Columns T AX & ESTATE

Not Your Typical Incentive Trust: The ROTE and FST, Part 2

by Jon J. Gallo, J.D.; Eileen Gallo, Ph.D.; and James Grubman, Ph.D.

Jon J. Gallo, J.D., chairs the Family Wealth either: (1) a restricted defi nition trustee] should be informed of the Practice Group of Greenberg Glusker Fields Claman of what health, education, mainte- purposes of the trust, the factors he Machtinger & Kinsella LLP in Los Angeles, California. nance, and support (the so-called is to consider, and something of the Together with his wife, Eileen Gallo, he is the HEMS ascertainable standard) general frame of mind in which the co-founder of the Gallo Institute and co-author of mean in order to limit both the settlor wishes him to act.”1 two books on children and money. Their websites are amount and purpose of distribu- 3. It elaborates the purpose state- www.galloinstitute.org and www.fi parent.com. tions, or (2) incentive provisions ment by delineating guidelines, that tie distributions to specifi c but not requirements, focused Eileen Gallo, Ph.D., is a psychotherapist in private behaviors. on the results of the benefi ciary’s practice in Los Angeles, California, where she works 2. It captures the settlor’s intent learning and demonstrating money with individuals and families dealing with issues regarding fi nancial skills through management skills. The trustee related to money. a statement of the trust’s purpose, is directed to take those results which addresses, among other into consideration when deciding James Grubman, Ph.D., of Family Wealth Consulting, things, such is a psychologist and consultant to families of wealth issues as trustee and the advisers who serve them. His website is www. fl exibility, desire jamesgrubman.com. to prepare the benefi ciary, and handling of The fundamental aim of the fi nancial e used the Money & Soul risks inherent skills“ trust is not that the benefi ciary column in this issue to in learning develops fi nancial management skills. Wintroduce the concept of skills for money the Results-Oriented Trust Environment management in The fundamental aim is to focus on (ROTE), which we fi rst described at life. This purpose whether the benefi ciary is avoiding the 45th Annual Heckerling Institute statement should on Estate Planning of the University be developed for fi nancial problems—the result of of Miami School of Law. This column each fi nancial having these skills. extends the discussion to show how a skills trust in ” ROTE may be used to create a Financial conjunction with Skills Trust (FST) as an alternative to a the client(s), pro- traditional incentive trust. posed trustees, A fi nancial skills trust is a ROTE and, if possible, the benefi ciaries. whether to make discretionary based on four main components: Professor Ed Halbach Jr. suggested distributions of income and/or 1. It uses the fundamental structure this approach 50 years ago: “Too principal and, possibly, whether of a largely discretionary trust, frequently the trust instruments and at what time the benefi ciary and it does not attempt to control provide no guidance as to the pur- becomes a co-trustee or sole the benefi ciary’s behavior through pose and scope of the power. [The trustee of his or her trust.

