Defeating the duty to disappoint equally--the total return trust

Robert B Wolf

Robert B. Wolf*

Editors' Synopsis: The treatment of principal and income in investment decisions has changed in recent years. The development of modern financial theory and changes in law such as the new prudent investor rule require that drafters of trusts respond to take advantage of these concepts. This Article discusses the important investment and legal developments and proposes the use of a total return trust as a model designed to take advantage of the changes. The author argues that such a trust can create a common investment goal among the trustee, life beneficiaries, and remaindermen.

I. INTRODUCTION

II. CURRENT TRUST DRAFTING FOLLOWS OLD RULES, CON TINUES OLD CONFLICTS, AND REDUCES RETURNS

A. The Duty of Impartiality Between an Income Beneficiary and Remaindermen

B. Beneficiary Expectations-Big and Bigger

III. THEINVESTMENT UNDERPINNINGS

A. Total Return Investing

B. Asset Allocation, Modern Portfolio Theory, and Diversification-the Keys to Long-Term Returns and Risk Management

1. Recent History of the Capital Markets

2. Modern Portfolio Theory and Diversification

3. Asset Allocation as the Key to Long-Term Returns

4. Asset Allocation is Key Because Over Time Stocks Earn More than Other Forms of Financial Investments

IV. CHARITABLE ENDOWME, THE UNIFORM MANAGEMENT OF INSTITUTIONAL FUNDS ACT (UMIFA), AND "SPENDING RULES"-THE NONPROFITS LEAD THE WAY!

V. RECENT DEVELOPMENTS IN THE LAW OF TRUSTS

A. Restatement (Third) of Trusts Promulgates the Prudent Investor Rule and Incorporates Theories of Risk and Return, Total Return Investing, and Modern Portfolio Theory

B. The Prudent Investor Act is at our Gates

C. A New Principal and Income Act in Progress-Accounting Alchemy-The Power to Adjust Principal and Income

VI. DESIGNING A NEW GENERATION OF TRUST VEHICLE

A. Goals

B. Alternatives

1. Do Nothing

2. Fully Discretionary Trusts

3. The Use of Indexed Payment Trusts

4. The Total Return Unitrust

VII. CHARACTERISTICS OF THE TOTAL RETURN TRUST

A. The Trustee-Life BeneficiaryRemaindermen Partnership

B. The Need for a Smoothing Rule

C. Meeting Expectations

D. The Need for a Force Majeure Power to Change the Spending Rule

VIII. THE TOTAL RETURN TRUST FORM

IX. TAX ASPECTS OF THE TOTAL RETURN TRUST

A. Qualifying for the Marital Deduction

B. Stock Pruning and Capital Gains Tax-Making More Into More and More

X. ROAD TESTING THE TOTAL RETURN TRUST

XI. CAVEATS AND CONCLUSIONS-NEVER A TRUST FOR ALL SEASONS

APPENDICES A, B, AND C

I. INTRODUCTION

During the twentieth century, tremendous changes have occurred in the practice of law, particularly in the estates and trusts practice. However, one aspect of the practice remains remarkably unchanged. Despite the explosion of "acronym trusts",1 most trusts are similar in one important respect. These trusts require the trustee to hold the principal of the trust and to pay the income to the beneficiaries. Clearly, in trusts for minors or sprinkle or spray trusts, the trustee may be given broad discretion to distribute a portion of the income, all of the income, or all of the income and some of the principal. However, the majority of trusts written for clients' surviving spouses and children are relatively specific. The document requires the trustee to hold the principal and pay the income, with invasions of principal generally limited to those circumstances that satisfy what Congress has called "ascertainable standards" under Section 2041(b)(1)(A) of the Internal Revenue Code (Code or I.R.C.), such as use for the beneficiary's "health, education, support, or maintenance."2 These traditional trusts that tell the trustees to hold the principal and pay the income are subject to an income rule and may be referred to as income rule trusts. This practice generally reflects the clients' wishes, since most of them understand (or think they understand) a fundamental difference between the income from property and the property itself. The remonstrance of our forbearers to never spend the principal was good, conservative advice, especially for those who lived during the Great Depression.

With the emergence of modern financial theory, total return investing, and the importance of inflation as a significant risk factor, it is important to change the way we view income and principal. For the most part, however, the language used in trust drafting remains rooted in the past. Important changes in the law of trusts and in the way estate planners view principal and income were foreshadowed by changes in the way charitable foundations managed their endowment funds as a result of the enactment of the Uniform Management of Institutional Funds Act (UMIFA).3 This uniform act and the creation of various spending rules that foundations and universities developed for their funds provide food for thought for private trust drafting.4 The new prudent investor rule reflected in the partial Restatement (Third) of Trusts and the Uniform Prudent Investor Act illustrate changes in the ground rules for trust investments.5 The changes incorporate modern portfolio theory with its more sophisticated understanding of diversification and asset allocation. Further, a new Uniform Principal and Income Act is being drafted that may give the trustee the power to adjust returns between income and principal.6 This could make an important difference to many trusts by expanding the availability of total return investing.

The trust and estate law community should not wait with its feet firmly planted in the sand while the tide of these new developments comes in. Estate planners should begin to use the best of these concepts. The primary purpose of this Article is to familiarize the reader with these important investment and legal developments and to suggest an alternative form of trust that would give the practitioner a tool to effect the changes now. The portions of these materials that are grounded in investment theory and history demonstrate the interrelationships between trust drafting and trust investing. In practice, as trusts are currently drafted, the beneficiary's income needs often dictate the asset allocation. Asset allocation, in turn, dictates the long-term returns enjoyed by the trust and its beneficiaries.

II. CURRENT TRUST DRAFTING FOLLOWS OLD RULEs, CONTINUES OLD CONFLICTS, AND REDUCES RETURNS

A The Duty of Impartiality Between an Income Beneficiary and Remaindermen

One of the most difficult duties imposed upon a trustee is the duty of impartiality between income and remainder beneficiaries:

The trustee should . . . take into account his obligation to act impartially between income and remainder beneficiaries, and not to make an investment which will favor one at the expense of the other. Thus it might be held to be a breach of duty to place the whole trust fund in low yield government securities in order to secure for the remaindermen the maximum of safety, since the income beneficiaries would obtain a yield much less than could be obtained from other legal investments which would have adequate security. And the making of an investment which had a slightly speculative character in order to acquire for the income beneficiary a higher than normal yield might well be subject to criticism by the remaindermen.7

This statement of the duty of impartiality reflects a view of yield that encompasses only current return and not principal appreciation. This view is expressed in the Restatement (Second) of Trusts, but not the prudent investor rule of the Restatement (Third) of Trusts.8 The balancing of trust interests required by the duty of impartiality is emphasized in the new

Restatement:

The interests of a life income beneficiary, for example, are almost inherently in competition with those of the remainder beneficiaries, especially in light of the risks of inflation; and the different tax circumstances of the various beneficiaries frequently create competing investment preferences.

These conflicting fiduciary obligations result in a necessarily flexible and somewhat indefinite duty of impartiality. The duty requires the trustee to balance the competing interests of differently situated beneficiaries in a fair and reasonable manner.9

In concrete terms, the trustee is required to decide between higher yielding fixed-income investments in which neither the income nor the principal is likely to grow over the life of the instrument, or equity securities, such as stocks or equity mutual funds, with lower current yields, but greater long-term returns in income and principal.

Long established practice dictates that the first question to be asked by the trustee with reference to the investment of the funds is "what is the life beneficiary's income need?" More often than not, the income beneficiary has a rather significant need for current income relative to the size of the principal in the trust. Because most life income trusts arise at the death of a loved one, the sense of loss that the income beneficiary feels is enhanced by their personal loss, as well as the loss of any earned income, pension, or social security rights previously provided by the decedent. As a result of the combination of these factors, both the expectation and the need of the income beneficiaries tends toward the higher end of the yield spectrum. With the intermediate government index yielding about 6.5% and the Standard & Poor's 500 yielding 2% as of January 1, 1997, a current income need of 5% after trustee's fees allocated to income will require 74.4% of the trust portfolio to be invested in fixed income and only 25.5% in stocks.'o Yet, most corporate fiduciaries are reluctant to invest less than one-half of their long-term trust portfolios in equity securities, simply because of the duty of impartiality and the historical truth that fixed income investments yield dramatically less in total return over long periods of time. With an even mix of stocks and bonds, one is currently able to generate only a net 3.9% return." This amount is not enough to satisfy the income beneficiary and is not enough of an equity mix to provide truly favorable returns when compared with the Standard & Poor's 500 average over longer periods of time.

B. Beneficiary Expectations-Big and Bigger

Unfortunately, income beneficiaries measure the performance of a trust based upon a comparison of current yield only. Typically, they compare their return with certificates of deposit or other fixed income investments. Remaindermen, on the other hand, often compare the performance of the trust with the growth of the Standard & Poor's 500. As a result, both income beneficiaries and remaindermen are often disappointed with the trust. Often they conclude that trust funds do not do well, almost as though a trust is, itself, a separate form of investment. Beneficiaries have expectations that are divergent and contradictory from the point of view of the trustee. Therefore, their expectations are often not met. This subjective standard, rather than any absolute performance standard, measures the success of the trust in the eyes of the income beneficiary and the remaindermen.

It is equally unfortunate that among the different categories of equity investments, small company stocks have, over long periods of time, with a compound annual growth rate of 12.5% from 1926 to 1995, significantly outperformed large company stocks, with 10.5% growth during the same period. These same small company stocks have even smaller dividend yields, so the income beneficiaries' needs literally squeeze small company stocks out of the investment portfolio. During the same time, when inflation is factored into the picture, short term ultra-safe fixed income investments like U.S. Treasury Bills resulted in a real (inflation-adjusted) return of almost zero, and long-term government bonds resulted in a real return of only 2%, 12

Here is the dilemma. Estate planners generally create trusts that require the principal be held and the income be distributed. The higher the need for income, the greater the amount of the trust that must be invested in assets that, over time, are least capable of producing returns. Worse yet, most trusts do not instruct the trustees on how much income they are supposed to produce. Yet, the trustees are required to impartially administer the trust between the needs of the income beneficiary and the remaindermen. Little wonder, then, that trusts and bank trust departments have such a reputation for producing less satisfactory returns than private investment managers.l3 Is the trust document, rather than the investment manager, dictating the investment returns?

