A great deal has been written recently singing the virtues of incentive trusts—trusts that explicitly spell out conditions, ranging from achieving a defined level of education to maintaining one’s weight to marrying within a certain religion, that must be met by a beneficiary in order to receive distributions—and the vehicle seems primed for a resurgence. Certainly, such trusts are invaluable tools in every advisor’s toolbox, but they come with a number of pitfalls that seem to be glossed over in the renewed excitement. Perhaps advisors should consider pumping the breaks just a little bit.
The allure of an incentive trust is understandable. Clients are excited about these trusts because they help assuage fears about their children not handling their inheritances responsibly and offer the client a chance to pass on certain “values” from beyond the grave. Practitioners are enamored with incentive trusts because they offer greater clarity in estate planning documents, which can be notoriously vague, allowing estate planners to more accurately reflect and enforce their clients’ wishes. And, trustees particularly like them, as such specificity takes many distribution decisions out of a trustee’s hands, freeing him from having to make difficult choices that may lead to potential liability. Who doesn’t want their job to be made easier and less risky, after all?
However, in attempting to so thoroughly encapsulate a given client’s wishes, advisors may ultimately be doing the client’s family a disservice. Incentive trusts represent an interesting dilemma for a planner, as to be enforceable, effective and satisfying to the client, the distribution requirements would ideally be drafted with a certain degree of specificity. Yet, when drafting testamentary documents, flexibility is considered key. Trusts must be drafted to stand the test of time and remain functional in the face of changing laws and social attitudes, sometimes extending far into the future. While flexibility and specificity aren’t necessarily mutually exclusive, the two concepts are certainly at odds with one another.
As an example, take the common case of a client concerned that a large inheritance will make their child lazy, so they include a trust provision mandating distributions based on the child meeting certain educational milestones (college, graduate school, etc.). Though such a requirement seems pretty reasonable on its face, especially seeing as education has its own value independent of the pot of inheritance gold at the end of this particular rainbow, this clause is, nonetheless, rooted in the knowledge available at its writing. Perhaps the child in question turns out to be learning disabled, and is incapable of meeting the goals through no fault of his own, or maybe he simply chooses to pursue a productive career in a field that trains through apprenticeship, as opposed to an academic path. Is it the client’s intent to withhold an inheritance from these, otherwise hardworking children as well? Maybe, but maybe not, who’s to say? The obvious answer here is to include some exceptions to the requirements, making allowances for unexpected events or non-traditional choices, but at a certain point, such granularity simply creates more confusion instead of less.
Passing on "Values"
There’s also the moral issue of clients attempting to control the lives and choices of their children even after death. Often this question is couched in terms of a client’s desire to pass on particular family “values” to the next generation. And, in certain situations, say if the child is a drug addict and the client wants to base trust distributions on sobriety, this is a valid concern, and an incentive trust may arguably be an effective instrument. However, like anything, this concept can be taken to an extreme, and “values” can take on a meaning similar to that which it holds in the political world, where people on both sides of the spectrum use “upholding traditional values” as veiled speak for “don’t do things we don’t like.” (That’s the PG version.)
For example, what practical value does a trust requiring marriage within a certain religion really offer? Either the child never intended to marry outside of the religion in the first place, in which case it’s wasted ink, or the impetus for the clause is that the child has already fallen in love with someone who doesn’t meet the parent’s specifications, and it’s a threat to attempt to dissuade the beneficiary from moving forward. Now, it’s important to note that a child isn’t entitled to anything the parent doesn’t want to give them. If the client disagrees with his child’s life choices to the point that they no longer want them to be an heir, then disinherit away! But why create a situation where the beneficiary is forced to choose between love and money (and, by extension, post-mortem parental approval), effectively ensuring their unhappiness no matter what they choose? Who exactly benefits from that arrangement? Not the client, he’s dead. Not the beneficiary, who has to make a very difficult decision. And, definitely not the advisor who helped set up the trust—the kid can’t fire dad, but he can certainly fire you—and who would blame him?
Not all clients looking to pass on “values” have insidious motives, though. Often they’ve spent so much time working to create the wealth that they’re now passing on that perhaps they couldn’t do as much parenting as they’d have ideally liked. Incentive trusts can look like an attractive way to try and make up for lost time and impart lessons that they wish they’d had the time to get to when the beneficiary was younger. And, they may be right.
Every family is different. One set of heirs might need the strong, and occasionally punitive, guiding hand of an incentive trust, while others might be better served by a gentler principle trust, where the “values” are more like suggestions for the trustee to guide distributions, instead of hard set rules, and for still others, maybe no form of dead-hand control will be effective. As advisors, it’s our job to know the families that we work with, not just the individual client whose name happens to be on the check, so that we can offer the most effective insight. An incentive trust can offer exciting possibilities, but it’s just another tool in the advisory toolbox, and like any tool, if used incorrectly, people can get hurt.