The Incentive Trust

A good way to build positive values,
or more strings than you intended?

It's a concern faced by virtually every high-net-worth parent: how to ensure children won't be negatively impacted by inheriting a large amount of money. One measure of the level of this concern is the growing popularity of "incentive trusts."

The idea has merit: specify certain conditions that must be met before your child, grandchild or other beneficiary receives proceeds from the trust. Those conditions can be as broad as specifying an age, or series of ages, before distribution takes place—or they can be as specific as requiring that the beneficiary graduate from college, marry, be active in the community or carry on the family business.

Some incentive trusts specify a list of shall-nots—the beneficiary must not use illegal drugs, abuse alcohol, gamble or engage in other behaviors the donor considers destructive.

While the benefactor’s goal may be worthy—to provide for the welfare of the beneficiary and protect against misuse of assets—the consequences of an incentive trust don’t always match the desired results.

As you talk through the issues, your advisor may help you see a number of ways to accomplish your goals and address your concerns without being so restrictive that the results actually work against your intentions.

It is important to remember that a trust may last for generations. It’s hard to anticipate all possible scenarios that your beneficiaries may face in their lifetime. The most effective trusts establish guidelines but also allow for flexibility.

During the financial planning process, we advise our clients to equip children or grandchildren with the skill set necessary to effectively handle receiving a large inheritance. The best way to ensure a positive outcome is to help your children and grandchildren build financial life-skills and solid personal values as they grow up.

While incentives or merit clauses in trusts can certainly be effective, they must be very carefully thought through with an eye toward all possible future circumstances a beneficiary may experience.

It is important to work with an advisor who can bring objectivity to the planning process, who can help you think through your goals and truly understanding the concerns you may have about any given beneficiary. In talking with you about the issues, your advisor may help you see a number of ways to accomplish your goals and address your concerns without being so restrictive that the results are actually contrary to your intentions.

What If... ?
The starting point is to put on paper what you want to achieve with the trust:

  • What values do you want to promote?
  • What stipulations or restrictions will encourage each of those values?
  • Will success in meeting your objectives be clearly measurable?
  • Will you provide any opportunity for the trustee to make judgment calls based on the goals you are trying to achieve, or will you cover everything in the trust terms?

Once you have written down the stipulations you have in mind, try applying them to the beneficiaries as you think through various life stages and scenarios. It helps to consider worst-case scenarios. For example, assume you direct that distributions are dependent upon college graduation, because you want to encourage education. What if the beneficiary suffers an injury or illness that prevents him or her from pursuing a college degree? At a time when financial need may be greatest, you will have blocked the trustee’s ability to respond as you would have during your lifetime.

Likewise, a stipulation designed to encourage marriage by withholding distributions from a divorced beneficiary might have the effect of trapping someone in a bad marriage.

A provision providing a match from the trust equal to the amount of income earned by the beneficiary may discourage that person from seeking work in socially useful but relatively low-paying occupations.

The goal is to draft provisions that are a meaningful but flexible way of projecting your values into the future while allowing your heirs the freedom to have their own goals and build their own lives.

It is important not only to put on paper what you are trying to accomplish, but to discuss your objectives in advance with those who will be involved in administering the trust funds, prior to executing trust documents. Naming a financial institution as trustee can provide the long-term continuity and objective decision making you seek.

There can be a place for incentives or merit clauses—but they must be very carefully thought through with an eye to all the possible circumstances a beneficiary may experience.

In addition, discussing the terms of the trust with your beneficiaries can help avoid misunderstandings and hopefully support your ultimate goal—inspiring them toward positive values and behaviors throughout their lifetimes. It can also provide you with a great opportunity to explain the legacy you want to leave for future generations and educate them about important concepts they may wish to consider in their own financial planning processes.

This article originally appeared in the Fall 2008 issue of Wealth magazine and has been updated here in February 2015.

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