The power to adjust: expanding the trustee's management tools

California CPA, Nov, 2004 by Richard E. Gilbert, David Jaffer

When the revised Uniform Principal and Income Act took effect Jan. 1, 2000, for all trusts and estates, California's trustees gained a new tool--the so-called "power to adjust."

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Pursuant to the California Probate Code (CPC) Sec. 16336, which is part of the UPAIA, trustees now can use their discretion in making adjustments between the principal and income of trusts under limited circumstances.

Simply stated, the new power permits trustees to reallocate amounts between principal and income when the income portion of the portfolio's total return is too small or too large due to earlier investment decisions.

Balancing PIA, UPAIA

The new tool tries to balance the tension between the Uniform Prudent Investor Act (PIA) and the UPAIA. The PIA encourages investing for total return, while the UPAIA provides reasoned guidance with respect to the allocation of receipts and disbursements between income and principal.

Many trustees struggle when making investment decisions that produce an optimal total portfolio return without stifling the beneficial interest of the income beneficiary.

Income beneficiaries demand that trustees create investment portfolios biased toward fixed-income assets to produce more income. But remainder beneficiaries want portfolios consisting mostly of equity investments for long-term capital appreciation.

To address this conflict, trustees balance investment decisions from two perspectives--the intrinsic worth of the proposed investment and yields equitable to both sets of beneficiaries.

Eliminating the link between trust income and traditional accounting income rules is one way to avoid this conflict. But this has to be done at the drafting stage.

The possibilities include: a total discretionary trust, such as allowing trustees, within their discretion, to pay the income beneficiary trust income and/or trust principal; an inflation adjusted annuity trust; and a unitrust requiring fixed distribution of the trust corpus paid annually. [See Hoisington, "Modern Trust Distribution Design and Implementing Strategies, Estate Planning," 1998, Chapter 5 (Cal CEB 1998)].

The Power to Adjust

The power to adjust is another solution. Yet, most trustees are not sure when to use it since the statutes' guidelines are inadequate. It is important to note that the power to make adjustment is discretionary--not mandatory.

The UPAIA states that "[n]othing in this section or in this chapter is intended to create or imply a duty to make an adjustment, and a trustee is not liable for not considering whether to make an adjustment or for choosing not to make an adjustment." [CPC Sec. 16336(h)].

Though discretionary, (the trustee is not obligated to consider making adjustments) other fiduciary obligations could be grounds for litigation. For example, trustees owe a duty of impartiality to all beneficiaries. Under CPC Sec. 16003, "If a trust has two or more beneficiaries, the trustee ... shall act impartially in investing and managing the trust property, taking into account any differing interests of the beneficiaries." So, failing to make an adjustment and protect the interests of current income beneficiaries and/or remainder beneficiaries could be grounds for breach of fiduciary obligations.

It's essential that trustees understand the power to adjust. When used appropriately, it can improve the relationship between trustees and trust beneficiaries, as well as reduce trustee liability.

Basics to the Power to Adjust

The power to adjust allows trustees to make adjustments between principal and income when no prohibitions in the trust prevent such discretion. Under CPC Sec. 16336(a), the trustee must adhere to the following prerequisites before making adjustments:

* The trustee must manage the trust assets under the PIA. Under CPC Sec. 16336(a)(1), the power to adjust may not be exercised unless "the trustee manages trust assets under the prudent investor rule." Absent other directions in the document, the trust would be so managed.

* CPC Sec. 16336(a)(2) requires that "the trust describe[s] the amount that shall or may be distributed to a beneficiary by referring to the trust's income," e.g., that the beneficiary is to receive "all of the trust's net income."

The California Law Revision Commission says this requirement is met when the trust's terms allow the trustee to distribute all income at regular intervals; distribute the greater of trust accounting income and a fixed dollar amount (an annuity); and distribute the greater of trust accounting income or a fractional share of the trusts assets (a unitrust amount).

* CPC Sec. 16336(a)(3) requires the trustee to determine, after considering the trust's terms, that the trustee is unable to fulfill its duties to treat all beneficiaries impartially, absent the power to adjust.

Under CPC Sec. 16336(g), the trustee may consider, but is not limited to, any of the following, in deciding whether or not to exercise the power--and to what extent:

* The nature, purpose and expected duration of the trust;