How Do Trust Funds Pay Out To Beneficiaries?

There are very few sources of literature for good guidance on the selection of a “trustee” for someone who wants to start a trust fund. This is an often overlooked problem, as it is the ongoing administration of a trust fund that ultimately determines whether or not the individuals that set up the trust fund accomplish what they intend for their beneficiaries.

In my review of publicly available trust documents, I have been surprised at how much litigation exists concerning the payments under a trust fund to the beneficiaries. Typically, a trust fund will include a provision that states all of the income will be paid out to beneficiaries, but the trust document itself will be silent on when the income must be paid out.

At a minimum, the Uniform Trust Code requires the distributions of income to be paid annually. The problem is that the trustee (especially if it is a bank or other financial institution) has an incentive to hold onto the income throughout the year so that it can collect a fee on the income produced.

For instance, if someone creates a $1,000,000 trust fund that carries an instruction for the income generated to be paid out to the two beneficiaries each year, the trustee has an incentive to invest the trust fund into low-yield investments as well as pool the money until the end of the year so that the fee (which is often 1% to 1.50% of total trust assets) can be collected.

If a trust fund generates $35,000 in income, and the income is paid out to the beneficiaries instantly, no fee is earned on that income. On the other hand, if the $35,000 is collected throughout the year, and is then distributed at the end of the year, the trustee is able to collect $300-$500 in fees on that income while it sits in the account before it is distributed to the beneficiaries.

To avoid these issues, it is important to draft a trust instrument that specifies payment when desired (i.e. quarterly, monthly, etc.) or else the trustee will have the discretion to choose, and may choose to pay out the income in December so that trustee fees can be earned on the accumulated income.

As a companion issue, it may also be important to set a minimum distribution amount by including a provision that says the trustees must pay out a minimum of 3% of the trust or the income it generates each year, whichever is higher. By including a 3% floor, the creator/grantor of the trust fund is able to protect against the risk that the trustee invests the money in low income-producing assets in order to build up the value of the trust to earn a higher fee by keeping the distributions lower than they should be.

Politicians often talk about the fiduciary rule in the context of financial advisors, but there is subtle conflict of interest concerns in the context of trust administration as well. Trustees of trust funds only have a fiduciary duty to exercise reasonable care in the administration of trust assets. Often times, paying low amounts to the beneficiaries can be justified as being in the best interest of the trust because it is easy to claim that one is engaging in long-term thinking by letting the value of the trust pile up.

Unfortunately, the courts are not usually much help, as state law typically requires that a trustee be removed “for cause” unless the trust instrument provides specific other criteria for trustee replacement. This means that quasi-self serving behavior is often not enough to result in the court-ordered removal of a trustee. The practical impact is that many beneficiaries are left receiving far less income from their trust funds than the creator of the trust fund anticipated at the time that the trust was created, with little remedy for resolving it.

Trust funds are great tools because they are so flexible. Essentially, unless it is illegal, you can include whatever odd provision in a trust that you want. Someone with a $2,500,000 trust could draw up an instrument that pays out $10,000 per week to each beneficiary until the fund is depleted. Someone else could draft a trust fund that says all the money must be invested in an S&P 500 Index Fund with the income generated to be paid out quarterly to the beneficiaries.

But this flexibility comes with a price. If the specific instructions are not included in a trust fund for the payment to beneficiaries, the trustee is permitted to determine what he thinks is the best interest of the trust fund for the income payouts, and the law only requires him to make the payouts to the beneficiaries annually. And from the perspective of the financial interest of the trustee, there is a financial benefit to waiting until December of each year to pay the beneficiaries their income for the year because that maximizes the trustee’s fees and minimally complies with the law.

With little competition, the most important decision when setting up a trust fund is finding a trustee that you believe will have the best interest of your beneficiaries in mind. Trustees at large banks are often evaluated among other trustees at banks based on how much annual income they bring in for the firm. This creates an institutional pressure to minimally serve the beneficiaries in terms of distributions.

The answer is to draft a trust instrument that specifically establishes a minimum standard for payouts, includes a provision that allows the beneficiaries to remove a trustee based on a unanimous or supermajority vote, and most importantly, to find someone to serve as a trustee that you can trust to do what is right.

The failure to do this likely means that the beneficiaries will be receiving a check every December for their share of the income from a trust. Hardly a tragedy, but a disappointment to the extent it frustrates what is intended to be accomplished.

Liked it? Take a second to support The Conservative Income Investor on Patreon!