Trustees: Know your risks

Many trustees, both professionals and lay people, unwittingly take the risk of being sued for negligence on a daily basis. Over the course of the next three issues of ECA, KARL LAVERY will examine the three main areas of risk faced by trustees. In this issue, he looks at the costs of running a trust.

Would you volunteer to be a trustee, knowing that, there is the possibility you might have to pay for the privilege as a reward for your efforts? The question may seem somewhat rhetorical. However, it seems that many trustees, both professional and lay people, unwittingly take the risk of being sued for negligence on a daily basis.

In my opinion, the risk to you as a trustee comes from three key areas. If these are addressed correctly, not only have you significantly reduced the risk of facing possible litigation, you will, by default, be providing your client with the excellent service for which you strive. The key risk areas are:

The costs of running the trust, which is covered in this issue. (This article is not intended to address how to best meet the often conflicting needs of different classes of beneficiary within a trust);
The relevance of Modern Portfolio Theory and the importance of using a robust and consistent investment process;
The impact of the Trustee Act 2000 and The Financial Services and Markets Act upon trustees.

Consider a typical trust. The trust will probably have to achieve growth of 3.5 per cent to five per cent per year just to meet the costs of running the trust. That is before any distribution of income to beneficiaries or achieving any growth to counter the effects of inflation.

A breakdown of annual costs

Where monies are invested into pooled investments such as actively managed unit trusts or open-ended investment companies (OEICs), such funds typically have a total expense ratio (TER) of between 1.5 per cent and 2.3 per cent. The TER includes the annual management charge together with other operating expenses such as the fund's legal and auditors' costs.
Alternatively, where you use stockbrokers instead of fund managers, their costs are typically in the region of one per cent to 1.25 per cent per year, plus dealing costs and commissions. These extra costs can be as much 0.5 per cent. In addition, it is common practice for many stockbrokers to use pooled investments for a significant portion of client monies, and although they may obtain a discount from the fund managers, active fund managers’ annual costs are still typically at least 0.5 per cent to one per cent per year.
Additionally or alternatively, there may be an independent financial adviser involved who is either taking trail commission from the funds used (usually 0.5 per cent per year) and/or taking initial commission on any investments and/or charging fees for advice.
Professional trustees’ expenses and fees can vary significantly depending upon the amount of ongoing work required and the size of the fund. Assuming a not untypical 0.3 per cent per year in fees gives us £600 on a £200,000 trust fund.
Tax – Most trust funds tend to have a basket of assets within them. This typically includes shares, pooled investments, corporate bonds, bank deposits and property. Given that all income received by a trust is taxed, now at 40 per cent for income and 32.5 per cent for dividends, we can see that on a portfolio with an income yield of say 4.5 per cent after expenses, the trustees would see a yield reduction of between 1.44 per cent and 1.8 per cent as a result of the tax charge.
Costs – The need to submit tax returns and the accompanying expense for those, not to mention the costs of the tax returns for beneficiaries in receipt of trust income, endeavouring to reclaim some or all of the tax paid should they be in a position to do so, will all add to the cost of running the trust.

If the operating costs of a trust are five per cent per year, we already know that such returns cannot be achieved from deposit-based monies, as a ‘risk free’ rate in a good deposit account is currently significantly less than the five per cent shown above for trustee accounts, and that is before deduction of tax at 40 per cent. To achieve the higher rate of return required (to both cover the costs of running the trust and providing the beneficiaries with a real return), real risk will need to be taken with the trust assets and with risk comes the chance of failure and therefore attack from disgruntled beneficiaries.

If we assume the need to generate an inflation-linked income of say three per cent net in addition to any growth and, for a beneficiary who is not able to reclaim any tax paid by the trustees, the trustees would need to achieve an annual gross return of up to 11 per cent per year just to secure the required income, let alone any real growth on the capital. This assumes an inflation rate of three per cent.

Herein lies the first risk. Why, as a trustee, do you use the advisers and investment mediums that you do? The costs are invariably too high and the tax burden is usually excessive. If you can reduce the costs of operating a trust, you automatically reduce the growth rate needed and, by default, the degree of risk that needs to be taken. A well run trust, with all the appropriate fund charges, advice costs and trustee costs, can cost between 2.3 per cent and 2.9 per cent per year. This can be broken down as follows:

Ongoing professional trustee charges of say 0.3 per cent;
Administrative platform charges of between 0.5 per cent and 0.85 per cent;
Fund-related charges averaging 0.45 per cent;
Tax returns costs - nil

As one would expect, the larger the trust fund, the lower the percentage costs through economies of scale.

