The New Rules of Incentive Trusts

Incentive trusts were one of the hottest estate planning tools of the 1990s. Much has been learned about their advantages and disadvantages, and it’s import- ant for estate owners to know the lessons learned. Incentive trusts became popular among people worried that bequeathing their wealth might have negative impacts on their children and grand-children.

They worried their descendants wouldn’t become independent adults who contribute to society. After inheriting a lot of wealth, the offspring could avoid productive lifestyles and instead pursue leisure activities or engage in destructive habits. Simply knowing they’re likely to inherit wealth could have negative effects on younger generations even before they inherit.

While many children of wealthy parents have successful, productive lives, many others don’t. Depression, anxiety and substance abuse are more likely among children of wealthy families than those from the middle class, according to research.

The idea behind an incentive trust is that income and wealth are made available to beneficiaries only after they demonstrate desirable behavior.

Usually, distributions are tied to meeting some benchmark or performance standard. Some incentive trusts make annual distributions that match or are a multiple of the income earned by the beneficiary. Other trusts distribute a fixed percentage of the trust principal as the beneficiary reaches certain ages, provided the beneficiary has met goals such as being employed or otherwise being productive (such as by doing volunteer work).

Some estate owners are worried about substance abuse and other destructive behaviors. Their trusts allow distributions only after it is established that a beneficiary demonstrates he or she hasn’t engaged in such behaviors. The terms of an incentive trust are limited primarily by the goals and imagination of the person creating the trust. Some incentive trusts have fairly elaborate formulas and standards regulating distributions.

One thing we’ve learned over the years is that most people don’t respond to financial incentives and disincentives as much as is assumed by creators of incentive trusts. People perform better when their expectation is a small reward than when a large reward is in the balance, according to research by economist Dan Ariely.

Apparently, the pressure of winning a big reward adversely affects performance and overwhelms the benefits of the financial motivation. Likewise, pressures such as those created by an incentive trust are unlikely to improve the behavior of many offspring who already struggle, and the pressures could make things worse. Many children of wealthy parents believe they are expected to at least match their parents’ success and, in many cases, believe they’re anticipated to exceed it.

They believe they’ll be considered failures if they don’t reach or exceed those expectations, and also believe achieving that level of success is a high benchmark. These fears and doubts decrease the likelihood that they’ll become independent, successful adults. Instead, a beneficiary needs to develop internal motivation to become self-sup- porting and not want to be fully supported by the parents’ or grandparents’ wealth.

The trust should be structured to support the beneficiary’s decision making and independence but in ways that adapt to the beneficiary’s personality and interests. The first step in this new type of incentive trust is full disclosure between the trust creator and the beneficiaries.

The parent or grandparent creating the trust should be clear about the amount of wealth that will be in the trust. Failing to disclose the trust’s value often is considered a sign that the trust creator doesn’t trust or have confidence in the beneficiary. Indeed, it’s often best for children or grandchildren to know fairly early in life that they’re likely to inherit so that over time they’ll become comfortable with the idea and learn how to manage and spend the money.

That potentially reduces the possibility of anxiety and other traits associated with “sudden wealth syndrome.” A second step is to avoid the black- and-white rules of the traditional incentive trust. In that structure, a beneficiary who doesn’t meet a benchmark often feels he or she is a failure and disappoint- ed the parents or grandparents, even if the trust creators are deceased.

A third feature of the trust should be to assume there will be failures and support the beneficiary after such a set- back. A goal of the trust is to encourage independence in the beneficiary, which means allowing the beneficiary to make decisions and learn the consequences of mistakes.

But the beneficiary is unlikely to make some decisions and become independent when he or she knows the result of failure will be a complete loss of income. Also, that extreme consequence of failure increases pressure on the beneficiary and makes success less likely. Instead, the distributions should be adjusted, but not eliminated, after a failure. A fourth feature of the trust should be to support overall mental and physical wellness of the beneficiary.

Good decisions are more likely when the beneficiary is well. Even when a beneficiary is unemployed or struggling, the trust should make distributions to support therapy, nutrition, counseling, physical fitness, education (even unconventional education), and the like. All these features make the trust resemble a traditional discretionary trust. The trustee is given the trust creator’s goals and reasoning. The trustee uses these to determine the distributions of income and principal to the beneficiary.

A criticism of the traditional discretionary incentive trust is that the parents or grandparents are trying to control the beneficiaries from the grave. That makes the beneficiaries less likely to develop decision making skills and independence.

In addition, the trust creator can’t accurately anticipate future events and structure the incentives to accommodate changes that might occur in the beneficiary’s life, the economy and society. In the incentive trust, much of the creator’s time is spent developing the incentives and the consequences of meeting or not meeting them. In the discretionary trust, the key action is the selection of the trustee. The trustee must understand the creator’s goals and reasoning and be able to apply them in changing circumstances. The trustee also must have regular and open communication with the beneficiary.

The grantor’s goals and motivation must be explained to the beneficiary and should be stated clearly in the trust agreement. But the trustee also must learn the beneficiary’s goals. Perhaps most importantly, the trustee must understand how the beneficiary responds to goals and incentives and whether they encourage the desired behavior or cause anxiety or other negative consequences.

The trustee must take all this information and decide what is best for the beneficiary while working toward achieving the creator’s goals. The trustee has a lot of flexibility and must exercise judgment. The trust creator also should spend a significant amount of time defining the goals of the trust and the expectations of both the beneficiary and trustee, while granting the trustee a wide range of latitude instead of black and white rules.

The discretionary trust is best set up while the creator is alive. Also, the creator should fully discuss the goals and reasoning with the beneficiary fairly early in the beneficiary’s life. The creator and beneficiary should have regular conversations about the trust, money and the long-term goals.