Journal of Financial Planning: June 2013
Eileen Gallo, Ph.D., is a psychotherapist in private practice in Los Angeles, California, where she works with individuals and families dealing with issues related to money. Along with her husband, Jon Gallo, she is the co-author of two books on children and money. Their website is www.galloconsulting.com.
The editorial focus of this issue of the Journal is trends in investing. For many of our affluent clients, their single largest investment is the family business. Unfortunately, the likelihood that this investment will survive the transition to the next generation is remote. Less than one-third of family businesses survive the transition from the first to the second generation, and only about 10 percent survive the transition to the third generation, according to stats reported in the Harvard Business Review.
For the last year, I have been working with the business planning committee of the American College of Trust and Estate Counsel (ACTEC) on a project to increase these depressing odds. This column introduces readers to the initial results of that project: the business skills trust.
In the article “The Use and Abuse of Incentive Trusts: Improvements and Alternatives,” which I co-wrote with my husband, Jon Gallo, and Jim Grubman, Ph.D. (from the proceedings of the 45th Annual Heckerling Institute on Estate Planning, January 2011), we introduced an approach to trust drafting that would encourage financial literacy through provisions that are clear, objective, and correlated with the beneficiary’s ability to manage money responsibly. We called the approach a Results Oriented Trust Environment, or ROTE™.
The ROTE concept stemmed from an engagement in which we were asked to create a trust to help motivate a young beneficiary to learn to manage money responsibly. Economists and psychologists distinguish between intrinsic motivation (motivation to do a good job that comes from within us) and external motivation (such as using money as a reward or penalty). Internal motivation works far better than external motivation if the behavior being motivated requires creativity, problem solving, and concentration—a good description of learning to manage money responsibly.
A management practice known as a Results Oriented Work Environment, or ROWE, is based on using intrinsic motivation to motivate employees. In a ROWE, management identifies concrete results for the employees to achieve—such as reducing costs by 10 percent, or developing a new product line—and gives employees the autonomy to decide how best to accomplish the result.
Motivating Beneficiaries to Manage Money
We decided that the best approach to motivating beneficiaries to manage money responsibly was to create a financial skills trust (FST) using a ROTE. An FST identified concrete results of responsible money management and used those results in three different contexts:
Curriculum: By identifying the results of responsible money management—such as living within one’s means or not abusing credit—it became possible to create a suggested course of study that would teach the skills necessary to attain those results.
Discretionary distributions: Identifying the results of responsible money management would create objective, concrete standards for the exercise of the trustee’s discretion understood both by trustees and beneficiaries. If a beneficiary requested a discretionary distribution of income or principal, both parties would know that one of the factors the trustee would consider was whether the beneficiary had demonstrated the financial skills to manage the distribution responsibly.
For example, one result of responsible money management identified by the co-authors is not abusing credit. Depending on the settlor’s values, this result could be described in operational terms ranging from maintaining a minimum FICO score or a desired debt-to-equity ratio, to paying off all credit cards monthly.
Other results of responsible money management include living within one’s means and responsibly managing and investing one’s assets. The FST is not concerned with how the beneficiary attains these results, as long as they are accomplished in a responsible and legal manner. For example, a beneficiary who has little or no interest in money management might delegate such functions to an accountant and an investment adviser. As long as the beneficiary responsibly supervises the accountant and investment adviser and lives within his or her means, has good credit and appropriate investments, the beneficiary has achieved the goal of responsible money management and could reasonably expect the trustee to favorably respond to occasional requests for discretionary distributions.
On the other hand, a beneficiary who couples a lack of interest in money management with consistent overspending, poor credit, and no savings would be unlikely to receive discretionary distributions other than for medical care.
Trusteeships: Estate plans frequently provide that beneficiaries become trustees upon attaining a designated age or some number of years after the trust is created. These factors have little or no correlation with responsible money management. By identifying the results of responsible money management, serving as a trustee could be made contingent upon the beneficiary demonstrating concrete evidence that he or she possesses the skills to manage the trust responsibly.
Components of a BST
In conjunction with the business planning committee of ACTEC, we have been working on a project to apply the underlying ROTE approach to the creation of a business skills trust (BST) that would minimize the typical causes of conflict when an irrevocable trust owns an interest in a family business. It also would provide operational criteria for the appointment of trustees.
In his landmark contribution to the literature of estate planning, Family Wealth: Keeping It in the Family (Bloomberg, 2004), author James E. Hughes observes that in his more than 35 years practicing law, very few beneficiaries actually have read and understood the terms of the trust of which they are the beneficiary when they first seek his advice. In our experience, the same observation can be made about trustees: very few have read and understood the terms of the trust of which they are trustees.
A business skills trust would have four main components:
- A BST would focus on results that are directly and objectively related to the overall goals. The goals of the BST would be to (1) increase the likelihood of responsible management of a family business held in trust by establishing minimum qualifications for trustees, and (2) minimize disputes between trustees and beneficiaries and among beneficiaries by educating trustees and beneficiaries. The results of achieving this goal would be identified and described in concrete and operational terms.
For example, a desired result of a BST would be reduced disputes over dividend/distribution policy from a lack of understanding by the beneficiaries of the financial theory behind the company’s dividend policy and the day-to-day ramifications of that policy. Because responsible management of trust distributions often would be a goal of settlors, we believe that settlors would also frequently wish to include the goals of the financial skills trust, namely responsible financial management.
- A BST would increase administrative transparency and minimize conflict between trustees and beneficiaries. By describing the desired results in concrete, operational terms, such as an understanding of the terms of the trust and the company’s dividend policy, the BST would provide objective guidelines that are understandable by the trustee and the beneficiaries. These results, as well as the optional results of the FST, would be taken into consideration by the trustee when responding to beneficiary requests for discretionary distributions and may also be used to determine whether and when a beneficiary becomes a co-trustee or sole trustee of his or her trust.
- A BST would involve the settlor in customizing his or her estate plan. First, the settlor is involved in identifying the desired results of a BST and in describing these results in operational, concrete terms. Second, a BST often includes a purpose statement that addresses such issues as trustee flexibility, desire to prepare the beneficiary, and handling of risks inherent in learning skills for money management. This statement is developed for each BST in conjunction with the client(s), proposed trustees, and, if possible, the beneficiaries. If the FST guidelines also are included, the purpose statement would address those guidelines as well.
- Although a BST identifies the desired results, it would not attempt to micromanage how the beneficiaries achieve those results. It would stay away from attempting to control—from the grave or the trustee’s office—the beneficiary’s life choices or non-financial activities. A BST would support autonomy and accountability by striking an appropriate balance between the clients’ legitimate right to expect responsible stewardship of inherited assets by their children and the children’s legitimate right to expect reasonable autonomy in their private lives.
The BST is not intended to replace family governance of a business or to create a one-size-fits-all trust within a rules-based framework. It is merely the means to lubricate the wheels of ownership transition through the use of a trust to mitigate any impact on the operations and profitability of the family business.
I plan to discuss the development of the business skills trust in greater detail in future columns.