36 JOURNAL OF FINANCIAL PLANNING | April 2011 www.FPAnet.org/Journal T AX & ESTATE Columns

4. It provides increased transparency 2. The ability to manage spending tions? This skill relates not so much in trust administration by clearly in order to save a portion of one’s to being able to make a budget as describing objective guidelines on income, as needed. The ben- being able to follow a budget. which the trustee’s discretion is efi ciary would establish this skill 5. The ability to understand and based. Those guidelines capitalize by demonstrating the ability to manage one’s personal assets, either on our growing knowledge about create a reserve, delay immediate using basic investment procedures motivation and fi nancial literacy gratifi cation, and resist spending and principles oneself or delegating and help to prepare inheritors for the reserve. The benefi ciary should these actions responsibly to appro- handling wealth. document situations in which priate advi sers. If the benefi ciary is there is deferred spending and a doing an eff ective job with guide- Financial Skills for Prudent Money cushion is retained for everyday lines 1 through 4, the benefi ciary Management living expenses and for special will build a reserve that will need The fi nancial skills trust uses fi nancial expenses. The application of to be managed. The benefi ciary skill benchmarks as guidelines for the this skill may depend largely on should understand the basics of exercise of the trustee’s discretion. the size of the trust—if a trust is sound investment principles. If Based on the literature about fi nancial suffi ciently large, the trust itself the benefi ciary delegates money literacy skills and our collective might legitimately be considered management, the benefi ciary will experience as wealth counselors and the benefi ciary’s retirement fund need to demonstrate the ability advisers, we have found there is a core and savings account. to responsibly oversee the money set of six interrelated, primary fi nancial 3. The ability to understand and man- manager. Fifty percent of the popu- skills fundamental to prudent money age credit and debt, thereby avoid- lation lives paycheck to paycheck. management, along with a secondary ing exces sive debt. This skill relates They think of money as income. list of two skills that are commendable to “closing the back door on an easy The idea of having skills to manage but not crucial. way to overspend.” The trustee will money as an asset requires a diff er- 1. The ability to live within one’s means; examine credit spending by the ent mind-set and diff erent skills. in other words, not spending more benefi ciary and determine whether For a benefi ciary who has never had than one’s income. The trustee the benefi ciary is staying out of excess distributions, the benefi ciary must work out with the benefi ciary credit card debt. The trust agree- needs to develop skills to manage what this means in practice in a ment would include operational assets rather than income. One manner that is both transparent and language providing that the trustee approach is to make the benefi ciary understandable. However, no value may ask the benefi ciary for copies an “apprentice trustee” at some judgments are made regarding how of credit reports that show how age, and to participate in money the benefi ciary spends money as long many credit accounts are open at management meetings. as expenses do not exceed income. any one time and the amounts. This 6. The ability to generate additional Amazingly, many trust benefi ciaries would provide for strict confi dence income through employment if have not learned this, so it is the very by the trustee and removal of the funds in addition to trust distribu- fi rst fi nancial skill. Expenses cannot trustee if this information were not tions are either required or desired. exceed income for any reasonable kept completely confi dential. The benefi ciary must be able to get period, but for special situations there 4. The ability to maintain reason- and keep a job if the benefi ciary could be exceptions (for example, able accounting of one’s fi nancial wants more money than just the starting a business, allowing expenses resources. Many benefi ciaries lack trust distributions. That involves to exceed income by 10 percent for this skill, which can lead to drastic specifi c skill sets, such as showing up to two years, etc.). The benefi ciary fi nancial mistakes. A benefi ciary up on time, getting along with co- will have to describe to the trustee may be ashamed of his or her workers, etc. If the benefi ciary does what he or she is doing to maintain inability to keep track of assets. not wish to get a job but still lives a budget and match spending with Can the benefi ciary keep a budget within his or her means without income. (One of the later skills deals that has any relation to reality and using credit to do so, that would with credit behavior, to avoid gaming that keeps the benefi ciary from meet this criteria. The trustee this guideline by using credit cards constantly coming back to the makes no judgment on the kind of or debt.) trustee for extraordinary distribu- job the benefi ciary pursues. www.FPAnet.org/Journal April 2011 | JOURNAL OF FINANCIAL PLANNING 37 Columns T AX & ESTATE