III. THE INVESTMENT UNDERPINNINGS

To understand the problems facing trustees and drafters, and the advantages and disadvantages of potential solutions, one must understand the fundamentals of modern investment theory including:

1. Total return investing; and

2. Asset allocation, modern portfolio theory, and diversification-the keys to long-term returns and risk management.

By examining these concepts, one is better able to see how trust and investment approaches have developed and how they fit into a trust and estate practice.

A. Total Return Investing

Simply stated, total return investing is the investing of funds for maximum return, regardless of whether that return is in the form of accounting income or appreciation of principal. The need to preserve both the value of capital and an income stream over long periods has always been a central concern in trust investing. Inflation, however, as a persistent longterm economic and investment factor, is a relatively new concern for investment planners. From 1926 to 1940, the economy experienced significant net deflation that started even before the economic downturn in 1929. In contrast, the period from 1941 to 1947 showed significant inflation by virtue of the Second World War, but the postwar era of the 1950s and the first half of the 1960s maintained excellent growth with very little inflation. It was in the latter half of the 1960s and thereafter, particularly the periods from 1973 to 1975 and 1978 to 1981, that forced investment planners to take inflation seriously.14 It was during this high inflation period that the concept of total return investing was born and nurtured.

Because of inflation, it is no longer sufficient to preserve the same nominal value in a trust. Rather, it is vital that investors maintain the real (i.e., after inflation) value of the principal and of the stream of income it produced. Studies of long-term returns, both in principal value growth and in current income, show that only equity investments that represented an ownership interest in assets and income producing property kept pace with inflation.15 For this reason, despite their far greater volatility, investments in equity securities and real estate were favored for their growth in principal value and the income streams they produced. A dollar of principal was just as valuable as a dollar of income,16 and the recognition that "a dollar is a dollar no matter how it is earned" gave birth to total return investing.

B. Asset Allocation, Modern Portfolio Theory, and Diversification-The Keys to Long-Term Returns and Risk Management

Recent History of the Capital Markets

The money management industry has witnessed spectacular growth over the past three decades. Part of this growth can be attributed to legislation such as the Employee Retirement Income Security Act of 1974 (ERISA).17 Managers and plan sponsors became more diligent with respect to managing the assets of retirement plans, their funding policies, and diversification of plan assets. The resulting diversification gave birth to a number of specialty investment firms, and managers and sponsors rushed to improve performance and provide unique investment services.

In the 1980s, 401(k) plans, as the fastest growing segment of retirement plans,18 led the change from defined benefit and defined contribution trusts to salary reduction plans. Unique to 401(k) plans was the transfer of investment policy responsibility to the individual, which required that numerous investment choices be available. The record-keeping infrastructure of the mutual fund industry and the array of investment alternatives quickly made mutual funds the product of choice of this market.

The demographic trends in the United States have kept rapid growth in the industry alive as the maturing Baby Boomers pass from the high consumption phase of their life cycles to the high savings and investment phase, which usually arrives after the age of forty-five. Their new-found appetite for investing has met with a dramatic proliferation of mutual fund products and financial-planning organizations, which are keen on selling investment services.

Overlaying the industry trends has been fifteen years of monetary policy that has focused on the ravages of high inflation and created an environment in which financial assets have been spectacular winners relative to hard assets such as gold and real estate.

The demand for money management has resulted in more than 22,000 registered investment advisors in the United States and more than 8,000 mutual fund products,19 eclipsing even the number of companies listed on the major stock exchanges.

2. Modern Portfolio Theory and Diversification

Central to any analysis of modern investment theory is the concept that a particular investment is valued as a function of its risk and return. An investment's risk is defined as the variability of it.; total return, including income and principal appreciation or depreciation. The frequency and amplitude of return variation is known as volatility. Generally speaking, the higher the volatility or risk, the higher the return the market will demand, since volatility is a negative to the investor and must be counterbalanced by a higher reward.20

Volatility can be managed to create lower risk without necessarily lowering the expected return. This is accomplished through diversification, a process that can be used on many levels.

Consider an investment in one company. Implicit in that investment is a market price that theoretically balances the probable return against the individual company's stock volatility or risk. The volatility of that individual stock reflects a number of levels of risk factors, starting with those risks that would only affect that particular company, or company specific risk.21 For example, to consider risks inherent in the stock of Intel Corporation, one might examine the current leadership, the chain of new product development, or the impact of alleged defects in its Pentium processors. A second level of risk might apply primarily to those within the semiconductor industry, a third to the entire technology sector, and a fourth to the U.S. stock market as a whole. If, instead of having one stockholding in Intel, an investor owned nineteen other stocks of various different industries, many of the risks specific to Intel would not apply to the balance of the portfolio.

Indeed, if a portfolio included ten stocks in different unrelated industries, all with the same projected risk and return, one might retain the same projected level of return, but decrease the risk because of the effect of diversification. Many of the risks associated with Intel might not be encountered for many or all of the other nine stocks in the portfolio.22 Looking at a particular investment as it relates to an entire portfolio and as it may increase return or decrease risk to the portfolio is a function of what is called modern portfolio theory, developed in part as a result of significant mathematical analysis and academic research.

Fiduciary law, on the other hand, focuses historically on each investment, judged by itself, rather than within the context of a portfolio. Was the investment of sufficient quality for use in a fiduciary portfolio? Has specific research been completed on the fundamentals of the company? Could the investment stand the test of prudence? But today, each investment is judged in the context of how it affects the risk and return of the portfolio as a whole.

Because investments that individually may be risky can, in combination, actually lower the overall risk of a portfolio, one can increase return or decrease risk without having to pay for it in overall portfolio performance. This is so because many investments show a negative covariance, i. e., when one goes down the other goes up, or at least does not go down. Combining assets that perform differently over time, such as bonds and stocks or diversified individual stocks within a portfolio, actually eliminates much of the company specific risk associated with security selection. However, risk that applies to an entire market, or market risk, remains.23

3. Asset Allocation as the Key to Long-Term Returns

In a seminal work on the subject of asset allocation, authors Gary Brinson, Brian Singer, and Gilbert Beebower studied a sample of ninety-one large pension plans.24 They concluded that the overwhelming contribution to return performance related to the allocation of assets to particular asset classes and specifically related to the portion of the portfolio allocated to common stocks. In an updated study in 1991, the same authors concluded that 91.5% of the variation in quarterly return was explained by the investment policy reflecting overall asset allocation of the portfolio with only a relatively few percent attributable to stock selection or active portfolio management.25Therefore, to build a sensible long-term trust investment program, the first and most important question to address is overall asset allocation. If the goal is to keep a fiduciary portfolio in liquid investments, then the primary choices are short-term cash equivalents, bonds, or common stocks. Once that decision is made, the focus can turn to the selection of managers and the product used to implement the longterm strategy.

4. Asset Allocation is Key Because Over Time Stocks Earn More than Other Forms of Financial Investments

The reason that asset allocation is important is that stocks have a significantly higher rate of return over longer periods, making them the asset of choice for the long-term accumulation of wealth. Since 1926, stocks have offered the highest average returns of any major asset class.26 Large blue-chip companies have offered returns twice as high as those of U.S. government bonds and three times the return of Treasury bills. The returns from stocks become even more compelling when considering the inflation adjusted returns.27 As detailed later, the preferential treatment of capital gains over ordinary income tax rates only adds to the already great differential between stocks and fixed income investments.

The problem with the higher returns associated with stocks is that they are usually accompanied by higher risk and volatility of the portfolio assets. In any single year, the range of returns from blue-chip stocks is substantial, with the best year since 1926 exceeding a 50% return while the worst year shows a decline of more than 40%.28 Over the long term, however, the case for investing in stocks remains compelling. The likelihood of losing money in stocks declines substantially over ten-year periods and is within 1% of the low ten-year returns from bonds.29 Over twenty-year periods, stocks have always provided positive returns30 even through the Depression, recessions, high inflation, wars, and other risks. Stocks are usually the preferred investment and, the longer the time frame, the more likely stocks are to be the best investment.

The tradeoff between risk and return is sometimes called the efficient frontier that displays the effects of asset class blending.32 A portfolio of 100% bonds (0% stocks) provides a low level of nominal return with a moderate amount of risk. As the riskier asset, common stock, is added to an all-bond portfolio, the return increases. Initially the portfolio risk is not increased by adding some stocks because stocks and bonds often perform differently, actually reducing the volatility of the portfolio. The lowest volatility portfolio of stocks and bonds actually has 15% stocks and 85% bonds, not 100% bonds. As one moves further up the efficient frontier, returns increase along with the risk of the returns in the portfolio. The key decision is determining where to position portfolios along the curve. What is the optimal asset allocation? That decision determines over 90% of the expected portfolio return over time.

While adding bonds to an all-equity portfolio may reduce risk, it is done at a substantial cost. By going from a 100% equity portfolio to a 65% stock-35% bond portfolio, the pretax return is reduced from 10.5% to approximately 8.2%. With inflation subtracted, the real return is reduced from 7.38% to 5.08%.

Diversification can also be accomplished by utilizing international securities. International equities are not highly correlated with the U.S. stock market, yet their historical rate of return has been somewhat higher. Therefore, adding international equities diversifies, lowers risk, and raises return.33 Another way to reduce risk in a domestic stock portfolio is to invest in different segments of the market such as value, growth, small, mid-capitalization, and large capitalization securities. Diversification has many faces.

Clearly the conclusion to be drawn from the data is that for a longterm investor or a long-term trust, the volatility of the stock market over the short term is a risk worth taking. No other liquid asset offers the nominal or absolute return derived from stocks. When inflation or real rates of return and the usual tax advantages of the asset are factored in, stocks clearly become the wealth-building asset of choice. The dividend history of stocks also gives the investor an increasing stream of cash returns not available from fixed-interest investments such as bonds or Treasury Bills. Only during short periods when inflation and interest rates are in an upward trend does a switch to fixed income securities lead to higher cash returns.

