Many financial planning clients intend to leave their assets to specific heirs, but they want those heirs to use the assets in the way that the donor would like to see them used. For this reason, many donors have turned to incentive trusts as a means of encouraging heirs and beneficiaries to meet certain criteria or achieve goals that the donor embraces, such as getting an education.
But while these trusts certainly have their place in the estate planning process, they also come with some potential pitfalls that advisors and their clients need to be aware of. (For related reading, see: 5 Mistakes When Creating a Trust Fund for Your Child.)
Incentive trusts are legal instruments that are designed to financially reward beneficiaries who meet the criteria specified by the donor in the trust. As their name implies, these trusts incentivize beneficiaries to either accomplish certain objectives such as obtaining a college or graduate degree, marrying someone within specific religious parameters or maintaining steady employment.
They can also incentivize beneficiaries to refrain from certain actions, such as substance abuse or other unhealthy lifestyle behaviors. This type of arrangement allows the donor to reward the beneficiaries for things that he or she would like to see happen without forcing the beneficiaries to do them.
Although incentive trusts are designed to reward beneficiaries who meet the trust’s criteria, this arrangement can go awry. For example, one of these trusts may be established by a parent for a child to reward them for getting a college degree. But what if that child decides to make the military a long-term career where a degree is not required? This is a perfectly respectable occupation, of course, but it would not satisfy the trust requirements.
Or a donor might establish a trust for a child who seems to be headed in one direction vocationally and the trust will reward the child for getting a degree in that vocation specifically. But what if the donor passes away, and then the child discovers that this vocation is not really his or her calling? Would the donor in this case really want all of that money withheld from the adult child? (For related reading, see: Should Each Child Get the Same Inheritance?)
The trustee may have some leeway in making this decision, but most incentive trusts are created with very specific language and instructions. This allows the trustee to escape any responsibility for having to interpret the donor’s wishes if unexpected circumstances arise. However, some trusts do give trustees a certain amount of give within the parameters of the intent of the trust to divert from the trust’s original exact instructions. If the child in the previous example was to become a commissioned officer in the military, then the trustee may be able to pay the beneficiary for this achievement in lieu of earning a college degree.
Some incentive trusts may conversely be too vague or open-ended. For example, the trust could stipulate that the beneficiary is paid once he or she becomes "an upstanding member of society.” But what does this mean exactly? The trustee would have to make a rather open-ended judgment call in this case.
The Bottom Line
Incentive trusts can motivate beneficiaries to accomplish many constructive goals or refrain from damaging behaviors. But they can also end up creating difficult dilemmas for trustees and beneficiaries when unforeseen circumstances arise that impact the donor’s original wishes. Some incentive trusts have a clause built into them that can give the trustee a certain amount of leeway if this happens, but it may make more sense for the donor to establish a principle trust instead, where the trustee has a great deal more freedom to disperse assets in conjunction with the beneficiaries living according to the donor’s values. For more information on incentive trusts, consult your financial advisor. (For related reading, see: Top Tips for Helping Clients Leave an Inheritance.)