How to invest trust assets
Planners are often called upon to invest assets held in trust, but there are many different types. How do you decide which assets are most suitable for a particular type of trust?
The following is an explanation of key features of common trusts, with some suggestions as to investment approaches that might make sense.
BYPASS OR CREDIT SHELTER TRUST
With recent tax law changes, the surviving spouse’s estate may no longer face an estate tax.
One of the most common trusts used in estate planning shelters the amount of exemption from tax available on death. Assets are typically held in such a trust to benefit the surviving spouse (but other descendants are often included as beneficiaries as well). On the death of the surviving spouse, the assets pass to heirs without being taxed in the surviving spouse’s estate, hence the assets “bypass” the surviving spouse’s taxable estate.
Some credit shelter trusts mandate payment of income to the surviving spouse each year. If so, then a primary investment objective will be to generate that income.
Others permit income to be sprinkled at the trustee’s discretion to the surviving spouse and descendants so that investing to generate income may be less relevant. Historically, the objective of a credit shelter trust was to grow assets out of the surviving spouse’s estate, so absent a mandatory income distribution requirement, the investment plan might have tilted toward growth assets.
With recent tax law changes, the surviving spouse’s estate may no longer face an estate tax. In such cases, growth will simply mean higher income tax costs to heirs, with no commensurate estate tax savings. In these cases, it might be advisable to move assets out of the trust (by permissible distributions or even terminating the trust if allowable).
Otherwise, a new investment objective might be to limit the unrealized appreciation inside the trust since those assets, by virtue of being excluded from the surviving spouse’s estate, will not qualify to have the basis stepped up on her death. Thus, the investment objective might shift from growth to income. Growth assets might be better held in the surviving spouse’s own name and nongrowth assets in the trust to maximize the assets that will obtain an income tax step-up on death.
QTIP MARITAL TRUST
These are trusts intended to qualify for the estate tax marital deduction. A requirement of this deduction is the payment of income at least annually to the surviving spouse, who must be the sole beneficiary. This income distribution requirement influences the investment allocation selected.
Nevertheless, consideration has to be given to protecting the trust and growing it for remainder beneficiaries, especially if they are children from a prior marriage in a case where a husband has formed the trust for his second wife.
Unlike the credit shelter trust, QTIP trust assets will generally be included in the estate of the spouse. So if her estate is not expected to be taxable, assets in the trust will receive a basis step-up on her death with no offsetting tax cost. If her estate is expected to be subject to an estate tax, then consideration should be given to that risk.
IRREVOCABLE LIFE INSURANCE TRUSTS
Traditional insurance trusts held little in the way of liquid assets other than an insurance policy. So any cash may typically have remained idle in a checking account or have been invested in cash equivalents.
While this remains true for many insurance trusts, it has become more common for life insurance to be held in trusts that own substantial other assets. In such a case, it might be advisable to determine the cash flow needed to maintain current and expected future life insurance, with any excess being invested under a longer-term plan.
Once the insured dies, the proceeds have to be invested in a manner that fits the post-death trust objectives. Many old style trusts simply mandated that trust assets would be distributed on death. In such instances, the appropriate investment plan immediately after death might be to hold the insurance proceeds in a checking account pending distribution.
Many other trusts divide the insurance proceeds after death into trusts for each beneficiary. In that case, an investment plan for each separate trust should be determined, based on the terms of the trust document and circumstances facing each beneficiary.
REVOCABLE (LIVING) TRUSTS
Since these trusts are fully controlled by the settlor who created the trust investments, allocations can be whatever the settlor wants. A trap with these trusts, however, is that if the settlor becomes incapacitated and a successor trustee takes over, that successor will probably be subject to the standards of a prudent investor and state law. If so, merely maintaining the investment plan of the settlor might no longer be permissible.
So, be certain to confirm who the trustee is and whether he is aware of his responsibilities. If the settlor has stepped down as trustee, a new investment plan may be called for.
DYNASTIC (OR GRANDCHILDREN’S) TRUSTS
Dynastic trusts were historically used to pay for college and would have been invested in a manner appropriate to that goal. With the growth of 529 plans, the use of grandchildren trusts for this purpose has waned.
Now, trusts for grandchildren are more typically intended to provide long-term growth for future uses. These might be to provide cash flow to grandchildren and future generations.
Such trusts would obviously suggest a long-term investment horizon. But be cautious in drawing that conclusion. Many of these trusts include provisions permitting the trust to own personal use assets. These might well be intended to help a grandchild or other descendant buy a house. If that is in fact permitted in the trust and the beneficiary has this goal, this fact may be relevant to the investment time horizon and risk profile.
GRANTOR RETAINED ANNUITY TRUSTS
These trusts, often referred to as GRATs, are created to minimize estate taxes. Historically, the optimal manner to structure these trusts was to use short-term GRATs — perhaps with a term of two years, for instance — with a very granular asset allocation. Each GRAT would have one stock or one asset class. If any GRAT grew substantially, it would be “immunized” by swapping in cash for the highly appreciated assets. When the GRATs ended, the process would be resumed. This is referred to as “rolling” or “cascading” GRATs.
Given the current environment of very low interest rates and threats in the Obama administration’s tax proposals to eliminate GRATs — threats that may be carried out if Hillary Clinton is elected president — a different approach may be needed. With the threat of repeal, the ability to re-GRAT assets sequentially year after year is not certain.
Thus, planning for GRATs for clients who are not elderly should take a longer-term approach and might be funded with a diversified portfolio. The goal of these might be to simply shift investment performance in excess of the current low interest rates out of the client’s estate over the term of the GRAT. The investment planning for this possible new application of the GRAT technique is dramatically different then what has been done historically. So planners must be careful to understand the specific trust and plan and not rely on what has historically been done.