In building an investment portfolio, patience is needed to endure the inevitable market corrections. Discipline is required for the plan to be carried out in the interest of building wealth. Most of all, careful asset allocation is essential for long-term investment success.

The analysis of risk, return, and asset allocation, which are critical to successful long-term investment, is limited in a trust context by the language of the trust document. If all the income, and only income, is to be distributed to a life beneficiary whose need is greater than the current dividend yield from stocks, then asset allocation takes a back seat to the trust provisions that direct the trustees.

IV. CHARITABLE ENDOWMENTS, THE UNIFORM MANAGEMENT OF INSITUTIONAL FUNDs AcT (UMIFA), AND "SPENDING RULES"-THE NONPROFITS LEAD THE WAY!

The management of endowment funds, particularly for colleges and universities, began to change in the mid-1960s. Like conservative private investors, these educational institutions followed the traditional legal rules for trusts to determine how much of their endowments to spend. Institutions would spend precisely that income that came in the form of interest, dividends, rents, or royalties. By the mid-1960s, the concept of total return investing began to erode the assumptions concerning spending and investment.34

Colleges and universities in many jurisdictions are free from the traditional restraints of income and principal allocation when dealing with endowment because of the local enactment of the Uniform Management of Institutional Funds Acts (UMIFA). This Act was promulgated by the National Conference of Commissioners on Uniform State Laws in 1972 as a result of concern that endowments were not generating the maximum return. This concern was brought into focus in the late 1960s and early 1970s by a series of Ford Foundation Reports, two known as the Barker Reports and two by Carry and Bright.

The specific thrust of the Ford Foundation Report was that colleges and foundations were investing too conservatively. The institutions were giving up capital gain returns because of mistaken definitions of prudence and a desire not to lock up capital gain in perpetuity in endowments. In other words, the spend-incomeonly rule was leading to unfortunate investment decisions. The UMIFA solution was to give universities the power to invest under a more liberal prudent person rule and to allow colleges to use either the traditional principal and income rule or a total return standard when making annual spending decisions.35

History shows that, during some periods of time, income return might be a very small proportion of the total return. Examples of such periods include the time from 1956 to 1968 and 1986 to 1995.36 On the other hand, very high yield bonds in the early 1980s might have been over-productive of income. High inflation expectations were built into their rates of interest, so spending based on accounting income often unfairly allocated return, and even worse, led to poor investment results simply because of the need to generate current income.

The investment goals for endowment spending have substantial similarities with the goals of private trusts. Endowments seek a stable flow of real income37 and either a maintenance of the purchasing power or an increase of the real value of the endowment. The role of most spending policies is to limit spending to no more than the real return, that is the accounting income and the increase in value over time as adjusted by inflation. Limiting distributions to the real return preserves the value of the underlying endowment fund. While this result is probably the goal of most spending policies at universities, universities pursue this outcome in different ways.

Many institutions use traditional income accounting rules.38 Many others have turned to a combination of total return investing coupled with a percentage payout of the endowment value, essentially creating a form of unitrust.39 The difficulty with a unitrust payout is that there is likely to be too much fluctuation in the payout. This is particularly important within the context of university budgets, which are highly inflexible and ill-suited to absorb significant swings in endowment income on a year to year basis. As a result, most schools have adopted some type of smoothing rule. Some simply increase spending every year on the basis that inflation demands it. Perhaps the simplest of these smoothing rules is to provide for a unitrust payout over rolling averages of three to five years of unitrust values. The use of a unitrust payout based upon a percentage likely to be no more than the real return provides a sensible theoretical base for endowment spending. A number of prestigious universities use moving averages to smooth their endowment income.40 The payout tends to average between 4% and 6%.

Recent analyses of the payout methods of endowments show that almost 40% of the foundations still cling to the income rule regarding payout, while approximately 30% of the foundations base their payout decisions on overall investment objectives and performance.41 The larger foundations tend to have more sophisticated and more complicated rules. Yale University uses a smoothing rule that incorporates a target percentage of current market value and a spending component from the previous year's expenditures.42

As these materials will indicate, the artificial43 distinctions between income and principal are losing ground in the charitable foundation area, as well as in the law of private trusts.

V. RECENT DEVELOPMENTS IN THE LAW OF TRUSTS

A. Restatement (Third) of Trusts Promulgates the Prudent Investor Rule and Incorporates Theories of Risk and Return, Total Return Investing, and Modern Portfolio Theory

The Restatement (Third) of Trusts first stated the prudent investor rule in its modern form as follows:

sec227. General Standard of Prudent Investment

The trustee is under a duty to the beneficiaries to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust.

(a) This standard requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust.

(b) In making and implementing investment decisions, the trust has a duty to diversify the investments of the trustee unless, under the circumstances, it is prudent not to do so.

(c) In addition, the trustee must:

(1) conform to fundamental fiduciary duties of loyalty ( 170) and impartiality ( 183);

(2) act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents (sec 171); and

(3) incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship (sec 188).

(d) The trustee's duties under this Section are subject to the rule of sec228, dealing primarily with contrary investment provisions of a trust or statute.44

The prudent investor rule represents a significant departure from prior law in a number of respects. First, the law has been that each individual investment is judged separately, not on a portfolio basis. Second, the duty to diversify is clearly stated. While this has long been accepted as good practice, it has not been black letter law nationwide. Third, delegation of investment and other functions is permitted as long as the decision to delegate and the selection and supervision of agents is done reasonably. Finally, cost control is required, no doubt a reflection of the efficient markets45 theory, which argues against the expenditure of additional funds to attempt to increase returns by timing or selectivity in investing.

One of the foundations of the requirement of diversification is the theory that in an efficient market each stock has the same expected return for a given level of risk, even though they will not in fact have the same rate of return. However, increasing the number of individual stocks reduces the volatility of the entire portfolio. When the volatility of the entire portfolio is reduced, there is a reduction in the overall risk without changing the probable average return of the portfolio. In this respect, the risk of having too small a number of individual investments of a particular kind is considered to be uncompensated risk, as opposed to the compensated risk of a particular market where risk and return tend to be directly related to one another. The higher the risk, the higher the return the market will demand in pricing the investment.46

The commentary to Restatement section 227 points toward the total return trust: In short, only when beneficial rights do not turn on a distinction between income and principal is the trustee allowed to focus on total return. . . without regard to the income component of that return. In other trust situations there exists a fiduciary duty to make the trust estate productive of trust accounting income. The trustee then has a duty to consider two aspects of the productivity question. First, what is an appropriate level or range of income productivity for the particular trust? As noted above, this is a matter for interpretation and fiduciary judgment . . Second, how should that productivity objective be incorporated into an overall portfolio strategy? In resolving the latter question the trustee is not governed by the productivity standard in the selection and retention of each individual investment. The standard applies to the portfolio as a whole.47

B. The Prudent Investor Act is at our Gates

Carrying forward the concepts introduced with the Restatement (Third) of Trust, the Uniform Prudent Investor Act was adopted by the National Conference of Commissioners on Uniform State Laws on August 5, 1994, and approved by the American Bar Association on February 14, 1995. Incorporating modern portfolio theory into the Uniform Prudent Investor Act abrogates all categoric restrictions on types of investments. The trustee can invest "in anything that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investing."48Section 2 of the Act also states a number of circumstances that the trustee must consider in investing and managing trust assets:

(1) general economic conditions;

(2) the possible effect of inflation or deflation;

(3) the expected tax consequences of investment decisions or strategies;

(4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;

(5) the expected total return from income and the appreciation of capital;

(6) other resources of the beneficiaries;

(7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and

(8) an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.4 In addition, the Act creates an express duty of impartiality in section 6:

If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries.50

This duty of impartiality implies a shift away from the general favoring of the life income beneficiary, often what the testator might prefer, in favor of an evenhanded duty between the current and remainder beneficiaries. This is likely to emphasize the burden on the trustee of the conventional income rule trust in selecting investments. Either the Prudent Investor Act or the Restatement's prudent investor rule has been adopted in some form in a number of states such as New York, Illinois, Florida, and Virginia, and will no doubt be seriously considered by many others in the near future.51

C. A New Principal and Income Act in Progress-Accounting Alchemy-The Power to Adjust Principal and Income

A third version of a Uniform Principal and Income Act has been drafted for consideration by the National Conference of Commissioners on Uniform State Laws. The primary purposes of this newest revision, which has been in progress for almost five years, are to update the prior Principal and Income Acts, i. e., to recognize new forms of investments, to reflect the modern portfolio theory of investing, and to allow fiduciaries the means for making the best investment decisions parallel with the prudent investor rules in the Restatement (Third) of Trusts and in the Uniform Prudent Investor Act.52

The proposed Uniform Principal and Income Act will reflect acceptance of total return investing and may give the trustee the power to reallocate or adjust returns between income and principal under certain circumstances, although the latter idea remains subject to considerable debate.

Section 104 of the Act, titled "Trustee's Power to Adjust," addresses the tension between the duty of impartiality and the duty to give due regard to the interests of both the income and remainder beneficiaries.53 The key language of section 104 in its present, and perhaps final, form reads as follows:

(a) A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust's income, and the trustee determine that, after applying the rules in Section 103(a), the trustee is unable to comply with the rule in Section 103(b).54

In essence, sections 103 and 104 of the Act, taken together, direct the fiduciary to allocate first according to the instrument, then according to any discretionary powers under the instrument, and then according to the Act. If the result still does not allow the fiduciary to comply effectively with its duty of impartiality, section 104(a) allows the trustee to adjust between principal and income to carry out the purposes of the trust.

The foregoing language should allow a trustee to distribute a certain amount of appreciation of principal by recharacterizing it or adjusting it as income under appropriate circumstances. The proposed Act also permits accumulation income under other circumstances to be fair and impartial to both beneficiaries.55 If the document does not call for impartiality, the power might be used to best effectuate the intent of the settlor given the economic conditions and investment alternatives available.

