiaries for at least seven generations.