Pandemic complicates discretionary trust payouts

This article appears in the Fall 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Trustees of discretionary trusts should review how much they’re paying out to beneficiaries, particularly considering the economic disruption and market volatility caused by the Covid-19 pandemic. Trustees must ensure they’re balancing the immediate needs of beneficiaries who may be facing financial hardship with the long-term preservation of trust capital.

“When we have an event like Covid-19, you need to be proactive and ask yourself: ‘How does this affect the things I need to do as trustee?’” says Tom Junkin, senior vice-president of personal trust services with Fiduciary Trust Canada, a part of Franklin Templeton Investments.

Margaret O’Sullivan, managing partner of O’Sullivan Estate Lawyers LLP in Toronto, says trustees have “duties of inquiry” to look at the prevailing circumstances when they exercise discretion. “Distributions can’t just be on automatic pilot,” she says.

While some trusts limit trustees to paying fixed amounts, most are now set up as discretionary trusts, experts say. These trusts give trustees either limited or full discretion in terms of the amount and timing of distributions to beneficiaries.

Trustees must balance the interests of income beneficiaries, who receive distributions out of income and/or capital of the trust assets during their lifetime, against those of capital beneficiaries, who receive trust capital once an income beneficiary dies. The market crash in March caused trust assets to fall significantly, leading some beneficiaries to wonder if their monthly trust distributions were at risk, Junkin says. Other beneficiaries reached out to ask if payouts could be increased to make up for the loss of employment income.

Equity markets’ recovery has alleviated some of the pressure on the long-term outlook for trust assets. However, markets continue to be volatile, and beneficiaries may be struggling under personal financial constraints. It is a trustee’s duty to stay informed about a beneficiary’s circumstances.

“A personal trustee — say, Uncle John — may have that information on a continual basis,” Junkin says. “A professional trustee should try to conduct at least an annual review. Extraordinary events like Covid-19 should trigger a review of vulnerable beneficiary situations immediately.”

The trust instrument governs how trustees must exercise discretion. For example, some settlors might leave instructions that the trustee is to favour the income beneficiary even at the expense of a remainder beneficiary when it comes to distributions.

With such instructions, O’Sullivan says, “we have a lot of comfort in terms of having a very generous distribution policy toward what we call the primary beneficiary. However, if the trust doesn’t have that kind of wording in it, then we have less latitude.”

Sometimes it’s not possible to increase distribution amounts because doing so would risk the trust assets’ long-term stability. In fact, distributions might need to shrink if the trust is to provide financial security through a beneficiary’s life as the settlor intended.

“The trust has only a set amount of assets; it’s not unlimited,” O’Sullivan says. “Notwithstanding that there might be increased need, or that a beneficiary’s income has now dropped, the trust can only generate a certain amount.”

Trustees might work with beneficiaries to avoid surprises when distributions are reduced, O’Sullivan says. “Perhaps look at a plan for them: What are their needs going to be for this year, next year, or the next five or 10 years?”

Personal trustees could have an advantage over professional trustees in terms of communicating to beneficiaries the need to rein in expenses and protect trust assets, says Junkin, since the beneficiary is less likely to feel as though they’re “being dictated to by a corporation.”

Both Junkin and O’Sullivan say that trustees are likely to remain challenged in the current low-yield environment to generate income from trust assets for income beneficiaries. Where, decades ago, trust assets might have been exclusively held in fixed income products, today trust portfolios tend to hold a greater percentage of assets in equities in order to generate adequate returns.

“A trust portfolio now looks like people’s retirement portfolios,” Junkin says.

Trustees can protect themselves from legal liability in the case of investment losses during market corrections by making sure they manage trust investments prudently, O’Sullivan says. This includes developing an investment plan, monitoring performance, rebalancing investments and seeking out professional advice where appropriate.

“[The law] doesn’t require that you get it right in terms of whether a portfolio does or doesn’t do well,” O’Sullivan says. “It just requires that you act prudently.”