The proposed Act also attempts to preserve the critical tax benefits of the marital deduction and the annual gift tax exclusion on a gift of an income interest. These benefits still rest upon the distinctions between income and principal.56

Further, the trustee may need protection from the power if the power might make the trustee or the grantor subject to the grantor trust rules; or worse, if the power might cause a federal estate tax inclusion in the estate of either the trustee or one who has a removal and appointment power for the trustee. Hence, these situations are excluded as well.57

Section 104 of the revised Uniform Principal and Income Act would deny this power to a trustee who is an interested party to such an adjustment, whether the trustee is a beneficiary or otherwise. If the trustee is interested or the use of the adjustment power would result in an inadvertent tax result, section 104 would deny this power to the interested trustee, but would allow a disinterested cotrustee58 to exercise the power if this approach would eliminate the difficulty.

Finally, the draft would allow the trustee to release all or part of the power provided by proposed section 104, either permanently or for a specified period, including a period measured by the life of an individual.59 The terms of proposed section 104 would not apply to every trust retroactively, but this power of equitable adjustment would apply "unless it is clear from the terms of the trust that the terms are intended to deny the trustee the power of adjustment."60

The comments and examples following the draft of new section 104 make clear that it is a power given in response to the evolution of the prudent investor rule and the Uniform Prudent Investor Act requirements of impartiality between beneficiaries in the context of total return investing. Examples 1 and 3 illustrate the particular importance of the ability of a trustee to compensate for a decrease in accounting income caused by an increase in the proportion of trust assets allocated to stocks in response to the prudent investor rule.61Another example makes clear that during a period of high inflation with high interest rates, a portion of the interest may be considered to be a return of capital and added to principal.62The purpose and scope of the provision are clear enough:

The purpose of section 104 is to enable a trustee to select investments based on the standards of a prudent investor without having to realize a particular portion of the portfolio's total return in the form of traditional trust accounting income such as interest and dividends. Section 104 provides a power to adjust total return between principal and income in the limited circumstances specified after applying the terms of the trust and the provisions in other sections of this Act. It sets forth a default rule that a settlor can expressly set aside in the terms of the trust.63

As with much in the area of planning for trusts and estates, the evolution of this section to allow an equitable adjustment between principal and income has seen significant change as a result of tax concerns.6 Hopefully, the specific examples agreed upon will give enough specific guidance to make this provision of real benefit to trustees. If a trustee does not know how to use the examples, they will not be used.

A power to reallocate capital gain or appreciation as income would be very useful in a number of situations in which the trustees otherwise are restricted by the terms of the trust document. The primary example is of a beneficiary who has a high need for income, but the trustee has no power to invade principal. When the need is between 5% and 6% of the actual trust corpus annually, and there is no discretion to distribute principal, the only alternative open to the trustees is to invest entirely in fixed-income investments. However, these investments do not grow. This investment strategy eventually harms not only the remainder beneficiary, but the income beneficiary as well.

The foregoing explanation provides guidance on the direction of the law, but it does not provide any help for trustees here and now. Furthermore, the current Principal and Income Act65 and the revised Act will be subject to the express provisions that are drafted into each trust. Efforts should therefore be focused upon drafting solutions.

VI. DESIGNING A NEW GENERATION OF TRUST VEHICLE

A. Goals

In designing a new generation of trust vehicle, taking into account the background principles discussed in this Article, eight objectives were established. First, the trust should enable the trustees to invest for the highest total return consistent with the level of risk acceptable to the trust and its beneficiaries. Second, the trust should allow for fair allocation of principal and income returns between the current beneficiary and remaindermen. Third, an identity of interest between the current beneficiary and remaindermen should exist with reference to investment decisions. Fourth, the trustee should have a clear rule for distributions to the current beneficiary under ordinary circumstances. Fully discretionary distributions without any type of standard or criteria increase the burdens of trusteeship. Fifth, the trust vehicle should create a distribution rule that is to some degree self-adjusting in times of unusual volatility, whether up or down. A sixth objective is to seek a smooth flow of distributions to the current beneficiary, consistent with maintaining identity of interest between beneficiary and remaindermen. Seventh, it is desirable to state clearly the goals of the trust in investing and distribution, recognizing that goals are not always attainable. Finally, there should be some form of force majeure provision to alter the distribution rate should that rate be rendered inappropriate by prolonged or permanent change in economic or financial circumstances.

B. Alternatives

In response to these objectives, a number of approaches could be followed, including the use of fully discretionary trusts, indexed payment trusts, or total return trusts. Each alternative is considered briefly, followed by a more detailed examination of the total return trust as the most appropriate trust vehicle.

1. Do Nothing

One alternative is to draft documents as before and wait for the new Principal and Income Act to be adopted to see if the Act helps. No doubt that is what many will do. It is difficult to fundamentally change the way documents are drafted. Anything really new creates anxiety for the drafter. Trust and estate lawyers are a rather conservative (some might say stodgy) crew, and they may well do nothing and continue to draft as they have. However, doing so will destine many beneficiaries and their families to disappointment. All the trustee can do is to try to fulfill their duty of impartiality by disappointing income and remainder beneficiaries equally!

2. Fully Discretionary Trusts

The use of fully discretionary trusts that allow the distribution of some or all of the income and some of the principal, perhaps to a variety of beneficiaries, could be expanded. A fully discretionary trust in this context would allow the trustee to invest for total return and then exercise discretion in distributing a fair and reasonable return to the current beneficiary while maintaining the balance in the trust corpus. While this may be appropriate in closely knit families and in situations in which income tax planning is paramount, it does not give the trustee any kind of guidance as to how to exercise that discretion, nor does it give the beneficiaries any basis for their expectations. The fulfillment of expectations, human nature being what it is, is 90% of a person's perception of performance.

3. The Use of Indexed Payment Trusts

Professor Dobris argues that often the intent of a settlor or testator is to provide an adequate flow of distributions increasing on a yearly basis by some inflation factor such as the Consumer Price Index (CPI) or the GNP deflator.66While this is eloquent in theory, the fact that such an indexed payout is linked to an external factor, inflation, which is not correlated with the return and may be inversely correlated to return, effectively requires that such a payout be set at a small initial level to be safe. During a period of high inflation, stock and bond markets are frequently adversely affected, and yet in such an indexed payment trust, the distribution to the current beneficiary would have to increase. For example, during the two-year period from 1973 to 1974, the CPI measured inflation of 21% and the total return for large company stocks was -41.13%.67 The increase in payout would have required liquidation of assets at low prices, having a negative dollar averaging affect. In contrast, a payout that was keyed to asset values would have reduced the depletion of capital and produced positive dollar averaging as illustrated later in these materials.

4. The Total Return Unitrust

The final category of trust alternatives is the total return unitrust (total return trust). This type of trust is a private, noncharitable unitrust that provides a trust partnership between the current beneficiary and the remaindermen, facilitates total return investing and creates expectations in the income beneficiaries that are likely to be fulfilled. By directing the trustee to pay out a specific percentage of the trust set forth by the grantor or testator, this type of trust instrument removes the great difficulty in fulfilling the duty of impartiality. Trustees are able to invest in any type of asset, whether it is over-productive or under-productive of accounting income, and to make the payments as needed from those investment returns. One of the noted advantages of charitable remainder unitrusts is freedom from conflicts between the interests of beneficiaries. The trustee is not required to balance the interests of one beneficiary against the other. The trustee need only to consider the risk tolerance of the beneficiaries and the likely duration of the trust. The trustee then may invest as the trustee thinks best. The life beneficiary profits in lock step with the remaindermen because what is good for one is good for the other. Furthermore, the expectations of the income beneficiary in the first year will always be met, making a suitable foundation for the relationship between the life beneficiary and the trustee. With this background and the reasons for the selection of a total return trust as a model trust for the future, the characteristics of the total return trust and some desirable special provisions can be examined.

VII. CHARACTERISTICS OF THE TOTAL RETURN TRUST

A. The Trustee-Life Beneficiary-Remaindermen Partnership

The trustee's compensation, the life beneficiary's distribution, and the remaindermen's share rest upon the growth in the market value of the trust corpus. The welfare of all three participants in the trust triangle depends upon performance, and the interests of the parties are the same in encouraging the growth of capital. The investment decision must center around the duration of the trust and the ability of the trust, given the needs and the time involved, to withstand volatility as a result of different asset allocation mixes. The questions of risk and return are the same for the trustee, the life beneficiary, and the remaindermen. Volatility affects trustee fees, life beneficiary distributions, and, potentially, the value to the remaindermen, which typically comes to fruition at of the death of the life beneficiary.

B. The Need for a Smoothing Rule

While a private, noncharitable unitrust would be effective on a historical basis, an ordinary unitrust that bases distribution on a one-year value (the year-end value of the preceding year) would have produced a significant number of dramatic declines. Appendix A illustrates a seventyyear-old $100,000 trust that invested in common stocks with the same returns as the Standard & Poor's 500. The illustration assumes a 5% payout throughout that entire period. Note that the Standard & Poor's 500 dividend yield between 1926 and 1944 was almost always between 4% and 6%, so that the use of an income rule trust throughout that period might not have made a substantial difference. The Ibbotson data from that time indicates that U.S. government bonds actually produced significantly lower yields than stocks during some portions of this period, particularly during the Depression. Clearly, this result was driven by one overriding need-safety.

The returns from the Depression era provide a real perspective on just how badly the stock market performed beginning in 1929. During that period, a 5% payout (and the market value) would have decreased by 70%. Interestingly, the dividend income on the Standard & Poor's 500 decreased by almost as much.68

Throughout this seventy-one year period of the hypothetical trust, there were twenty-three years in which there was a reduction in the distribution, and fourteen years in which the reduction was more than 10%. The more recent decline in 1974 and 1975 resulted in a 45 % reduction in distribution. At the same time, this seventy-one-year record of distributions on a Standard & Poor's 500 portfolio with a 5 % unitrust is still quite impressive, with a beginning market value of $100,000 growing to an end market value as of December 31, 1996 of $4,800,464. Even with that impressive overall performance, however, the volatility of distributions in a strict unitrust seems too great for most private trusts. A smoother stream of distributions would be desirable for the welfare of the life beneficiary, usually the spouse or other dependant of the testator or settlor.