These costs exclude the cost of any investment or asset allocation advice – this is typically between a further 0.60 per cent and one per cent per year.

By using the right ‘tax wrapper’ for a trust, you can eliminate the need for the trustees to submit a tax return every year, which saves on accountancy and trustees’ fees. It avoids the trust being liable to the 40 per cent and 32.5 per cent tax charges on the aforementioned income and dividends.

As you will be aware, ever since the Finance Act of 1998, it has become increasingly clear that an investment vehicle best suited to many trusts is an investment bond. The reasoning for this is that an investment bond is a non-qualifying whole-of-life contract. Essentially, it is a life-assurance policy, as such, it is not deemed to be an income-producing asset. Therefore, any income the fund receives, will be deemed to have been received by the fund and not the individual (or the trust). There are two advantages to this. Firstly, there is no tax for the trustees to pay; resulting in better compounded returns (as the fund is able to gain a return on the monies that now remain invested instead of being paid out in taxes). Secondly, the trust should incur no accountancy costs for unnecessary tax returns. (This is always provided that the Capital Taxes Office agrees to issue periodic returns every few years rather than annual ones on the basis that none of the trust investments are income producing).

It is worth noting that investment bonds are not without their drawbacks. The investment house running the bond pays a composite rate of tax of circa 20 per cent on the profits made by the fund each year, if the bond is an onshore contract. Use of an offshore contract instead, based in the Isle of Man for example, would see the benefit of gross roll-up on the profits in the fund, (deferring the income tax payable).

The tax only becomes payable once the monies are remitted to the UK (if policy owner(s) are UK-domiciled). At this point, a chargeable event occurs. This effectively gives the fund the use of the tax monies to make more money before the tax becomes payable.

Even the tax due upon distribution of the trust assets can be mitigated. For example, if monies from an offshore contract are assigned to a beneficiary prior to encashment and remittance to the UK, the gain becomes the taxation responsibility of that beneficiary. Imagine a university student receiving say £8,000 toward the years’ expenses, of which £3,000 was profit. The student will be able to offset the tax liabilities on the profit against their unused personal income-tax allowance (currently £4,745 – for the 2004/2005 tax year). In such a case, there is the genuine potential for some tax-free return.

Bonds have had some bad press of late, largely due to adviser greed and poor advice. There are three reasons for this. Some bonds can offer up to seven per cent initial commission, which leaves the client with either significant acquisition costs and/or extensive lock-in clauses.

Added to this, many clients have used bond structures to access the perceived security of ‘with profit funds’, in recent years. The resulting collapse in bonus rates and imposition of market value adjustments, (exit penalties), has given these useful structures an undeserved poor name.

Historically, actively managed offshore bond funds have been more expensive to run than their onshore equivalent. This has been partly down to the genuinely higher costs of appropriating locations and staff in offshore havens such as the Isle of Man. Additionally, offshore funds are not allowed to reclaim the withholding tax on dividends, nor are they able to claim their operating expenses against tax, given that the funds pay no tax on their profits.

Fortunately, due to advances in technology, trusts can now have access to very efficient platforms on which bonds, both onshore and offshore, can be run. With these, the additional cost of running an offshore contract can now be negligible – if done correctly. The same platforms can also be used to run unit trusts, OEIC, investment trusts and share portfolios equally cost effectively. These platforms are known generically as ‘wrap platforms’, and can be used to access virtually any pooled retail investment funds, be they active or passive, together with funds normally only available to institutional investors.

In the next issue of ECA, Karl Lavery will address the importance of using the Modern Portfolio Theory for asset allocation and the correct use of wealth management, both in terms of achieving the optimum returns for the beneficiaries and protecting the trustees from accusations of negligence.

References

1. Roughly equivalent to deposit rates.

Karl Lavery is a holistic fee based financial planner with Baxter Fensham Limited and can be reached via 0113 2741100, mobile: 07958 736397 or e-mail klavery@baxterfensham.com.