Regulating Trustee Emotions and Their Compliance with Financial Objectives

Journal of Financial Planning: August 2012

Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.

A theme for this issue of the Journal is compliance and regulation—a perfect fit for an estate planning column. After all, regulations and compliance control everything we do, from how we draft documents to how we communicate with clients.

But the type of regulation vitally necessary for the successful transfer of wealth down the generations is rarely discussed in the estate planning literature; it is what psychologists call emotional regulation—the ability to manage and control emotions. Without emotional regulation, we would give in to every impulse: if we became angry with someone, we would hit him; if we needed money, we would rob a bank. Children learn emotional regulation by being given tools and techniques by their parents and teachers that allow them to modify their initial emotional response to situations. Psychologist Aaron Beck describes the process as creating a series of rules that we learn as children and follow as adults, even though we are not aware of the rule book.

In the best of all worlds, the tools and techniques that parents provide children would include a financial rule book that allows them to regulate their behavior with money as adults. In the real world, this is not always the case. And we estate planners are often confronted with the need to prepare trusts in situations where the next generation is, to be charitable, financially immature.

Fundamental Financial Skills

In the April 2011 issue of the Journal, my wife, Eileen Gallo, Ph.D., and I devoted our columns to an innovation in trust construction designed to help motivate beneficiaries to manage wealth responsibly. The Financial Skills Trust (FST) helps provide the missing financial rule book for beneficiaries who may not have received it growing up. The underlying structure of the FST is based on results of numerous studies in motivational psychology and management theory. The most successful means of motivating people to engage in behaviors that involve judgment and reasoning, such as prudent financial management, is to (1) establish concrete operational goals, and (2) give the participants the autonomy to accomplish those goals rather than trying to micromanage them. The FST uses this approach by identifying seven fundamental financial skills, and using the beneficiary’s degree of mastery of these skills as guides to both trust distributions and the time when the beneficiary becomes a co-trustee or sole trustee of his or her trust.

The seven skills are:

1. The beneficiary lives within his or her means, managing spending consistent with his or her level of income
2. The beneficiary is able to save a portion of his or her income
3. The beneficiary manages credit and debt, leading to avoidance of excessive debt
4. The beneficiary maintains reasonable financial records
5. The beneficiary prudently manages his or her personal assets, and understands the investment procedures and principles that guide the trust’s investments as well
6. The beneficiary has the ability to get and keep a job to generate additional income if required or desired beyond trust distributions
7. The beneficiary contributes to society by using a portion of his or her income and/or financial resources to support charitable activities

Results in Concrete Terms

One of the problems with earlier attempts to use trusts to motivate beneficiaries to manage money responsibly was the failure to describe the desired results in operational and objective terms. We suggested that part of creating a financial skills trust is to ask the client to describe what each of these skills would look like to him or her in day-to-day life and to use the client’s input to describe them in operational terms. Several planners have asked us to provide examples of the first five skills that they can use to facilitate this conversation with their clients. Interestingly, no one appears to have had difficulty describing skills six or seven: the ability to get and keep a job and involvement in philanthropy.

Here are several approaches to making the first five skills operational:

1. Living Within Your Means. There are at least two approaches to defining the concept. It can be defined as not spending more than one’s income from all sources, whether earned or derived from the trust or other sources. In financial terms, this translates to spending no more than 100 percent of one’s net income after taxes in a given year. It can also be defined as living below one’s means and therefore spending less than one’s income from all sources in order to create savings, which is the second financial skill. If the skill is expressed as living below one’s means, it will be necessary to define how much below.
2. Saving. There are again at least two approaches to defining the concept. It can be defined as saving some portion of earned and/or unearned income. If so, it is necessary to determine the percentage. If the trust corpus is sufficiently large, the trust may be viewed as the saving account. In that case, distributions from the trust must be less than or no more than the actual growth of the trust assets via investment.
3. Not Abusing Credit. There are at least four approaches. One could specify a minimum FICO score, a policy of paying off all credit card debt monthly, a debt-to-income ratio not to exceed certain levels, or a level of debt service that remains proportional to income or assets up to a specified range. FICO scores range from 300 to 850. Most financial websites treat any score above 700 as good. One could use a FICO score at or above the national average or a FICO score that is some multiple of the national average, such as 110 percent. Debt to income ratios are computed based on gross income. Conventional single family home financing requires a debt-to-income ratio of 28/36 or better, which means that no more than 28 percent of gross income be devoted to debt service on the house and no more than 36 percent of gross income be devoted to all debt service. Debt-to-equity ratios above 80 percent are considered very risky for individuals. A ratio of less than 50 percent is recommended.
4. Maintaining Reasonable Financial Records. Beneficiaries should be able to demonstrate a reasonable grasp of their assets, the relative size of their main accounts, and the basic parameters of their monthly or quarterly expenses and income. One approach used by some trustees is to provide the beneficiaries with Quicken or a similar software program and request that they use it to track their accounts, balance their checkbook(s), and maintain a financial statement.
5. Prudent Management of Financial Assets. Two levels of money management are involved. The first is managing one’s own money effectively. The benchmark for managing the beneficiary’s own assets is the ability to manage one’s investment assets with average attention to risk, asset allocation, and market conditions using the multitude of investment vehicles available to the general public. The second level becomes important if the beneficiary’s financial skills are to be considered in determining whether the beneficiary eventually becomes a co-trustee or sole trustee. Such a beneficiary must either possess the requisite learning and skills to manage assets prudently in accordance with state law and the terms of the trust or must delegate that investment responsibility to a person or institution the trustee reasonably believes possesses the requisite learning and skills, and thereafter the trustee must possess the skills to reasonably monitor the performance of that person or institution.

If you have suggestions for other ways to help make these financial skills concrete and operational, please share them with me at jgallo@galloconsulting.com.