By using a three-year rolling average of market values to determine the annual payout, the trust can provide much smoother streams of distributions. Appendix B shows the same hypothetical trust illustration as was shown in Appendix A, but with a three-year rolling average smoothing rule. Note that the market value at the end is $5,217,253, a 5,217% increase.69Note also that, in the revised unitrust table with a three-year smoothing rule, instead of twenty-three negative years, there are only thirteen negative years and only seven with a decline of greater than lOlo. Despite three one-year or longer corrections in the market since 1977, there would have been no decreases in the distribution under this smoothing rule since 1976.70 Even longer smoothing rules with five-year and ten-year rolling periods were calculated, but they did not reduce the number of years of decreased payout,71 although the ten-year period substantially lowered the payout over time to the life beneficiary.

Based on the foregoing information, a model document was drafted with a three-year rolling average smoothing rule. This represents the best compromise between the need for smoothness in the distributions and the need to increase or decrease distributions along with market performance quickly enough to preserve the trustee-life beneficiary-remaindermen partnership. When drafting a trust for a seventy-five-year-old beneficiary, a five- or ten-year smoothing rule may simply be too long to adequately produce the identity of interest that is the heart of the total return trust.

C. Meeting Expectations

One of the most difficult problems facing the trustee is meeting the expectations of a life beneficiary. Usually the beneficiary has lost a spouse or other loved one. That personal loss compounds whatever financial loss may have occurred. The loss of earned income, social security, and investment as a result of taxes all combine to set the life beneficiary up for disappointment. Beneficiaries often compare their income return with the rates available on bank certificates of deposit. Only the relatively sophisticated beneficiary will understand that a 2% or 3% current yield in a trust may very well translate itself into substantial long-term gains and substantial growth in income distributions. By providing a clear rule, such as 5So or some other percent of the initial value of the trust, the drafter can insure that in the first year the trustee and the beneficiary will have a meeting of the minds. Five percent of $1,000,000 will be $50,000 every time, and the trustee will meet the beneficiaries' expectations in year one of the trust. After that, trustees are on their own to meet or exceed the investment markets. The importance of expectations to human nature makes this feature very significant in helping to bond the triangle of the trustee, the life beneficiary, and the remaindermen.

D. The Need for a Force Majeure Power to Change the Spending Rule

No trust is perfect for all seasons. Examination of the past seventy years of investment history and computer modeling of different trust payment rules suggests that using a three-year unitrust payout will work reasonably well within the range of 4% to 5%, when the need for current income is moderate to high. However, it is possible that substantial changes in the investment markets such as inflation or the relationship among dividends, rates of interest, and total return may cause any particular level of spending rate to become inappropriate in the future.

Accordingly, if a trust is intended to last for a very long time, it may be important for the trustee to have a power under unusual circumstances to change the distribution rate to accomplish the intended goals.72While it is not anticipated that this power would have to be exercised frequently, or at all, the ability to change the distribution rate for the application of the unitrust might someday become a critical factor. This power should only be included in a trust that has an independent trustee, since its discretion goes far beyond ascertainable standards.

vIII. THE TOTAL RETURN TRUST FORM

The following total return trust model is drafted based on the research and discussion set forth previously. This model is a new form of trust that has not been tested within this context. However, it is based on well established principles of current law, including the trends likely to occur as the Prudent Investor Act and the new Uniform Principal and Income Act gradually influence fiduciary law.

THE TOTAL RETURN TRUST

1. I give the residue of my estate to my trustee to hold as the Residuary Trust under the following provisions:

A. During spouse's life. My trustee shall pay the distribution amount set forth below to or for the benefit of my during h life, in quarter-annual installments.

B. Distribution amount. The trustee shall pay to my in each tax year of this trust during h life an amount equal to five (5%)73 percent of the average of the fair market values of the trust as of the close of the last business day of the trust's three previous tax years (or such lesser number of tax years as are available for the first three tax years of the trust). In the case of a short tax year, the distribution shall be calculated as set forth in subparagraph C below. In the case of contributions to or distributions from the trust, including initial funding, the distribution amount shall be determined as set forth in subparagraph D below.

C. Short year. For a short tax year, the distribution amount shall be based upon a prorated portion of the distribution amount set forth above, comparing the number of days in the short tax year to the number of days in the calendar year of which the short tax year is a part.

D. Contributions and Distributions. In a tax year in which assets are added to or distributed from the trust (other than the distribution amount) (hereinafter "adjustment year"), the distribution amount shall be increased (in the case of a contribution) or decreased (in the case of a distribution) by an amount equal to five (5%) percent times the fair market value of the assets contributed or distributed (as of the date or dates of the contribution or distribution), multiplied by a fraction, the numerator of which is the number of days from the contribution or distribution to the end of the calendar year, and the denominator of which is the days in the calendar year. Further, the year end values for the two tax years preceding the adjustment year shall be increased by the amount of such addition, or decreased by the amount of such distribution, for purposes of determining the distribution amount for years following the adjustment year.

E. [Insert for QTIP, or delete and reletter subparagraphs] If in any tax year of the trust the net income of the trust exceeds the distribution amount, such excess net income shall be distributed to my at least annually.

F. All computations of the trust's fair market value, or the value of any contributions or distributions as set forth above, shall include accounting income and principal, but no accruals shall be required. If the trust includes assets for which there is not a ready market, the trustee shall adopt such method of valuation as the trustee deems reasonable in its discretion under the circumstances.

G. Income earned in estate prior to trust funding. In addition to the distribution amount as determined above, the net accounting income earned in my estate and allocable to the residue shall be paid to the trust, and distributed to my

H. Source of distribution amounts. The distribution amounts from the trust shall be paid first from net accounting income, next from net realized short-term capital gains, then from net realized long-term capital gains, and as necessary from the principal of the trust.

I. Discretionary distributions of additional amounts. In addition to the distribution amounts as set forth above, my trustee shall distribute such additional amounts, if any, of accounting income, capital gain or principal to my said as the trustee deems advisable for my 's health, maintenance and support in h accustomed standard of living, taking into account other income or assets which are available to h . [Comment: Discretionary distributions may be advisable for the same reasons as they are in any trust. ]

J. Death of spouse. On the death of my , the trustee shall distribute the balance in said trust to my then living issue, per stirpes, subject to the Trust Continuation Provisions hereinafter.

K. Goals of trust and trustee's power to alter distribution rate.

The goal of this trust is to provide a relatively smooth flow of distributions to my which distributions over the anticipated term of the trust may maintain, to the extent practicable, their real spending power in the face of inflation. A second goal is to maintain the real spending power of the principal of the trust for the remaindermen. It is my intent by using a total return trust, that is one which does not distinguish in investment goal (or distribution) [Delete for QTIP] between the production of income and short- and long-term capital gains, to eliminate any conflict of interest which the trustee might otherwise experience between attaining the two goals set forth above. I have set the distribution rate at five (5 %) percent based upon my hope that, over long periods of time, this distribution rate can be maintained and still have the distributions increase sufficiently to offset inflation. If this goal is achieved, the principal of the trust will also have maintained its value. I recognize that these goals will not be attainable every year, and may not even be attainable over the term of the trust. I accept that the setting of the five (5%) percent distribution rate is my own decision and recognize that the two goals set forth above may not be attainable as a result even if my trustee acts with reasonable prudence. As a further safeguard, if the trustee becomes convinced that the goals as set forth above cannot be attained as a result of substantial and long-term changes in the investment marketplace, because of inflation, deflation, or other secular economic change that would make advisable a change in the percentage distribution rate used for determining the distribution amount, then my trustee shall have the discretion to modify such rate as my trustee may deem necessary. Such a change in rate shall be within the sole discretion of my trustee given the investment and distribution goals for this trust. My trustee shall not be held accountable for such discretionary act by any party provided that my trustee have acted in good faith. [N. B. Trustee must be independent to insert this power].

2. Executors and trustees powers. In addition to the powers conferred by law, my execut with respect to my estate, and my trustee, with respect to any trust, shall have the following powers, to be exercised in their absolute discretion, without the necessity of application to any Court, in the capacity to which such powers may be applicable: [optional except that they shall have no power as to the Marital Trust which would disqualify it for purposes of the marital deduction:

[Customary Provisions Omitted]

B. Investments. To invest in any type of investment that plays an appropriate role in achieving the investment goals of the trust, which investment shall be considered as part of the total portfolio. It is my specific direction that no category or type of investment shall be prohibited. I specifically do not wish to limit the universe of trust investments in any way other than is dictated by the trustee's exercise of reasonable care, skill, and caution. In connection with the trustee's investment and management decisions with respect to this trust, the trustee is specifically entitled to take into account general economic conditions, the possible effect of inflation or deflation, the expected tax consequences of investment decisions or strategies, the role that each investment or course of action may play within the overall trust portfolio that may include financial assets, interests in closely held enterprises, [Note-consider valuation problems here] tangible and intangible personal property, and real property; [Note-valuation problem] the expected total return from income and the appreciation of capital; other resources of the beneficiaries, the needs for liquidity, regularity of income and preservation or appreciation of capital, and the asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries. Nor shall my trustee be limited to any one investment strategy or theory, including modern portfolio theory, the efficient markets theory or otherwise, but should be free to consider any appropriate investment strategy or theory under all the circumstances.

C. Delegation. The trustee may delegate investment and management functions that a prudent person of comparable skills would properly delegate under the circumstances. Should the trustee delegate such function, the trustee shall exercise reasonable care, skill, and caution in selecting an agent, establishing the scope and terms of the delegation consistent with the purposes and terms of the trust, and periodically reviewing the agent's actions in order to monitor performance and compliance with the terms of the delegation. Should such delegation occur as set forth above, the trustee that complies with the requirements for delegation shall not be liable to the beneficiaries or to the trusts for the decisions and actions of the agent to which the function was delegated, but by accepting the delegation of a trust function by the trustee of this trust, the agent submits to the jurisdiction of the courts of this state. [Insert for QTIP: Should the trustee invest in property which is unproductive, my spouse shall have the right to require the trustee to convert the same into productive property within a reasonable time.74]

I. Reformation. The corporate trustee, acting alone and in its sole discretion, shall have the power to reform this instrument, with or without Order of Court, in order to make any changes necessary so as to preserve and make the best use of the marital deduction for federal estate tax purposes and the exemption from generation-skipping transfer tax. Any provisions of this will shall be interpreted or reformed so as to preserve these benefits wherever possible, provided that such interpretation or reformation does not do violence to my primary intent to provide for my spouse and my children.

