Spousal trusts are often the default solution in blended-family estate planning because they can provide income to a surviving spouse while limiting access to capital and preserving the remaining wealth for children from a prior relationship. However, that apparent balance can mask an underlying tension. The spouse needs income during life; the children are waiting for capital later. Those potentially competing interests can pull the estate plan in different directions from the outset.
Consider a $1-million portfolio held in a spousal trust. The surviving spouse is entitled to the income but cannot access the capital except as permitted by the trust. The children are the remainder beneficiaries of the trust. Suppose the portfolio appreciates from $1 million to $1.5 million. That is an excellent result for the children, but what has it accomplished for the spouse?
If much of the return consists of capital appreciation rather than income, the spouse may receive relatively little benefit from that additional $500,000. This raises a legitimate planning question: What economic incentive does a life beneficiary have to maximize capital appreciation if they cannot participate in it?
This does not suggest that a surviving spouse will act irresponsibly. It recognizes that the structure can create competing interests. The spouse may favour investments producing greater current income, while the children may favour long-term capital growth.
This conflict is only one consideration.
The carrying costs of a spousal trust
A spousal trust is typically intended to operate for many years and can generate ongoing costs that are sometimes overlooked in the planning analysis.
One cost category is investment-management fees. These fees reduce the return available to both generations, while requiring the trustee to oversee a portfolio suitable for beneficiaries whose interests may differ.
A second cost category is income tax. Generally, a qualifying spousal trust requires the surviving spouse to be entitled to all the trust’s income during their lifetime, with that income typically taxed in the spouse’s hands. Interest, dividends and, in some cases, realized gains can therefore create annual tax consequences for the spouse, even though the capital beneficiaries may not be affected until much later.
A third cost category is administration. A continuing testamentary trust, such as a spousal trust, requires annual T3 returns, T3 slip preparation, accounting records, trustee decisions, beneficiary reporting and ongoing accounting and legal advice. Trustee compensation may also be payable.
Individually, these costs may appear manageable. Over decades, they become significant.
Assume a $1-million trust incurs $10,000 annually in investment-management costs and another $7,500 in accounting, tax, trustee and other administrative expenses. That represents $17,500 of annual carrying costs.
Over 15 years, those costs total more than $260,000 on a simple cumulative basis, without considering the investment return that could otherwise have been earned on those amounts.
Separating income from inheritance
Instead of asking one pool of capital to provide income to the spouse while simultaneously preserving capital for the children, another approach is to separate the objectives.
A life annuity can address the first issue — how much income the surviving spouse requires for life.
Life insurance can address the second — how much capital the client wants the children to receive.
Consider the same $1 million. Suppose, for illustration, that $600,000 is used to purchase a life annuity for a 75-year-old spouse and the remaining $400,000 is allocated to permanent life insurance or other legacy planning.
If the $600,000 annuity generated approximately $55,000 of annual lifetime cash flow, the spouse would receive approximately $4,580 each month, regardless of whether they lived another five years or another 25.
These figures are illustrative rather than current insurer quotations, but they demonstrate the planning concept.
Where an annuity qualifies for prescribed taxation, the tax treatment may also be more predictable and attractive. A portion of each payment is treated as a return of capital, while the taxable portion is spread evenly over the expected payment period. As a result, the surviving spouse may be in a stronger after-tax cash-flow position than if they were receiving portfolio-related income that is fully taxable each year.
Inflation
Inflation is an obvious concern. A level annuity payment that appears adequate at age 75 may have substantially less purchasing power at 90. An annuity may instead be structured with payments that increase by a specified percentage over time. The trade-off is usually lower initial income in exchange for increasing future payments.
Additionally, annuity guarantees or death-benefit features may also be considered where there is concern about the spouse dying relatively soon after the annuity is purchased, although these features will generally reduce the income available.
The annuity option transfers investment, administration and longevity risk to the insurer. The spouse receives contractual income directly and no longer depends on a trustee to balance their need for current cash flow alongside the children’s interest in preserving capital.
The remaining capital can be directed toward permanent life insurance intended to provide the children with a defined death benefit.
Assume, purely for illustration and subject to underwriting and product pricing, that the $400,000 allocation could support permanent insurance providing a $600,000 death benefit. The economics are now quite different.
The spouse has a contractual lifetime income. The children have a separately funded legacy. There is no need to maintain a $1-million investment portfolio for decades simply because two groups of beneficiaries require different things from the same assets.
Instead of asking, “How should we invest $1 million so that it generates sufficient income without jeopardizing the children’s capital?” the advisor can ask two more precise questions: “How much annual income does the spouse need?” and “How much inheritance does the client want the children to receive?”
Once those amounts are established, capital can be allocated to each objective.
The price of certainty
The annuity-and-insurance approach is not a universal replacement for a spousal trust. A trust offers flexibility, which is valuable.
That flexibility may be essential if the surviving spouse may need access to capital for housing, health care or unforeseen expenses. A trustee with an appropriate power to encroach on capital can respond to changing circumstances.
Once capital has been exchanged for an annuity, that flexibility is generally reduced or lost.
Insurance also depends on age, health, underwriting and product pricing. A strategy that works well for one family may be uneconomic or unavailable for another. There are also important tax considerations. Property transferred to a qualifying spousal trust can generally benefit from a tax-deferred rollover, which may be particularly valuable if assets have significant accrued gains.
The appropriate question, therefore, is not simply which strategy produces the highest projected return. It is a comparison of flexibility versus certainty, after accounting for tax, product availability and the carrying costs associated with each structure.
For some blended families, separating the objectives may be preferable to asking one pool of assets to serve beneficiaries with competing economic interests for decades.
The annuity can provide for the spouse. The insurance can protect the children’s legacy. And the estate plan may no longer need to keep income and capital pulling in different directions.
Michael Kulbak, MBA, CPA, CMA, TEP, is principal of Kulbak Trust Solutions in Mississauga, Ont.
