adam smith 20 pound noteCertainly one of Adam Smith’s core insights in The Wealth of Nations was that incentives matter.

I believe examples are everywhere about how Smith was correct – ranging from California water shortages and student loan debt, to tax policy and white collar crime.

If incentives matter in these areas, shouldn’t they matter in designing trusts that maximize successful outcomes for descendants?

Clients often have an instinct that “incentive trusts” may improve outcomes for their descendants.

While I don’t discourage this instinct, I do try to channel it.

Precisely because incentives do matter, it’s important to design incentive trusts very thoughtfully.

 Incentive trust design begins with several questions:

  • What do you want beneficiaries to become?

Usually, answers center on the general theme of “becoming productive, engaged, flourishing adults.”

  • What do you want beneficiaries to do?

Certain achievements and behaviors tend to correlate highly successful, fulfilling life outcomes – and clients often want to encourage these.  Examples include the obvious – finishing college and/or graduate school, avoiding debt, working productively, dodging divorce, and staying healthy.

  • What do you want beneficiaries not to do?

There are obvious pitfalls clients want beneficiaries to avoid, often including substance abuse problems, criminal activity, serial failed relationships, and workforce non-entry or failure.

Once a family develops clarity on the key questions above, they and their advisors can consider a wide range of incentive trust design options, including:

  • Delay distributions until certain age(s).

Reducing distributions (or delaying them entirely) until a beneficiary reaches a particular age (for instance, 30, 35, or 40) will have incentive effects on career choice, attention to studies, and workforce effort when a beneficiary is young.

It’s easy for young adults to overestimate the long-term financial security provided by a particular amount of assets.

Remember when you were in college – didn’t $100,000 seem like an almost “infinite” amount of money? Now, at mid-career or nearing retirement, perspective changes, doesn’t it?

Because careers last so long, and the compounding effects of income differences can grow so large, avoiding distortions in beneficiary career choice because they (incorrectly) feel they “don’t need to earn very much” can be a very positive outcome of delaying distributions until somewhat older ages.

  • Delay distributions until certain accomplishment(s).

A family might want to use the “carrot” of future trust distributions to encourage a beneficiary to complete college and/or graduate school in a timely manner – avoiding the “perpetual student” problem.

Alternatively, a very wealthy family with beneficiaries who will not need to work for economic reasons might, nonetheless, want beneficiaries to gain experience and perspective from paid employment for while, before receiving a large inheritance.

A family with a closely held business which they hope descendants will enter might require the child to work in the business (or, more commonly, gain experience working outside the business) before receiving distributions.

  • Allow a beneficiary to be his or her own trustee on certain conditions.

Trusts can provide asset protection from creditors and divorce that can be difficult for even the most responsible and competent beneficiary to replicate on his or her own.

Even so, trusts are also commonly used to protect assets from being depleted by bad beneficiary decisions.

With these issues in mind, a trust could be designed to initially use a third-party or corporate trustee, but permit a beneficiary showing maturity and stability to be his or her own trustee.

Although there’s no airtight way to measure maturity and stability, one can try.

For instance, a person who has stayed out of jail, avoided bankruptcy, completed college and/or graduate school, and gotten and stayed married to the same person for a long period is more likely to be stable than a person who has done none or few of those same things.

Once a family settles on attributes of maturity and stability that fit its goals and values, the qualifications for a beneficiary to be his or her own trustee can be written into the trust agreement accordingly.

  • Only permit distributions for certain purpose(s).

If a family wants to dilute the effects money will have on their beneficiaries, they could limit distributions to particular purposes – for instance, funding educational expenses, or paying for unusually large health care bills.

Because other purposes (such as vacations, or buying a larger house, or retiring early) wouldn’t be permitted purposes for distributions, beneficiaries might be less likely to make career choices or design lifestyles that families believe aren’t desirable.

  • Reduce distributions when a beneficiary is not working.

Wealthy clients often want to make sure that beneficiaries live in safe circumstances with a certain dignity (a “minimum lifestyle”) even if they turn out to be very low functioning (for instance, due to mental illness, substance abuse, or perhaps just outright laziness).

On the other hand, they usually don’t want a beneficiary’s incentives to work productively to be reduced or removed because of trust distributions.

In other words, like Warren Buffett, they want their children to be rich enough to do anything, but not so much that they could do nothing.

One way to balance these concerns is to provide for a trust to make an inflation-adjusted minimum distribution (for instance, $50,000) at any time a beneficiary is working age and not disabled or providing full-time care to minor children, but make the trust’s distribution standards much more generous if a beneficiary is working, past ordinary retirement age, disabled, or providing full-time care to minor children.

  • Use distributions to “match” income from a job or a business.

It’s a very values-driven decision whether a wealthy family prioritizes descendants being economically successful (e.g., investment banker) or instead perhaps just being productive and happy (e.g., boarding school teacher).

If a family does want to transfer wealth to descendants, but still provide ordinary (or even enhanced) incentives for wealth creation by beneficiaries, a trust can certainly be designed to do that.

For instance, a trust could distribute a fraction (or a multiple) of a beneficiary’s documented W-2 income, or distributions received from a closely held business. If a family was ambitious, and tolerant of complexity, the extent of matching could be varied at different levels of income.

Obviously, trust design could differ substantially, depending whether a family’s goal was for children to amass as much wealth as possible, or instead for children to achieve a certain level of income, and then focus on other priorities (such as health, creative pursuits, or relationships with friends and family).

  • Reduce or stop distributions when a beneficiary isn’t substance-free.

It’s not too difficult to design a trust that provides substantial financial incentives for sustained recovery from substance abuse problems. Testing for substance use (paid for by trust assets) and negative test results could be a condition to receive distributions.

In addition, the trustee could be expressly indemnified from trust assets against all costs (including legal fees) relating to any effort by a beneficiary to challenge the trustee’s distribution decisions.

The result would be that a disgruntled (and, possibly, addicted) beneficiary would be depleting his or her own eventual inheritance if the beneficiary sued the trustee.

Based on what a family believes is best for each beneficiary, the incentive trust design options outlined above (along with others) can be combined in a myriad of ways to customize incentive trusts with a personalized, individualized approach.

And that raises a larger question: are incentive trusts a good idea?

I believe that’s a decision for each family to make – and not one for a trust and estates attorney to impose.

I’ve seen many situations where incentive trusts weren’t used, but very difficult and unpleasant outcomes could have been avoided if they had been.

I’ve seen other situations where incentive trusts were poorly aligned with a beneficiary’s actual circumstances, and beneficiaries were very resentful.

At a minimum, families considering whether an incentive trust might fit their circumstances should know their wide array of options, consider them carefully, and apply them thoughtfully.

While musing on those issues, they might consider a question Smith posed in The Theory of Moral Sentiments:

What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?