IX. TAX ASPECTS OF THE TOTAL RETURN TRUST

A. Qualifying for the Marital Deduction

Many of the trusts that employ the total return trust form will be used for a surviving spouse, and one of its best uses would be for Qualified Terminable Interest Property (QTIP) marital trusts. QTIP marital trusts may be formed for generation-skipping transfer tax reasons to allow a reverse QTIP election under I.R.C. 2652(a)(3). One of the major reasons for this type of trust is concern about a second marriage, when the life beneficiary is a second spouse and the remaindermen are children by a prior marriage. In these situations, the potential conflict of interest is particularly strong between the life beneficiary and the remaindermen. The testator's use of a total return trust with a specified percentage payout will make the trustee's job a great deal easier both by taking away the need for the trustee to determine how much income is enough for the surviving spouse, and also by making the duty of impartiality rest more easily on the trustee's shoulders. To be a qualifying income interest for life under I.R.C. sec2056(b)(7)(B)(ii), the surviving spouse must be entitled "to all the income from the property, payable annually or at more frequent intervals," and "no person [may have] a power to appoint any part of the property to any person other than the surviving spouse. "75 Even if there were no smoothing rule, the distribution rate might be less than the amount of the income under some economic conditions, so the total return trust form includes optional language to ensure that it distributes all of the income in a QTIP. Without the added language the trust is unlikely to qualify, even though it may pay out significantly more to the surviving spouse than a conventional income rule trust under present economic circumstances.76 Optional language in the trust form is also added to deal directly with the question of unproductive or underproductive property. This is probably unnecessary because state law generally will reach the same result. Section 240 of the Restatement (Second) of Trusts provides:

Unless it is otherwise provided by the terms of the trust, if property held in trust to pay the income to a beneficiary for a designated period and thereafter to pay the principal to another beneficiary produces no income or income substantially less than the current rate of return on trust investments, and is likely to continue unproductive or under-productive, the trustee is under a duty to the beneficiary entitled to the income to sell such property within a reasonable time.77

Section 240 of Restatement (Third) of Trusts defines property as underproductive if the income is "substantially less than an appropriate yield on the trust investments. "78 In the following portion of the new QTIP regulations, there is a hint that payment from other assets of the trust might cure this problem, but the language is not clear:

. . . [flor example, assume that the corpus of a trust consists substantially of property which is not likely to be income producing during the life of the surviving spouse and that the spouse cannot compel the trustee to convert or otherwise deal with the property as described in subparagraph (4) of this paragraph. An interest passing to such a trust will not qualify unless applicable rules for the administration require, or permit the spouse to require, that the trustee provide the required beneficial enjoyment, such as by payments to the spouse out of other assets of the trust.79

Without a clear definition of "required beneficial enjoyment," it is hard to find comfort in this language.80In any event, the total return trust form language requires that any net income in excess of the distribution amount be distributed at least annually and specifically allows the spouse to compel the trustee to make the property productive. The I.R.C. sec2056(b)(7) election should be fairly surrounded and supported by a sufficient number of belts, suspenders, and safety pins.

B. Stock Pruning and Capital Gains Tax-Making More Into More and. More

With the current financial markets, the use of a total return trust will encourage the use of a greater proportion of stocks and other equity investments, as opposed to fixed income, by virtue of the flexibility the total return trust provides and the fact that equity securities over longer periods tend to produce a higher total return.

Furthermore, the highest categories of return even within the subset of stocks tend to be the small capitalization growth stocks. The use of a total return trust would inevitably lead to periodic use of a small amount of the principal every year to meet the distribution payouts required by the trust. Traditionally, this practice would seem aggressive or even speculative, but the investment data presented in these materials tends to show otherwise, particularly in the case of a total return trust with individual equity securities. There is also a significant tax advantage to using principal a little at a time-referred to as stock pruning.

To demonstrate the tax advantage, two different portfolios of $100,000 each will be created, one invested in taxable fixed income and the other in a widely diversified group of individual stocks with a current level of dividends of 2.5% and appreciation of 6% per year. To level the playing field, the same total return of 8.5% will be assumed for both trusts as well as a constant trust payout of 4% per year. The rate of tax inside the trust for any reinvested ordinary income will be 31 %.81A 31% tax bracket will be assumed for the trust beneficiary as well. Both the fund balance and the after-tax distribution to the trust beneficiary significantly appreciate:

The 4% payout in the foregoing chart after 31% tax gives an after-tax return of 2.76% and the 4.5% income compounded in the trust yields 3.105% compounded. This result is appealing until it is compared to the use of a total return trust with equities:

These results come from the tax deferral that applies to most of the gain in the stock values for the sixteen-year period. While the distributions to the beneficiary begin as the same size as the distributions from the fixed income total return trust, they are also largely tax sheltered because each share of stock sold is entitled to use its individual share cost basis. Thus, the original trust portfolio investment cost offsets the amount of capital gain realized each year. In the first few years, the stock holdings that are pruned are primarily a recovery of the cost basis, so the effective tax rate is very low. If the process continued long enough, the tax bracket would approach 28%, the maximum tax on capital gains. The cumulative after-tax distributions for the first sixteen years are 27% larger, even using the same total return from each form of investment.82The equity total return trust after sixteen years has built up almost 30% higher its value while wearing down its cost basis to slightly under $80,000. In a QTIP trust, this capital gains tax would never be paid because it is includable in the life beneficiary's estate under I.R.C. sec2044 and there would be a new cost basis at death.83 Consequently, this type of investment program with pruning may be valuable for older trust beneficiaries as well as young ones. But what if all of that deferred capital gain has to be recognized at the end? Would the trust be worse off? Even if all of the trust securities that now had a relatively low remaining cost basis were sold at once and taxes of $36,884 were paid, the after-tax assets would exceed the value of assets under the fixed income trust by more than $11,000. Also, the beneficiary would have received significantly larger after-tax distributions by using the QTIP trust.

Over significant periods of time, equity securities not only earn more, but they are also significantly tax favored if managed properly. Equity returns come mostly in the form of capital gains that are taxed not only at a lower rate, but can be structured with stock pruning to be tax deferred as well.

X. ROAD TESTING THE TO ToTAL RETURN TRUST

To test the total return trust in the real world, the author favors a test similar to a consumer's test of a car. On a theoretical basis we have already kicked the tires and examined its specifications. However, the trust should be critically examined during a period when the markets, specifically the stock market, provide a bumpy and winding road.

The period from January 1, 1973, to the present was selected for two reasons. The first reason is that 1973 and 1974 accounted for the worst stock market performance in recent history. During 1973 and 1974 stock prices declined 17.4% and 29.7%, respectively, a 42% decline during that two-year period. The second reason is the similarity between the dividend and interest yields at that time and those yields of 1996. The Standard & Poor's 500 dividend yield was an average of 2.86% in 1973, while intermediate governments bonds were approximately 6.5%, averages that are similar to the relationship today. During the nine years that followed, interest rates and inflation were tremendously volatile. However, the next fifteen years provided a favorable financial market. This period should provide a good opportunity to test this new total return trust.

Assume that a $100,000 portfolio is created for a surviving spouse. To produce a 5 % initial net yield, the trustee is forced to adopt a 33 % equity and 67% fixed income portfolio.84 That mix will be favorable in the shortterm because bonds will significantly outperform stocks over the next nine years.85 Table 1 runs the total return trust with an all-equity portfolio represented by the Standard & Poor's 500 in Column A against this 33%/67% mix and other investment mixes that use income rule distributions. Table 1 below runs for the next twenty-four years.

An examination of columns A and B through 1981 reveals that the income rule trust, with the one-third equity/two-thirds fixed income trust, distributed substantially more income to the life beneficiary, but fell short in year-end market value by December 1981 by only about $11,000. The current income distribution from the largely fixed income trust is dramatically different from the total return trust, that has a 5 % distribution. In 1981, the fixed income mix produced more than double the annual distribution that was produced by the total return trust in column A even though interest rates and inflation were high during the second Arab oil embargo.

During the next fifteen years, however, the total return trust dramatically outperformed the income rule counterpart. In 1995, the total return trust distributed twice as much as the income rule trust and reflected almost 2.75 times the market value. Just as amazing is the actual nominal decline in income of the income rule trust beneficiary from 1981 to 1995, while the total return trust beneficiary quadrupled her income during the same period. With a secular decline in interest rates and inflation since 1982, the life beneficiary in column B simply has not participated in the dramatic growth of the markets. As a result of the drastic changes in interest rates and the income rule requirement, a disproportionate return was distributed to the life beneficiary during this period. Further, during the second portion of the test track, the life beneficiary's share in column B diminishes as a proportion of market value. At this point it is unlikely that either the life beneficiary or remaindermen thinks the trustee has performed satisfactorily compared to the total return trust.

Columns C, D, and E in Table 1 illustrate the use of a conventional income trust with other investment mixes to show how the income stream and the market values changed over time. Only the 80% equity/20% fixed income in column E ends with anything comparable to the market value of the total return trust, but, for that mix to work, one would have had to settle for an initial starting income of 3.6%. Furthermore, as the dividend yields declined on the Standard & Poor's 500, the income rule trust beneficiary in 1995 was receiving only a 2.8% yield on the year-end market value.