The following two skills are advis- ing), the trustee would take these facts both the trustee and the benefi ciary. It able though not crucial. Many settlors into account when the benefi ciary next uses money to reinforce behaviors that may object that the fi rst six skills are requests the trustee to purchase a car for relate only to money, without trying to too elementary and don’t have values his or her use. The fi nancial skills trust motivate other behaviors in ineff ective attached to them. For them, encourag- empowers the trustee to do the wise and and counterproductive ways. It bal- ing the last two skills may be very appropriate action: withhold giving out ances benefi ciaries’ right to reasonable important. These last two skills are any more cars until the benefi ciary fi rst autonomy with settlors’ reasonable subjective, and it is much harder to (or fi nally) learns how to drive safely. expectations for accountability. And come up with specifi c standards. in encouraging (but not requiring) 7. The ability to use a portion of one’s Focusing on Results thoughtful fi nancial self-management, income and/or fi nancial resources Surprising as this may seem, the it is consistent with fostering positive to support charita ble activities of fundamental aim of the fi nancial skills values conducive to a more happy and one’s choosing. trust is not that the benefi ciary develops fulfi lling life. 8. The ability to show initiative, fi nancial management skills. The funda- We think of a ROTE as an umbrella engage in entrepreneurship, and mental aim is to focus on whether the set of principles, beneath which various demonstrate purpose in paid or benefi ciary is avoiding fi nancial prob- trusts may be developed emphasizing unpaid work. lems—the result of having these skills. diff erent life skills. In addition to a As with a results-oriented work It is results-oriented in terms of how fi nancial skills trust, a ROTE could be environment, a fi nancial skills trust distributions or trusteeships are granted. used to assist clients in developing a supports autonomy and accountability If the benefi ciary does not wish to grow trust that emphasizes philanthropic or because trust distributions are tied to or maintain fi nancial self-management entrepreneurial skills, creating either a the benefi ciary’s money skills and little skills, that is the benefi ciary’s choice. Philanthropic Skills Trust (PST) or an else. It also stays away from attempting What the fi nancial skills trust is clear Entrepreneurial Skills Trust (EST). to control from the grave or the trustee’s about is that discretionary distributions, The fi nancial skills trust approach may offi ce the benefi ciary’s life choices or acceleration of mandatory distribution be used in various drafting contexts: non-fi nancial activities. dates, or granting of co- or sole trustee- • The trustee may be authorized to We use what we call “the car analogy” ships will not occur in the absence of an distribute income and principal to to explain why the fi nancial skills trust observable demonstration of eff ective the benefi ciaries in the trustee’s is unique. Assume that a benefi ciary fi nancial skills. If a benefi ciary is living absolute discretion, but requested asks the trustee to buy him or her a within his or her means, avoiding to take into consideration the car. Under an ascertainable standard excessive debt, knowing basically how behavioral guidelines approach, the benefi ciary must explain much he or she has for income and • The trustee may be authorized but why he or she needs the car in the expenses, etc., the benefi ciary knows not required to distribute income context of the HEMS standard: to drive that the trustee is far more likely to and principal to those benefi ciaries to work, to drive to school, to drive to make a discretionary distribution of whose behavior meets some or all medical appointments. Under an incen- income or principal than if the ben- of the guidelines tive trust approach, the benefi ciary may efi ciary is not demonstrating positive • The trustee may be directed to be entitled to receive the car by getting fi nancial self-management skills. Such distribute income and principal to a college degree or making a certain an approach encourages open, transpar- those benefi ciaries whose behavior amount of income. With a fi nancial ent, and periodic communication about meets some or all of the guidelines skills trust approach, there is only the match between the trust’s provisions The drafting question turns on one question truly relevant: “Can you and the benefi ciary’s behavior, including whether the trustee is granted absolute, drive?” Furthermore, once the benefi - any necessary limit-setting on the part limited, or no discretion in distributing ciary has shown that he or she can drive, of the trustee when results seem to be income and principal to benefi ciaries. it is his or her judgment about how to missing in the benefi ciary’s fi nancial The fi nancial skills trust approach may use the vehicle, not the trustee’s or even self-management. be used as a guideline to the trustee’s the settlor’s. Of course, if the benefi ciary By using results-oriented criteria to exercise of discretion or in lieu of keeps getting into accidents or does not evaluate benefi ciaries’ money skills, ascertainable standards or incentive have a valid driver’s license (perhaps the fi nancial skills trust achieves many provisions. having lost the license for drunk driv- positive objectives. It provides clarity for In a fi nancial skills trust, the trustee’s

38 JOURNAL OF FINANCIAL PLANNING | April 2011 www.FPAnet.org/Journal T AX & ESTATE Columns

focus is on the extent to which the periodic communication between the religious faith, level of education, or benefi ciary has mastered the six trustee and benefi ciary. This typically level of earned income, to name the primary fi nancial skills. As a result, it involves meeting at least annually to talk most common decisions that settlors stays away from vague qualities that over the benefi ciary’s activities, goals, seek to control through incentive the settlor believes may be desirable and skills to maintain the relationship trusts. In doing so, the FST seeks to but are so subjectively defi ned as to between the trustee and the benefi ciary. preserve that which is highly precious invite either overly judgmental parental The optimal situation involves collabo- to most people in life: autonomy. We attitudes or abuse of discretion by the ration and planning between the trustee believe that the fi nancial skills trust trustee. It seeks to be as operational and the benefi ciary as well as looking provides the best balance between the as possible in order to minimize mind ahead to understand the benefi ciary’s benefi ciary’s right to autonomy in one’s reading on the part of the benefi ciary plans, review decision-making, and personal life choices and the settlor’s and uncomfortable subjectivity on the discuss any adjustments that may occur right to hold benefi ciaries accountable part of the trustee. Second, it avoids in the discretionary decision making of to manage inherited assets prudently. placing trustees in the inevitably futile the trustee based on the benefi ciary’s position of trying to undo those failures abilities in mastering the six primary of parenting or circumstance that money skills. The trustee is empowered created poor results in benefi ciaries’ to set timelines, off er educational or self-management. tutoring opportunities, or any other Endnote method that may facilitate the develop- 1. Halbach Jr., Edward. 1961. “Problems of Administering the Trust ment of needed skills by the benefi ciary. Discretion in Discretionary Trusts.” Columbia Administration of any irrevocable trust, The fi nancial skills trust avoids Law Review 61, 8: 1425. and especially a trust being admin- meddling with benefi ciaries’ life choices istered as a ROTE, requires eff ective about career, spouse, place of residence,

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