From the August 2008 issue of Investment Advisor • Subscribe!

August 1, 2008

A Prospect With a Plan

A prospect with an existing plan often presents opportunities

Every advisor has heard some version of the phrase: "I've done my planning already." The implication is that once they've endured the financial planning process, the work is complete. An examination of their plan documents, however, will often reveal defects that will cause their wishes to go unfulfilled--at the very least--and in some cases produce totally unexpected asset distribution scenarios.

Sometimes problems arise from an attorney working in isolation without the benefits of an advanced planning team to review documents and work through the potential scenarios of distribution, wealth transfer, and legal mechanics. Inadequate trust documents come less from technical or drafting errors than poor alignment with the client's wishes, family dynamics, financial plans, and the need for flexibility because of future changes in circumstances. A will with boilerplate clauses may serve some clients, but not the affluent client with a range of assets owned in many jurisdictions, for example.

Trusts that are out of date. Affluent families who created trusts in the 1980s and '90s did so in response to the family situations at that time, but many have failed to update them since. Real estate values and the stock market have gone through many cycles since then, so today's asset levels and the value of particular assets such as certain property holdings may reflect very different numbers. In addition to a revised net worth, changes in family circumstances, such as new sons- and daughters-in-law, and questions about the maturity of certain adult children to manage a large inheritance may be reason enough to consider revising the documents.

The growth in the value of undeveloped property is one example that can drive a change from original plans. Such property that had been geographically remote from commercial development may end up greatly increased in value by several multiples because it now borders recently expanding towns. If the undeveloped land or a similar lower-value asset were placed in a trust for the grandchildren, an unexpected boost in value could trigger the generation skipping tax.

Trusts with specific bequests. If an old trust or will specifies a particular dollar amount, such as $75,000 or $100,000 intended for a trusted employee, or a specific asset, such as all IBM stock to a son by the first wife, the actual current value may not reflect the grantor's intentions.

Alternately, the current value of that asset may not reflect the appropriate portion of the total assets. For a trust with a highly concentrated portfolio composed almost exclusively of one company stock received through employment, that current value is highly variable. A once modest specific dollar bequest that needs to come from such a portfolio could represent too substantial a portion if that stock's value is seriously depressed at the time of disbursement. Ford stood at 8.48 on May 1 of this year; ten years earlier it closed at 46.81.

Trusts that lack flexibility. While trusts can be as flexible or tightly controlled as the client might desire, many grantors with very strong views have opted for rigid documents that can cause problems later. Dynasty trusts that are in force for many decades, for example, need flexibility for a trust protector to amend the document if family circumstances or other factors change or for a new successor fiduciary to take over from the initial fiduciary. The family's long-term relationship with a bank can disappear with one financial institution merger and new management with very different concept of the fiduciary role could take over.

The inability to adjust distributions can cause financial problems for other family members as well. In one case, a trust was split 50/50 between a brother and sister. The sister had full access to her share. The brother's half, however, was held in trust, since he was not responsible with money. The trustee could give him 100% of the net income of his trust up to $100,000 per year, while the residual at his death would go to the sister's children. The brother's trust was large, however, and the investment advisors planned for it to generate about $250,000 annually, so instead of using the extra income for the best use of other family members today, the excess of more than $100,000 each year remains undistributed. It will eventually go to the sister's grandkids, depending on the brother's lifespan.

Another problem related to inflexibility is a trust with no provision to assign a successor trustee, whether it's an individual or a corporate trustee, such as bank. In either case, the trustee needs to understand the provisions of the trust and the life situations of the beneficiaries. With a corporate trustee named without the provision for a successor, the beneficiaries could find themselves with new trustee officers with little understanding of the family but a mission to follow the letter of the document. They could also feel stuck with trustees whose investment management has been poor.

While a provision for successor trustees seems like an essential aspect of any trust, advisors and estate attorneys have noted its absence surprisingly often. Estate attorney Edward Koren, of Holland & Knight, LLP in Tampa, Florida, has previously noted that the evidence suggests more problems arise when attorneys who don't focus on estate planning create documents.

Trusts that mingle assets through marriage. In some family situations, it may be a better strategy to leave assets in the trust rather than distributing them. When the parents pass away, for example, a trust might make a full distribution to an adult married son. For his own planning, the son may establish his own family trust, and his attorney will likely suggest not commingling assets, in case of divorce, and instead using a separate property trust within the family trust rather than treat it as community property. The son and his wife would then face a potentially awkward conversation that could cause lasting friction. The parents could have avoided this situation by keeping the money in trust and making regular distributions to the children.

Trusts where all assets are not equal. If a trust bequests specific assets (e.g., a home) to one child with the residual of the trust (IRAs or 401(k)s) going to the other child to "equalize" the estate, the distribution isn't equal even when the real estate and retirement accounts appear to have similar values. The other assets are subject to income taxes upon the withdraw of funds.

Trusts that restrict distribution. Trusts often specify that money is to be held for children until they reach the age of 21 or 25. Planners and estate attorneys have dealt with a more charged family situation when one of the children reaching adulthood may have a drug abuse or emotional problem that affects their ability to act responsibly with money, even when the sums aren't substantial. Trusts that don't allow the trustee to control distributions in the event of incapacity can fuel drug habits and other problems.

Here again, relatively simple language of a facilitating distribution clause could provide the flexibility a trustee would need not to make mandatory distributions if a beneficiary is declared incapacitated. Typically a certificate from a doctor provides the documentation a trustee would require.

Trusts that are unsigned. Perhaps the most surprising discovery for a prospect is the painful sitting-in-the-drawer syndrome--perfectly executed documents waiting for review and signatures or otherwise not implemented many years after the attorney provided them. The syndrome often occurs when the prospect doesn't understand the financial plan and/or the documents and is initially reluctant to sign off. One of the most important tasks for the advanced planning team is making sure the client understands the plan and full implementation takes place.

In the case of the syndrome, the prospect may have no executable financial plan at all. Advisors have discovered unsigned wills, unfunded trusts, and unchanged ownership of assets. Sometimes, a partially implemented plan may be the result with bad consequences for beneficiaries, such as a large insurance policy that gets counted and taxed as part of the decedent's estate.

When no signed documents exist, the prospect dies intestate, and the state jumps with a court-appointed administrator to decide which survivors get how much in the way of assets--not the financial plan any high-net-worth prospect would want.

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