What portion of this better performance was due to the asset allocation? Table 2 uses the total return trust model with the same investment mixes as Table 1. Note that column B, with the investment mix of one-third fixed income and two-thirds equity, ends with what appears to be a far better result applying our total return trust formula rather than the ordinary income rule trust. At the end of 1996, the final market value is $359,203 versus $203,800 in the income rule trust. Note also the much smoother stream of income with the same investment mix. Can it be that using the total return trust formula for distributions produces a higher investment return than an income rule trust even with the same investment mix?

The reason the total return trust appears to work so much better regardless of the asset mix is sensible enough. During the high inflation and high interest rate periods, both bond and stock markets experienced significant declines. During that same period, the income rule trust distributes all of the income to the life beneficiary, while the total return trust reinvests a portion of the income at the bargain basement prices afforded during those markets. As a result, the total return trust has an advantage over an income rule trust, particularly in the difficult test track selected for giving the new trust paradigm a challenge.

Now compare the total return trust to the indexed payout trust. An indexed payout trust would start at some predetermined level, in this case a 5% distribution, and then each year index the distribution for inflation, regardless of investment return or accounting income. Table 3 illustrates the surprising result.

Starting in January 1973, the 100% equity portfolio with the same total return was eliminated by the annual inflation adjusted distributions by 1994. The other investment mixes, while having smaller total returns over the entire period, faired better because they avoided the substantial negative effect of liquidating significant amounts of principal during bad markets in order to match the CPI indexed distribution. Nevertheless, with a distribution of $18,096 and rising and a trust valued at $53,903 or less, none of the investment mixes will support this type of indexed distribution indefinitely. Therefore, the conclusion on an indexed payout trust is correct, that unless one is very lucky, for the distribution from such a trust to be safe, the distribution must be small, probably small enough to make it unattractive in the real world.88

Perhaps just as importantly, the uncoupling of the interests of the life beneficiary from the remaindermen in an indexed payout trust is not generally a good thing and is inferior to a partnership, unless the life beneficiary is clearly intended to be favored. Because inflation and the financial markets appear to be inversely related, such a formula seems designed to produce worse long-term results regardless of the investment mix.

With an income rule trust, trustees in today's markets are confronted with a difficult investment problem. A fifty-fifty mix of fixed income and the Standard & Poor's 500 will generate only a 3.9% return. No professional fiduciary wants to be below a 50% equity position considering market history and the trustee's duty of impartiality. Will asset allocation in the future make as much of a difference as it has in the past? Time will tell, but regardless of one's view of the optimal asset allocation, the trustee is in a far better position to carry it out and to adapt its strategy over time with the total return trust than with the traditional income rule trust.

XI. CAVEATS AND CONCLUSIONS-NEVER A TRUST FOR ALL SEASONS

Despite the compelling case for asset allocation favoring equity securities for long time periods, there will clearly be times, like the 1970s and the 1930s, when fixed income securities will be safer. History suggests allocation favoring equities, but the terms of the total return trust do not require it. The thesis of these materials is not that a total return trust requires equity securities, but rather that this form of trust simply frees the trustees to make the best possible choice concerning asset allocation and investment decisions.

There are also situations, such as trusts for minors, trusts for incapacitated persons, and trusts when flexibility amongst beneficiaries is helpful that suggest a sprinkle, spray, or fully discretionary trust. Since these trusts free the trustees to invest and distribute as they deem advisable, total return investing can be implemented just as easily as with the modified unitrust proposed in this article. The total return trust should not take the place of fully discretionary trusts in these cases. However, for the typical life beneficiary, such as a surviving spouse and remaindermen in the next generation, the total return trust does a number of things that no other trust can do as well:

(1) It creates realistic expectations;

(2) It forges a life beneficiary-trustee-remaindermen partnership that emphasizes a common goal of providing maximum return given the risk tolerance of the beneficiaries and the trust's probable duration; and

(3) It eliminates the burdens of the trustee's duty of impartiality by setting an appropriate distribution rate, regardless of how the trust is invested.

Overall, the total return trust breaks the chains by which trustees and trust investments are bound to the distinctions between accounting income and principal.

1 These trusts include: QTIP Trusts, which are Qualified Terminable Interest Property Trusts, allowed under I.R.C. 2056(b)(7); QDOTs, Qualified Domestic Trusts, allowed by I.R.C. 2056A for the benefit of a non-citizen spouse; QSSTs, Qualified Subchapter S Trusts, allowed by I.R.C. 1361(d)(1), which are special trusts that are permitted to own subchapter S corporation stock without disqualifying the corporation from subchapter S status; QPRTs, Qualified Personal Residence Trusts, allowed by Treas. Reg. 25.2702-5(c); CRATs, Charitable Remainder Annuity Trusts, allowed by I.R.C. 664(d)(1); CRUTs, Charitable Remainder Unitrusts, allowed by I.R.C. 664(d)(2); CLATs, Charitable Lead Annuity Trusts, allowed under Treas. Reg. 20.2055-2(e)(2); CLUTs, Charitable Lead Unitrusts, allowed under Treas. Reg. 25.2522(c)-3(c)(2)(vii); and ILITs, Irrevocable Life Insurance Trusts, designed to avoid the three-year requirement of I.R.C. 2035 and the "incidents of ownership" rule contained in I.R.C. 2042(2).

2 I.R.C. 2041(b)(1)(A) (West Supp. 1997).

UNIFORM MANAGEMENT OF INSTITUTIONAL FUNDS ACT, 7A U.L.A. 316 (West Supp. 1997) (Table of Jurisdictions).

See Joel C. Dobris, Real Return, Modern Portfolio Theory, and College, University, and Foundation Decisions on Annual Spending from Endowments: A Visit to the World of Spending Rules, 28 REAL PROP. PROB. & TR. J. 49 (1993).

See UNIFORM PRUDENT INVESTOR ACT, 7B U.L.A. 21 (West Supp. 1997) [hereinafter PRUDENT INVESTOR ACT]; RESTATEMENT (THIRD) OF TRUSTS (1990). UNIF. PRINCIPALAND INCOME ACT 104 (Commissioner s Draft of May 19, 1997).

GEORGE T. BOGERT, TRusTS 387-88 (6th ed. 1987). 8 See RESTATEMENT (SECOND) OF TRUSTS 183 (1959); RESTATEMENT (w1 HIRD) OF TRUSTS, supra note 5, 227.

RESTATEMENT (HRD) OF TRUSTS, supra note 5, 227 cmt. c at 13.

If x = the fixed portfolio y = the stock portfolio x + y = 100%

.065 x +.02 y = .0535 times 100% (35 basis needed for trustee's fees) Replace y with 100% - x .065 x + .02 (100% - x) = .0535 .065 x + .02 - .02 x = .0535 .045 x = .0335 x = .0335 = 74.44% .045

tl (6.5% + 2%)12 = 4.25% less .35% trustee's income compensation.

12 IBON ASSOCIATES, STOCKS, BOND, BiL, AND INFLASON 1996 YEARBOOK 2731, 84 (1996).

13 Real trusts pay capital gains taxes too. Private investment managers rarely take these taxes into account. The capital gains impact on a real trust cannot be ignored. The corpus used to pay the tax is simply gone.

14 The cumulative consumer price index from 1927-1995 is charted in Appendix C, infra.

IBBOTSON ASSOCIATEs, supra note 12.

16 An analysis of "stock pruning" demonstrates that a dollar of principal is even more valuable than a dollar of income. See infra text accompanying notes 81-83.

17 Pub. L. No. 93406, 88 Stat. 832 (codified as amended at 29 U.S.C. . 1001-1461 and in scattered sections of titles 5, 16, 26, 31 and 42 U.S.C.). ls At the same time, retirement plan assets were the fastest growing segment of individuals' net worth, rising from 11.6% of total individual net worth in 1970 to 30.5% by 1989. See THE WORLD ALMANAC AND BOOK OF FACTS 1991, 121 (Mark S. Hoffman ed., 1990) (providing Federal Reserve System data).

19 See Office of the Comptroller, Florida Department of Banking and Finance, News Release (Sept. 23, 1996). Reports and analyses of mutual funds are now readily available on the Internet. See, e.g., .

20 JONATHAN R. MACEY, AN INTRODUCTON TO MODERN FINANCIAL THEORY 17 (1991).

21 Id. at 21-23.

22 A portfolio of ten stocks provides 88.5% of the possible advantage of diversification. A portfolio of twenty stocks provides 94.2% of that advantage. Id. at 23 (citing RICHARD A. BREELY, AN INTRODUCTION TO RISK AND RETURN FROM COMMON STOCKS (1969)).

MACEY, supra note 20, at 21.

4 Gary P. Brinson, et al., Determinants of Portfolio Performance, FIN. ANALYST 1., July-Aug. 1986, at 39.

25 Gary P. Brinson, et al., Determinants of Portfotio Performance Ii.' An Update, FIN. ANALYSTS J., May-June 1991, at 40.

26 Chart 1 in Appendix C, infra, illustrates the tremendous difference between the returns in these asset classes. The charts in Appendix C are derived from financial data compiled from NBBo'soN ASSOCIATES, supra note 12, at 29-47 (Tables 2-6 through 2-11). 27 See infra Chart 2 in Appendix C. zs IBBoTSON ASSOCIATES, supra note 12, at 43, Table 2-7. 2 See infra Chart 3 in Appendix C. 3 IBBOTSON ASSOCIATES, supra note 12. 31 Id. at 43, Table 2-7.

32 See infra Chart 4 in Appendix C.

33 See, e.g., Stanley T. Klinefelter, The Care and Feeding of Trustees (ACTEC Annual Meeting), March 1997, Ex. C. The material illustrates that from 1980 through 1995, a blend of large and small capitalization equities, international equities, and fixed income should have produced better returns and fewer risks than simply blending fixed income and large capitalization stocks alone. Id.

34 See Dobris, supra note 4 (analyzing the change in investing attitudes prevalent in the 1960s).

Id. at 51-52.

IBBOTSON ASSOCIATES, supra note 12, Table 2-6. 37 Real income is income adjusted for inflation.

3s Dobris, supra note 4, at 56 n.21. 39 Id. at 56-61.

