Hostak, Henzl & Bichler
840 Lake Avenue, Suite 300Racine, WI 53403
Phone: 262-632-7541

Total Return Trusts

By Stephen J. Smith
The Family Vision Experience


Sometimes clients conclude they cannot leave an adult child’s inheritance outright, perhaps because the child cannot manage money.

Hypothetical example: One of Adam and Mary’s children, Tom, age 28, has had mental health issues since he was an adolescent. There is concern about his long term employment prospects, and they have twice had to bail him out from credit card debt. They know that if they leave his share (an estimated $800,000) outright to him, it will not last.

Traditional Trust

Based on discussions with trust officers and over 40 years of practice in estate planning, most lawyers (virtually all, from what we hear) would draft a trust which provides:

  • Hold the $800,000 in trust with a third party trustee (bank or individual)
  • Distribute the income to Tom each year
  • Allow the trustee to invade principal for Tom, but only for specified purposes
  • Remainder at Tom’s death to his family

Issues for the Traditional Trust

  • The trustee is in a structural conflict:
    • Tom may want to see the trust invested to maximize current income, to maximize what he receives.
    • Potentially, his children want to see the trust invested to maximize long term appreciation and, hence, what they receive when he dies
  • This issue leads to the trustee trying to balance out both interests in a compromise investment mix driven as much by income expectations.
    • A better goal would be for the trustee to select an investment mix driven by the goal of maximizing total investment return (both income and capital appreciation).
  • To the extent the trust is invested to achieve income, it is all distributed to Tom; nothing is reinvested to help the trust keep pace with inflation.

Real Life Tom

A while ago someone in Tom’s situation came to us 25 years after his parents had died and had left his inheritance in a traditional trust.  He was not gainfully employed and depended on the trust for his support. He was vulnerable, because since he was not employed, he was not paying into Social Security and could not look to it as a safety net if all else failed. 25 years earlier he had persuaded the bank trustee to focus on bonds so he could maximize his income distribution, rather than investing in stocks paying a much lower percentage out as a dividend. All was invested in bonds, and all interest was paid out to Tom each year. For the reasons Tom’s parents left his share in trust in the first place, Tom spent all that he received each year from the trust.

25 years later he compared notes with his brother’s trust. They had started out with equal amounts. Tom’s brother’s trust had not distributed as much to begin with, as it was invested in a balanced portfolio with a significant stock component paying a much lower rate of dividend than the bonds in Tom’s trust.

25 years later Tom’s brother’s trust was worth more than double Tom’s trust and by this time was paying out more each year than Tom’s trust, due to the growth of the stocks.

Total Return Trust

Let’s roll back the clock 25 years and re-do Tom’s trust. If all investment return is distributed to Tom each year, with none of it reinvested, then the trust will not grow in value. If it does not grow in value, it will not keep pace with inflation, and so the real value of the trust will gradually but definitely  go down. We have seen that the traditional trust, distributing accounting income to the beneficiary, fails to adequately compel a responsible approach.

How it Works

In a Total Return Trust, accounting income is irrelevant. Tom’s parents designate a percentage (I will use 4% as an example).  The trustee shall calculate the market value of the trust each January 1 and multiply that total times 4%. This amount is distributed over the coming year. The investment return of the trust would be a combination of interest and dividends (income) and also capital gains (the investments have gone up in value and may have been realized by selling them or be increased “on paper.”).  If the total return for the year is greater than 4%, then the calculation the next January 1 will cause a larger amount to be distributed to Tom over the coming year.

Goal of a Total Return Trust

The primary goal is to build in a system seeking to assure Tom’s parents that the trust is hard wired to gradually increase in total value, and if it gradually increases in value (because it is distributing less than its total investment return), then Tom can look forward to receiving more each year than the year before.

How does the Total Return Trust benefit Tom?

  • The percentage of market value is set low enough that Tom’s parents can reasonably expect that the trust, over the long haul, will normally generate total investment return at a higher rate.
  • If the rate of investment return is greater than 4% in this case plus an assumption about inflation, then the distributions to Tom will grow over the years, even after considering inflation, a real advantage.
  • Over the long term, stocks will earn a higher total rate of return than bonds, but they typically start out paying a smaller rate of income as dividends.
    • In a traditional trust, the goal is to have enough invested in primarily income-producing assets, such as bonds, to ensure the current distribution to the beneficiary seems adequate. Doing this can hold down the potential of the trust to maximize total return.
    • In a Total Return Trust, it is unnecessary to earn enough income to cover the 4% distribution in Tom’s example. Suppose it were invested in mutual funds focusing on stocks. Cash could be raised (at a capital gains tax rate) by selling off a little of it to make the 4% distribution. IN OTHER WORDS, THE TRUSTEE COULD AFFORD TO PUT MORE IN INVESTMENTS PAYING LITTLE OR NO CURRENT INCOME BUT OFFERING HIGHER LONG TERM RETURN PROSPECTS.

What about the traditional trust’s tension between the needs of the current income beneficiary and the needs of the successor beneficiaries who receive the remainder when “Tom” dies?  This is where the Total Return Trust shines. The greater the long term total return of the trust, the more the trust grows in value. The more the trust grows in value,

  • the greater the distribution of 4% is to Tom
  • the greater the remainder is to his family when he dies

By its structure, there is no conflict of interest.

This article is intended to only be an introduction to the topic. There are more details and choices in designing a Total Return Trust which Tom’s parents could explore. The longer the period time, if not Tom’s complete lifetime, which Tom’s parents believe the trust will last, the more compelling the Total Return Trust is as an option to be explored.

In my practice over the years I have honed a Total Return Trust exhibit that not only follows the above reasoning but carefully lays out the investment thinking behind the idea, so that in a given case, perhaps a generation from now, the trustee will have the flexibility needed to implement the Total Return Trust to achieve the long term goal.

In The Family Vision Experience™, we stress an approach where the clients genuinely understand and feel like they own their plan for their loved ones. The Total Return Trust is just one tool we recommend to our clients where it stands a chance to make a lifetime of difference.

© 2019 by Stephen J. Smith 
creator, The Family Vision Experience