Question: My wife and I have been discussing the pro’s and con’s of creating a living trust for us that would become irrevocable after the first of us dies so it could continue for the survivor and then for our children.

Since my wife and I will have income from Social Security and retirement while we are living, we anticipate enough cash flow to take care of our needs. However, at the time of the first death, this income will be reduced and, at the second, it will stop. With interest rates as low as they are now, we are concerned that there may not be enough income to provide for the survivor and then for our children. We don’t want those who are to get the income to keep going back to the trustee to get more principal that, in turn, will reduce future income and what is left. Is there any way to avoid this?

Answer: Until recently, the vast majority of trusts required that the trustee invest the principal and distribute the income to the designated “income beneficiary” -- or beneficiaries. And, depending on the language of the trust, the trustee might also have the discretionary authority to distribute a percentage of the principal each year. At the death of the income beneficiary, the remaining principal would be distributed to the “remainder beneficiary” -- or beneficiaries.

Since the income beneficiary wants the highest income available, and the remainder beneficiary wanted the assets invested for growth, the trustee, who must be impartial, could not please both.

With the adoption of the “the Prudent Investor Rule” in most states, more and more trusts are now drafted to provide for different distribution requirements -- unless the language of the trust specifically provides to the contrary. Today, more trusts require distributions based upon the “total return” which blurs the difference between income and principal under what is called the “modern portfolio theory.”

The use of a total return trust seems best where the income and remainder beneficiaries are not the same person -- such as in a second marriage where each spouse has their own children. In this way, the income beneficiary can receive greater distributions while the remainder beneficiary can benefit from asset growth.

Total return trusts can make distributions either like an annuity -- a fixed amount is paid in each time period regardless of income or principal balance and the amount will not vary -- or a unitrust -- a fixed percentage of trust assets and income is paid during each time period and the amount varies with market fluctuations.

For example: If a total return trust is established with $100,000 and provides for the payment of $5,000 per year for the life of the income beneficiary, the beneficiary would receive $5,000 per year like an annuity, even if the principal grew to $200,000 or $300,000.
On the other hand, if the annual payment was set at five percent of trust balance (both principal and income) at the end of each year for the life of the income beneficiary, and the trust principal grew to $200,000, the income beneficiary would receive $10,000. However, if the principal fell to $50,000, the income beneficiary would receive only $2,500.

The decision of whether to use an annuity or unitrust format depends on the whether the degree of risk that one is willing to assume and the respective needs of the income beneficiary and the remainder beneficiary. Total return trusts should be considered when appropriate and only in connection with a coordinated plan created with the assistance of a qualified lawyer and investment professionals.