40 These schools include Brown University, Bryn Mawr College, Bucknell University, California Institute of Technology, Georgetown University, University of Michigan, University of Minnesota, Mount Holyoke College, University of Pennsylvania, Radcliffe College, Columbia University, Tulane University, Vanderbilt University, College of William and Mary, and many others. Id. at 62 n.45.

LESTERM. SOLOMON & KENNETH P. VOYTECK, MANAGING FOUNDATION ASSETS: AN ANALYSIS OF FOUNDATION INVESTMENT AND PAYOUT PROCEDURES AND PERFORMANCE 48 (1989).

42 Dobris, supra note 4, at 65 n.60.

43 The apparent assumption is that the accounting income is the real or excess return (after taxes and inflation), so that if it is consumed, the underlying investment will retain its value. This concept may devolve from our agrarian roots when the fruits of the land could be consumed while the land itself maintained its value. Actually, the accounting income may have either no relationship or an inverse relationship to total return. See William L. Hoisington, Modern Trust Design: New Paradigms for the 21st Century, 5-5, 5-6 (Materials for Miami Institute, January 1997); See also Jerold I. Horn, Prudent Investor Rule Impact on Drafting and Administration of Trusts 25 (Dec. 10, 1996) (revising 20 ACTEC NoTEs, Summer 1994, at 26 and 21 ACTEC NoTs, Winter 1995, at 219).

RESTATEMENT (THIRD) OF TRUSTS, supra note 5, , 227. 45 An efficient market is one in which all relevant information and factors are known and considered in the marketplace so that price is always a fair reflection of risk and return. See MACEY, s*

RESTATEMENT (THIRD) OF TRusTS, supra note 5, 227 cmts. e-h. 47 Id. at 227 cmt. I (1990) (Some Special Duties of Trustees).

48 ' IETIV*W ACT, s'pr 4 pFwrrlNvWroR Acr, JUpra note S (po now tbo Ac l*::0*e Jet). 04;tJ ` , : ,*5,* J_ * *. C : : : : - -,` ` : d. ':wk ** A, i , X, ` X \ 0 : X : X : S,`g.

51 Robert Freedman, Proposed New Prudent Investor Rule, PA. B. NEws 10 (Sept. 223, 1996).

UNIF. PRINCIPAL AND INCOME ACT, supra note 6, prefatory note. Id. 104.

54 Id. 104(a). Section 103 of the Uniform Principal and Income Act reads as follows:

(a) In allocating receipts and disbursements to or between principal and income, and in any matter within the scope of [Articles] 2 and 3, a fiduciary: (1) shall administer a trust or estate in accordance with the terms of the trust or the will, even if there is a different provision in this [Act]; (2) may administer a trust or estate by the exercise of a discretionary power of administration given the fiduciary by the terms of the trust or the will even if the fiduciary exercises that power in a manner different from a provision of this [Act];

(3) shall administer a trust or estate in accordance with this [Act[ if the terms of the trust or the will do not contain a different provision or do not give the fiduciary a discretionary power of administration; and

(4) shall add a receipt or charge a disbursement to principal to the extent that the terms of the trust and this [Act] do not provide a rule for allocating the receipt or disbursement to or between principal and income.

(b) In exercising the power to adjust granted by Section 104(a) or a discretionary power of administration regarding a matter within the scope of this [Act], whether granted by the terms of a trust, a will, or this [Act], a fiduciary shall administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries, unless the terms of the trust or the will clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries. A determination in accordance with this [Act] is presumed to be fair and reasonable to all of the beneficiaries.

55 Id.

56 Id. 104(c)(1), (2). 57 Id. 104(c)(5), (6). 58 Id. 104(d).

9 Id. 104(e). Whether the power to release will give greater or lesser comfort to a trustee remains to be seen. If the trustee continues to retain some interest in the trust which might make the release a transfer with a retained interest, that trustee would not be able to effectively release a power of appointment considered to be general if the trustee is trying to avoid death tax includability. See Rev. Rul. 86-39, 1986-1 C.B. 301. For this reason, a disclaimer qualified under I.R.C. 2518 might be needed within nine

months of the creation of the power. See I.R.C. 2518 (1997). Hopefully, the tax protective provisions contained in the current draft relative to death tax includability will be respected by the Service. The Service has taken a dim view of provisions drafted by a taxpayer who conditioned the lapse of a right of withdrawal on such lapse not resulting in federal gift tax. Tech. Adv. Mem. 89-01-004 (Jan. 1, 1989), citing Commissioner v. Proctor, 142 F.2d 824 (4th Cir. 1944), cert. denied 323 U.S. 756 (1944). Surely, the Service would treat a local law, particularly one derived from a uniform law, more kindly than it did the taxpayer's drafting in the technical advice memoranda. UNIF. PRINCIPAL AND INCOME ACT, supra note 6, 104(fl. 61 Id. 104 ex. 1 & 3. 62 Id. 104 ex. 2. 63 Id. 104 cmt.

64 Some might say too much. See, e.g., Hoisington, supra note 43, at 5-3. 6 UNIF. PRINCIPAL AND INCOME ACT, 7B U.L.A. 145 (1962).

66 Joel C. Dobris, New Forms of Private Trusts for the Twenty-First CenturyPrincipal and Income, 31 REAL PROP. PROB. & TR. J. 1, 22-29 (1996). Hoisington believes that a CPI adjusted annuity may better effectuate the intent of some settlors. Hoisington, supra note 43, at 5-15.

67 IBBOTSON ASSOCIATES, supra note 12, at Table 2-5 and Table 2-6.

68 Dividend income decreased by 55% from 1930 to 1934. See infra Appendix A.

6 This increase constitutes a real (after inflation) increase of 588 % which is adjusted by the 3.5% CPI increase in 1996. The cumulative inflation rate is 888% during 19261996. IBBOTsoN AssocIATEs, supra note 12, at Table 5-1.

70 A trust invested in the Standard & Poor's 500 that distributes only the dividend income (believed by many to be the "gold standard" in smoothness of distributions), is only slightly smoother, with twelve negative years and five years with a decline greater than 10%. This projection was derived from Ibbotson data with a spreadsheet program.

7 In fact, there were sixteen decreases in an equity portfolio with a five-year smoothing rule, and fifteen decreases with a ten-year rule. The reason for this result is that bad market years linger in the distribution formula longer with the longer smoothing rules.

72 The model trust states its goals, which should be customized in each case to reflect the client's wishes. Surprisingly, the goals of a trust are rarely stated in trust drafting.

n Five percent was chosen to model difficult situations when current income needs are high. It is clearly preferable to use a lower payout. Four percent is a more neutral payout between growth and income need, and 2So-3% is best for a trust in which growth is a primary goal.

74 Much of the language in paragraphs B and C is taken from the PRUDENT INVESTOR ACT, supra note 5. Concern expressed by Bob Freedman in his article was the basis for granting the trustee the express power to employ any appropriate investment strategy, not just the one which is currently most popular. See Freedman, supra note 51.

75 I.R.C. 2056(b)(7)(B)(ii)(I)-(II) (1997). 76 Dobris, supra note 66, at 17 n.47.

7 RESTATEMENT (SECOND) OF TRUSTS, supra note 8, 240. 78 Id.

7 Treas. Reg. 20.2056(b)-5(f)(5) (1994).

go Such degree of enjoyment is given only if it was the decedent's intention . . . that the trust should produce for the surviving spouse during her life such an income, or that the spouse should have such use of the trust property as is consistent with the value of the trust corpus and with its preservation." Treas. Reg. 20.2056(b)(5)(f)(1) (1994).

st This rate is a conservative assumption considering that the 36% bracket begins at $5,950 in taxable income and the 39.6% bracket begins at $8,100 for a trust or estate in 1997.

s2 This analysis implies the damage that occurs when equities are held in highturnover mutual funds. If a fund with 100% turnover is used instead of individual stocks, almost all of this advantage is lost (leaving only the rate differential between 28% and the ordinary income tax rate). No deferral remains which deprives the investor of the 29% increase in value. The lowering of the top capital gains tax rates to 20% under the Taxpayer Relief Act of 1997 will only increase the advantages of stock pruning and the total return trust. See I.R.C. l(h)(1). 8 I.R.C. 1014(a) (1997).

84 This formula takes into account thirty-five basis points for trustee's fees charged to income. These thirty-five basis points are left in the schedule of distributions to keep the comparison consistent with the total return trust 100% equity portfolio. ss IBBOTSON ASSOCIATES, supra note 12, Table 5-1.

* These tables are likely to overstate somewhat the advantage of the total return trust with fixed income reinvestments because the intermediate government index was used starting fresh and rebalancing the portfolios (adjusting the percentages to the asset allocation selected) each year. Since a real-world fixed-income portfolio will generally turn over more slowly, the portfolio would exhibit a smoother flow of distributions than illustrated, with less negative dollar averaging, but the trends would be the same. The portfolio rebalancing will, in itself, tend to produce dollar averaging on a different level. Both diversification and investment-dollar averaging have many dimensions.

s C.P.I. Indexed Distribution reflects the amount of distribution needed to maintain the purchasing power of the original distribution.

as Using the Standard & Poor's 500 as a proxy, computing total return for the cash flows on the indexed payout trust starting at 3%, a total return trust starting at 3%, and an income rule trusts shows total return of seventy basis points higher with the total return trust than with either of the alternatives. This result occurs because dividends tend to increase along with inflation, even in periods when total return is negative.

Member, Tener, Van Kirk, Wolf & Moore, Pittsburgh, PA. A.B., 1968, Yale University; J.D., 1971, University of Virginia. Earlier versions of this Article were published by the Pennsylvania Law Institute and in ACTEC NoTEs, published by the American College of Trust and Estate Counsel. It is republished with their permission. The author gratefully acknowledges the support and assistance of PNC Bank, N.A., in the preparation of this Article and, in particular, Donald G. Berdine, Senior Vice President and Chief Investment Officer of PNC Bank, who worked on the investment underpinnings section of the Article, and Bruce A. Guiot of the Personal Trust Department of PNC Bank, whose computer simulations, enthusiasm, and hard work were invaluable. John W. Sofis and Julianne M. Hallenbeck also provided valuable assistance for which the author is grateful.

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