“YOU CAN’T BE MY HEIR UNTIL YOU CUT YOUR HAIR!” — THE RISK OF INCENTIVE TRUSTS
By: Bobby Kouretchian
It’s common for wealthy parents to worry about how they will devise their estate to their children.
How much of an inheritance is too much? How much is not enough?
At what age should they receive their inheritance?
Should there be “strings attached” or should the children simply receive their inheritance outright?
How much is enough to make sure they will be taken care of, but not so much that they end up becoming jaded, or perhaps left with a sense of entitlement?
According to a study in 2007, about one-third of affluent family trusts include some sort of “incentive trust” component. An incentive trust does just what the name suggests— it incentivizes good behavior and provides disincentives for bad behavior. The only problem is that in order to accomplish the goals, incentive trusts can sometimes end up being unfairly rigid to the beneficiaries, or simply fail to account for the future well enough.
As an example, suppose you wish to make sure your child attends a religious college, and so you condition the receipt of inheritance upon your child’s graduation from a religious college. What happens if your child receives a scholarship to an elite university that perfectly fits her needs? Would you really want her to make a decision between attending the elite school, on the one hand, and losing out on her inheritance, on the other? Probably not.
But more than just the risks, studies show that incentive trusts might not work, even when the children do exactly what was asked of them. In other words, even if a child reaches the benchmark set out in the incentive trust, it might be that the overarching goal of the incentive trust still wasn’t accomplished. Going back to the example above, suppose your reason for wanting your child to attend the religious school is that you hoped to promote some sort of religious practice. It could be that your child has gone and received her education from the religious institution but is no more likely to follow a religious practice than had she never gone at all. Incentives don’t work as often as we’d like to believe.
According to a paper published in the Journal of Financial Planning incentive trusts might only work in certain limited cases. The reasoning is that:
“Using money as an incentive is typically not effective to develop the very skills incentive trusts seek to encourage in beneficiaries, such as work ethic, responsible money management, and empathy for others leading to involvement in philanthropy. In fact, money incentives actually decrease performance involving such cognitive skills as judgment and reasoning by converting what would otherwise be viewed as an interesting and challenging activity into routine work.
“It appears that many typical incentive provisions—particularly those relating to education and income matching—have little correlation with the ultimate goal of an incentive trust: that the beneficiaries become responsible money managers. It turns out that the behaviors on which incentive trusts typically focus are not reliable predictors of responsible money management… As most of us know from our practices, the fact that someone has substantial earned income or a college education is not in the least predictive of whether this person lives within his or her means, makes sensible investments, or avoids abusing credit.”
So is there a place for incentive trusts? Yes, but according to the paper, incentive trusts “may work for some beneficiaries who need just that little extra push…in order to get motivated…” Don’t rely on incentive trusts for too much more than that. When you do use them, make sure your attorney sets forth clear benchmarks within the trust that are oriented towards achieving results. Make sure those results relate to the overarching goal for the incentive.
There are other ways to make sure your children are taken care of, while limiting their risk of contracting “affluenza”. If you have any of these concerns, make sure to share them with your estate planning attorney when you meet with them. The more information you can give them about your concerns, the better chance you can have an estate plan that meets your objectives.
Bobby Kouretchian can be reached at (760) 487-8330 or at firstname.lastname@example.org.