Steven Smith: Smart Investing

Trust portfolios

‘When you come to a fork in the road, take it.’

— Yogi Berra

Trust investing often requires taking two paths at once. Trusts typically have multiple beneficiaries, each with different circumstances, demanding portfolios that produce income, growth or both.

The Uniform Prudent Investor Act (UPIA) is in effect in 43 states, and it governs the investment of trust funds. This week, I examine how to: incorporate the law into your estate plans, serve as or advise trustees under UPIA and become a knowledgeable, effective and UPIA-ready beneficiary.

Objectives of UPIA

• Prudence is applied to the portfolio as a whole rather than to individual investments.

• The fiduciary’s main consideration must be the tradeoff between risk and return.

• The act abrogates investment restrictions by type: The trustee can invest in anything that aims toward the risk/return objectives.

• Diversification has been integrated into the definition of prudent investing.

• Trustees may prudently delegate investment functions.

A family trust

Every trust arrangement differs, including the circumstances of beneficiaries. But let’s explore a prototypical family trust.

Consider the hypothetical case of Karen, who dies at age 58. Karen owned two office buildings, together valued at $7 million — with $2 million of equity and a $5 million mortgage. She is survived by her second husband, Roger, two children from her second marriage and a daughter and a 3-year-old grandson from her first marriage.

To take advantage of the estate tax exemption — currently $2 million — Karen had established a trust to be funded initially with the two properties. Her brother, Tom, a CPA, and 54-year-old Roger serve as trustees.

The trust allows property to bypass Roger and pass to her three children and grandchild. Typically, the trust sets aside income (e.g., interest, dividends and net rents) for the surviving spouse for his lifetime. Karen’s trustees can make principal payments to Roger and any of the children or grandchildren according to certain guidelines, such as use for education.

Following Roger’s death, the trust property — or remainder — becomes available to the children and grandchild. Karen’s trust stipulates that, upon Roger’s death, 75 percent of the remainder goes to her children and grandchild — to be held in trust until they reach certain ages — and 25 percent to a donor advised fund at the local community foundation.

Invested wisely, the value of the trust upon Roger’s death could be two or three times the original value. Plus, there is no imposition of estate tax at Roger’s death, as there might have been had the property passed to him directly.

Two major decisions

The trustees must decide how to strike a balance in the portfolio between income and growth and whether to sell the properties to diversify the portfolio.

Open and honest communication among the participants is essential. In this case, that includes the trustees, third-party advisors (if Tom and Roger choose to use them) and the beneficiaries — Roger and Karen’s adult children. The process begins with financial planning, which assesses the needs, desires and risk tolerance of the beneficiaries.

Roger requires only a modest income from the trust to supplement his salary now; however, he may need more upon retirement. The remainder beneficiaries, whose interests ripen years away, desire long-term growth. Roger, cognizant of his inherent conflict of interest, delegates this decision to Tom, the disinterested trustee.

Income-producing investments and growth investments typically differ. Investment grade bonds, dividend yielding stocks and preferred stocks produce income and are considered safer; growth, small company and emerging markets stocks have much higher expected returns but are riskier.

After consultation — and documentation — Tom decides to de-emphasize current income and undertake moderate risk to invest for growth. The trustees will reevaluate this decision in five years as Roger approaches retirement and the needs of the children and grandchild become more apparent.

Next month, I’ll wrap up this examination of trusts by looking at the intricacies of establishing and managing a diversified portfolio consistent with the beneficiaries goals and risk tolerance — in accordance with the UPIA.

<i>Steven R. Smith, JD, CFP® is the principal of RightPath Investments & Financial Planning, Inc. a “fee-only” registered investment advisory firm in Frisco. If you have questions or comments, contact him at (970) 668-5525 or steve@rightpathinvestments.com. (Specific investments or resources mentioned are illustrations only and are not recommendations. Past performance does not guarantee future results.)<i/>