Many clients express concern that an inheritance may have a negative impact on their children. This is often the case for clients who created their own wealth, experienced hard work, and spent and invested their earnings carefully. Will leaving an inheritance to their children inhibit their children's drive and make their children complacent? Will an inheritance make life "too easy," depriving their children of the benefits of "making it" on their own? Frequently our conversation turns to incentive trusts, and whether an incentive trust might counterbalance the perceived negative effects of "free money."
Incentive trusts are trusts that permit payments to a beneficiary if certain goals are met, or if certain behavior is avoided. Examples include directing a payment to a beneficiary upon graduation from college, for achieving certain grades, or to match a beneficiary's W-2 income. Others may prohibit payments to a beneficiary that engages in self-destructive behavior, such as substance abuse.
At first blush, incentive trusts seem like a great idea. They simultaneously motivate a beneficiary while conveying what is important to you, and life lessons you have learned. But, as with all things, there are pitfalls with incentive trusts.
What if the beneficiary is physically or mentally unable to achieve the stated goals? What if circumstances have changed sufficiently that the goals make no sense? What if a beneficiary wants to stay at home to raise a family, or pursue a career in a meaningful field that pays a low income?
Further, an incentive trust is invariably a subjective analysis. Providing measurable targets to the trustee and the beneficiary is critical. Will the person you've selected as trustee be capable of evaluating the beneficiary, and denying a payment if the beneficiary does not meet the goals?
Incentive trusts are necessarily more expensive to craft than a typical trust because they must be specifically tailored to your heirs and the behavior you want to motivate. If you are determined an incentive trust is right for you, however, some things you can do to make the process more efficient and effective are:
Identify the list of behaviors you want to motivate or to discourage, the specific criteria the beneficiary and trustee will use to measure progress, and whether there will be time limits to achieving goals (e.g., the perpetual student problem). Think through as many possibilities as you can to plan for the unexpected, and consider giving examples.
Consider tying goals to criteria such as "being useful, contributing members of society," or the "passionate pursuit of a chosen endeavor to achieve excellence," or "to be loving, caring parents and family members."
Identify the reward for meeting the objectives. It could be a percentage of trust funds or a stated dollar amount.
Determine who will be the trustee(s) to make the determination, whether the trustee(s) will be able to deny distributions, and whether there will be a process for the beneficiary to challenge a determination.
Determine whether the trustee will be given the flexibility to make payments if circumstances substantially change or if a beneficiary cannot meet the criteria.
A critical key to a successful incentive trust is good communication with the trustee and with the beneficiary. Consider writing side letters to the trustee and beneficiary, explaining in your own words why you established the incentive trust, what you hope to achieve (or avoid) with the trust, and your philosophies about life lessons important to you.
These side letters are often referred to as ethical wills. They can be the document by which you transfer your values and reflections on life, and should include mistakes from which you've learned as much as successes from which you've gained. Topics to consider include:
What made you happiest in your life?
What are you most proud of?
What are your biggest regrets?
What events hold deep personal meaning or life lessons for you?
Who have you learned the most from?
What does spirituality mean to you?
There are many helpful resources online and in bookstores to assist you with writing an ethical will. It is important to remember, however, that a side-letter or ethical will is not legally binding, and must be coordinated carefully with your estate plan to ensure it does not hamper or contradict provisions in your estate plan. Further, the language you use is vitally important to whether your incentive trust will be viewed as insensitive and controlling, or appropriately encouraging. Finally, there is no substitute to expressing your views in person with your loved ones.