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Trusts and “Total Return” Investing in Challenging Times: Adopting a Winning Approach

One of the perceived disadvantages to using a trust in estate planning is that restrictions on trustees’ investment decision-making under trust law will result in lower investment returns. In particular, this is a concern where a trust has an income beneficiary to whom income is paid, usually for his or her lifetime (frequently used where there is a surviving spouse), and on the income beneficiary’s death, capital is paid to one or more capital beneficiaries.

The major overhaul to modern trust legislation in many jurisdictions, including to Ontario’s Trustee Act in 1999, resolved the historic issue of inflexible restrictions placed on trustees’ choice of investments to what was called the “legal list” of conservative, income-oriented investments. The adoption of the prudent investor rule in modern trustee legislation allows trustees to invest in any investment a prudent investor would. As well, under such legislation, including under the Ontario Trustee Act, trustees are to focus on the total return of a trust’s investment portfolio. 

The problem trustees are confronted with where there is an income beneficiary, followed by a capital beneficiary, is achieving a fair balance between generating income for the income beneficiary who is entitled to the trust’s income, including interest and dividends, while ensuring–at a minimum–preservation of the trust fund’s real capital value adjusted for inflation, where the trust provides for an equal balancing of the income and capital interests.

In our low-interest, almost deflationary times, there is a significant challenge to generating an appropriate income level for an income beneficiary if a will or trust agreement does not provide sufficient flexibility. Sometimes too much emphasis is focused on generating interest and dividends at the expense of a “total return” approach which would allow trustees to shift asset allocations more nimbly, depending on market conditions, to investments which are growth-oriented to achieve better overall returns.

Incorporating flexible capital encroachment powers or including, where appropriate, the ability of trustees to pay, or an income beneficiary to withdraw, from the trust a fixed percentage of capital each year, or an amount equivalent to the total return of the trust on an inflation-adjusted basis are useful options. As well, letters of wishes setting out helpful guidelines can assist in the process of optimizing investment returns. These approaches can free the trustee from the traditional approach of looking only at the nature of the receipt and whether it is income or capital. Investment decisions can be better separated from distribution or allocation decisions. Too often, however, there is a lack of flexibility and standard provisions, not nuanced tailored ones, unduly constrain the trustee.

We foresee only an increasing need for and use of trusts of successive interests of an income beneficiary followed by capital beneficiaries in future for a variety of reasons including:

  • avoiding the costs of an increasingly onerous probate system, including legal expenses, valuations, fees and taxes paid to probate a will
  • providing for capital succession to children and further descendants, in particular for blended families and for high value estates
  • minimizing and deferring taxes
  • protecting wealth in general, including matrimonial and creditor protection

To optimize financial returns when using a trust, it will be increasingly important to adopt creative but careful approaches.

In the United States, the use of and experience with percentage trusts, called “unitrusts” and discretionary allocation trusts allowing trustees to adjust receipts between income and capital as part of modern portfolio theory and total return investing is very developed, and most states have legislation for such purpose.

In the Canadian setting, we are far behind. The Uniform Law Conference of Canada’s 2012 Uniform Trust Act, which is model legislation that can be adopted by any Canadian jurisdiction, includes provisions to allow for discretionary allocation trusts and percentage trusts to facilitate a total return policy.

We foresee further development in the use of a total return approach in appropriate situations. While it is true that existing Canadian income tax legislation can make it difficult to fully embrace a total return approach for spouse trusts designed to get a tax-free rollover which require all trust income be paid to a spouse, thoughtful trust design can go a long way to protecting the interests of both the income beneficiary and the capital beneficiaries, while optimizing returns–a “win-win” for both.

– Margaret O’Sullivan

Be sure to check out our next blog post on practical considerations relating to the use of powers of attorney for property, including the timing of their release. 

The comments offered in this article are meant to be general in nature, are limited to the law of Ontario, Canada, and are not intended to provide legal or tax advice on any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate to your personal circumstances.