Incentive Trusts Can Keep Your Heirs Motivated

Back in 1891, Andrew Carnegie wrote in Advantages of Poverty that “the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.” Today, families are trying to fight that deadening of talent with incentive trusts that aim to ensure the next generation doesn’t become a pack of trust-fund slackers.

Incentive trusts have strings attached: They impose specific, objective conditions for distributions, and leave little room for discretion by the trustee. They might, for example, require that the trust’s beneficiaries graduate from college in order to receive any money. They could reward beneficiaries who do charitable work, or buttress the incomes of those who choose low-paid, yet meaningful careers, or toil away as actors and musicians. They also could penalize beneficiaries who don’t work, by cutting off (or decreasing) distributions, or placing restrictions on heirs with addictions by requiring that payments go directly to rehab centers.

“It’s a matter of saying what behavior you want, and aligning the incentives,” says Brent Brodeski, chief executive officer of Savant Capital Management, a wealth-management firm in Rockford, Ill.

But be aware that these trusts are controversial. “I’m not a huge fan of incentive trusts,” says Gail Cohen, vice chairman and general trust counsel at New York-based Fiduciary Trust International. The risk of unintended consequences is too high, she says.

Consider a clause that cuts off payments to beneficiaries who use drugs. Sounds noble, but it can be an enormous headache, says Mark Scott, a principal in the estate and trust group at Kaufman Rossin in Miami. Require that all beneficiaries get drug tested regularly, and the trust could find itself knee deep in medical-privacy issues. What if the addict had no way of paying for housing or food outside of the trust distributions? “These tend to be the things that become arguments, where a court has to decide what was the settlor’s intent,” Scott says. “Did they really mean that if the child was on drugs, the trustee wasn’t allowed to pay for that person to have a roof over their heads? You can see where a slippery slope can form.”

Alternatively, grantors can set down their wishes but leave more discretion to their chosen trustees. “We are seeing a significant uptick in giving nonbinding instructions to the trustees,” says Martyn Babitz, national director of estate planning for Philadelphia-based Hawthorn, PNC Family Wealth. The larger question, of course, is whether restrictions on funds are really the best way to instill family values.

For those who choose to use incentive trusts, careful drafting is critical. These trusts can be tied to all types of incentives but are most commonly tied to education and employment. A simple incentive trust might match beneficiaries’ income dollar-for-dollar, requiring tax forms as proof. A more complex trust could offer a double- or triple-match to the salaries of those who choose low-paid, socially valuable employment at, say, schools or nonprofits. Employment restrictions usually drop off after a certain age, or are suspended if the beneficiary becomes disabled.

Incentive trusts for education can pay for college or provide funds on completion. In one case, Brodeski says, trust beneficiaries received money for a down payment on a house when they graduated from college. If they failed to graduate, no down payment.

In another case, a woman funded an educational trust for 20 nieces and nephews with a variety of rules: It would pay for only four years of college and only for those whose grades stayed above a C, and the payments would max out at a set amount. At the end of the trust’s term, whatever was left would be split equally among all of the beneficiaries. “You want to make the money available for those who are serious,” Brodeski says. “You don’t want the kid to go to school for seven years and smoke pot the whole time.”

Spell out everything clearly. In an employment-related incentive trust, how will “earned income” be defined, and at what age will the employment requirement disappear? In an education-related one, will it pay more for a more expensive school? What if a chosen career doesn’t require schooling? More broadly, how do you ensure that you are motivating the right behavior — and not just maintaining control over future generations to their detriment?

Hawthorn’s Babitz recalls a grantor who wanted to impose a lot of requirements, including becoming a registered member of a particular political party. Other trusts required beneficiaries to marry within the family’s religious or ethnic background — or even tried to encourage a beneficiary to divorce, something courts have frowned on.

“It is certainly possible that a court would say that some of these provisions are void for public-policy reasons,” Babitz says.

He prefers leaving room for changed circumstances and unintended consequences. “Make [incentives] nonbinding, and exercise a lot of care in who that trustee is going to be,” he says. For example, someone working in a low-paid job might need funds from a trust that matches salary. But a higher paid beneficiary may not, and yet could be forced to take distributions anyway, even if leaving the money in the trust was better for tax purposes or for shielding assets from liabilities.

So let the trustee make the final call. Fiduciary Trust’s Cohen says that the problem with very specific incentives is that it’s impossible to see far enough into the future to anticipate all of the curve balls life can bring. “My concern is that they won’t be drafted to meet future needs,” she says. “It should be an expression of intention, not a mandate.”