Total return trusts: why didn't we think of that?

• Author: Begley, Thomas D., Jr.

The total return trust is an idea whose time has come. With the arrival of the Prudent Investor Rule[1] and the development of the modern portfolio theory,[2] trustees now have great flexibility to invest aggressively and to improve the total return for both income beneficiaries and remaindermen.

Traditional Trusts

Traditional trusts were known as income rule trusts. Under these trusts, the trustee held the principal and distributed the income. There was inevitable conflict between the income beneficiary who wanted trust assets invested to produce the highest possible income and remainder beneficiaries who wanted trust assets invested for growth. The trustee has a duty of impartiality and the inevitable result was that everyone was unhappy.

Investment duties of trustees were defined by the Prudent Person Rule.[3] Under the Prudent Person Rule the trustee had a duty "to make such investments and only such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of the income to be derived."[4] (Emphasis added)

Total Return Trust

Total return equals ordinary income plus capital appreciation. The total return trust is based on the Prudent Investor Rule and the diminished distinction between income and principal.

* Prudent Investor Rule

Under the rule the trustee is charged with investing trust assets "as a prudent investor would do given the purpose, terms, distribution requirements and other circumstances of the trust."[5] The Prudent Investor Rule has been adopted in most states. It is a default rule. Under trust law, the terms of the trust instrument control. State statutes governing trust investments apply only if the trust instrument fails to define the trustee's investment duties. If there is no prudent investor statute in a given state, the drafter must design the trust to include prudent investor standards. Conversely, if the state has a prudent investor statute and the grantor does not want to follow that statute, the drafter must design the trust so that the trustee's investment duties are otherwise restricted.

Interestingly, the rule applies only to trustees and to trusts and not to executors or personal representatives of decedents' estates.[6]

* Modern Portfolio Theory

Value is a function of the total return that assets are anticipated to generate, and the risk that the actual return will fall short of the anticipated return. In a departure from Prudent Man Investment Standards, the risk analysis focuses on the entire portfolio, not on individual assets.

* Distinction Between Income and Principal

The traditional distinction between income and principal is diminished under modern portfolio theory. The focus...