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When meeting with clients to design their trust provisions, whether their children/beneficiaries are five or thirty-five years old, I often hear the same concern.    They are worried that the funds will be spent irresponsibly.  To combat this fear, we estate planners will often suggest the inclusion of language in the trust that will either; 1. Give the trustee absolute discretion to control the distributions in order to protect the funds, OR 2. List criteria that is intended to incentivize or discourage certain behavior (carrot or stick approach) in the beneficiary.  An example of these strategies is a trust stating that in order for the beneficiary to receive a distribution or become trustee of his/her own trust, he/she must attain a certain age or accomplishment.  Unfortunately, research shows neither of these approaches are the most effective ways of addressing the client’s primary hope that their child act in a financially responsible manner.

The danger of giving a trustee absolute discretion over the funds is that we are relying exclusively on the judgment of the trustee and their understanding of what the client would deem as an appropriate use of the funds.  With insufficient guidelines, this leaves the trustee in a precarious position.  Furthermore, if the chosen trustee is a not a neutral third party, it can create unwanted conflict between the trustee and the beneficiary, jeopardizing their personal relationship.

The Carrot/Stick approach can be problematic for a number of reasons.  Primarily, the benchmarks that must be obtained (certain age or accomplishment) are not generally reliable indicators of financial responsibility.  Age is certainly not a good indicator of financial responsibility.  I have clients with children in their fifties who do not handle money well!  Clients also often use obtaining a college degree as a benchmark, when, in fact, studies have shown that individuals with some college education account for over 50% of all bankruptcy filings.  Finally, studies have shown that money is not a good way of motivating behavior, and in reality, monetary incentives can often backfire!  So, in terms of encouraging financially responsible behavior for beneficiaries, a traditional carrot/stick approach is simply not the most effective.

An approach that does work requires an analysis that focuses on easily identifiable, objective standards. Many parents believe that education is a method for their children to achieve financial stability and success.  However, this focus on the method rather than the result is where traditional planning falls short, and after all, the results matter most, not the method.     Instead, we need to outline clearly the behavior we are trying to achieve, i.e. financial responsibility.  Some components of financial responsibility include the ability to manage income versus debt AND the ability to make and save money.

An example of an objective, results oriented benchmark is a FICO score, a measure that is widely used to represent the creditworthiness of a person and the likelihood that a person will pay his or her debts.  A FICO score is a mathematical equation that takes into account a number of factors including: payment history, amount of debt owed, length of credit history, and types of credit used.  The FICO score represents the result of a history of someone’s ability to manage their debt.  The benchmark of a high FICO score (however that is defined) would be an easily ascertainable way for a trustee to determine the financial responsibility of a beneficiary.

Another way to objectively evaluate one’s ability to live inside their means and save money would be to look at the percentage of their income that is spent over a specified period of time.  A trustee could use bank statements and tax returns to determine this percentage.  Theoretically anything under 100% of income spent would indicate the ability to live within ones means; however, most people would like to see their child have the ability to save money as well.  Evidence of a sustained savings outside of the trust assets would indicate this ability.

Why is looking at the result better than the method?  It is too difficult to lay out a specific path for someone.  There are simply too many variables in life and the incentives we create might not actually serve as motivators.  My job in assisting and counseling the client in these matters is to find a solution that will actually work and not create more problems.  Therefore, in estate planning we choose neither the carrot nor the stick!

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