Morgan Stanley Publications

Global Economic Forum Journal of Applied    Corporate Finance

At Morgan Stanley’s Global Wealth Management Group, our experienced professionals can work with you and your family to develop estate planning strategies that address a broad range of wealth preservation and transition needs. In this paper, Morgan Stanley’s David Rubinowitz, Executive Director of Planning Solutions, John Sabino, Executive Director of Personal Trust and Alan Wolberg, Executive Director of Wealth Planning, review several estate planning strategies that families can use to foster financial literacy in their children. Using the insights from leading academic authorities and industry practitioners, they outline strategies that are not only sound investment vehicles but also help teach children about investing, build their confidence in their own decision-making, and illustrate the responsibilities that come with wealth.

Use Lifetime Gifts to Help Children Gain Experience

David Rubinowitz cites examples of experts who can offer good counsel. If you want your children to manage money responsibly, they need to have money to manage. That is one of the key ideas from Jon J. Gallo, an estate planning lawyer with Greenberg Glusker Fields Claman & Machtinger in Los Angeles and co-author with his wife, Eileen, of The Financially Intelligent Parent (Penguin) and Silver Spoon Kids (McGraw-Hill). And there’s no better way to do this than to start small.

In one family with three adult children who couldn’t do much more than balance a checkbook, the Gallos recommended a couple of interim steps before the parents gave the children any money of their own to manage. First, the children were asked to track their expenses for several months, which proved to be an eye-opening experience for each of the children. The tracking revealed that they were spending more than they ever imagined. Next, the Gallos suggested the parents put $50,000 to $100,000 in a brokerage account. Each child was then assigned the responsibility of investing a designated portion of these funds for one year under the tutelage of the Gallos and family financial advisers. If the funds grew in value, the appreciation would belong to the children. As it happened, the child with the least financial acumen at the start of the exercise earned 18 percent, while the other two earned about 3 percent.

This exercise may provide you and your children with an ideal introduction to managing funds; however, you have to accept the possibility that your children could also lose money. As the Gallos note though: “Wouldn’t you rather have your kids lose [a nominal] sum, which is not going to impede your standard of living and learn from that experience, as opposed to losing 15 or 25 or 30 percent of their inheritance?”

According to the Gallos, the next step in expanding their responsibility level is to give children money of their own. Under current federal law, individuals can transfer assets worth up to $12,000 a year to an unlimited number of people free of any gift tax. Furthermore, spouses can combine these annual exclusion gifts to give away up to $24,000 per recipient tax-free. Considering your budget and your child’s age and maturity will help you determine whether to give your child the entire amount permitted under the annual exclusion or a smaller sum. By that point you might be ready to allow your children free reign, or you may prefer to observe how they use the funds so that you can provide guidance as necessary. Keep in mind, though, the intention is to foster their independence.

Structure Trust Payouts to Increase Gradually

Alan Wolberg, Executive Director of Wealth Planning at Morgan Stanley, leads a team of professionals that help clients with these issues. He points out how properly structured trusts can help with financial education. As with lifetime gifts, trusts can be written to distribute money to beneficiaries incrementally, rather than all at once. This strategy can provide your children with the opportunity to gain experience in dealing with and receiving increasingly larger sums, and limits their ability to use up their inheritance at a young age. Trusts may start distributing income or principal at specific ages (e.g., income to beneficiaries beginning at age 21 and distributions of principal staggered at ages 30, 35 and 40). Having learned the value of money during the period when they were receiving income payments from the trust, children will presumably be better prepared to receive distributions of principal at a later age.

You can also encourage responsible financial decision-making in your children through the way in which the trust is set up for distribution of principal. Many trusts provide for distributions of principal according to what is called an ascertainable standard. This is a narrow directive that authorizes the trustee to make payments of principal only for very specific reasons concerning health, education, maintenance or support.

The alternative is a trust that is fully discretionary, Wolberg explains. Here, there’s either no standard stated in the trust document, or it includes a far-reaching one that would allow the trustee full discretion to pay principal for any purpose. With fully discretionary trusts, the trustees will exercise much more independent judgment and can, therefore, disperse funds at a beneficiaries request for a wide variety of reasons.

Choose Trustees Who Can Be Money Mentors

Whether you rely on a corporate fiduciary or an individual one, Morgan Stanley’s John Sabino suggests that you appoint trustees who can support your efforts to teach your children responsible money management. Exposing your children to good financial role-models can be a helpful way to provide them with guidance and direction as they deepen their understanding of investing and financial values. Some people find the most flexible arrangement is to designate as co-trustees an individual who knows the family well, and a corporate fiduciary with extensive experience in overseeing investments.

Whoever you choose as trustee, Jon Gallo recommends the trust specify that once beneficiaries are about 14 years old, they begin meeting with trustees on a regular basis. They can talk about how the trust funds are being invested and review their own budgets. This will help broaden their understanding of the decision-making process and prepare them for their future responsibilities. As Gallo notes, “The goal is to prepare beneficiaries to eventually become co-trustees of their own trusts.”

Make Children Co-Trustees of Their Own Trusts

According to Charles W. Collier, senior philanthropic adviser at Harvard University and author of Wealth in Families (Harvard University), making children co-trustees of their own trusts affirms the message that their parents respect them and have confidence in their ability to learn about money. It’s also a wonderful platform for financial education. In a safe, supportive environment, children can work with other co-trustees to learn about investments, and the roles and responsibilities of trustees and beneficiaries, Collier says.

One couple with whom Collier worked were initially uneasy about the idea, but ultimately made their son, 21 years old and on his third college, co-trustee of a trust worth more than $1 million. Although there were other, more substantial trusts in the family, each of them had intervening beneficiaries and this was the first trust from which the beneficiary was entitled to any payouts. Current income was about $30,000 per year, and the trustees had the discretion to accelerate payments of principal that the son would not otherwise receive until much later.

In this example, the son shared all responsibilities with two other trustees: a family lawyer, who cared about money and education, and an aunt, who cared about her nephew’s life course. In making investment decisions, the three trustees consulted with the family’s financial advisers. For decisions about principal distribution, the son needed the votes of the two other trustees to preserve the creditor protection that the trust afforded.

As a result of their guidance, the son has grown enormously during the three years that this arrangement has been in place, Collier says. Being a co-trustee has been a “great training tool” to prepare the son for much larger distributions he will ultimately receive from other family trusts.

Incentive Trusts as a Motivator

Incentive trusts are designed to encourage desirable behavior, such as maintaining a certain grade-point average, graduating from college, holding a particular kind of job or being active in charitable causes, or discourage undesirable behaviors or actions, like drug abuse or criminal activities. Often, incentive trusts can be a strong motivator for children to live responsibly. By requiring beneficiaries to meet certain conditions before they will receive funds, incentive trusts may lessen the feeling of entitlement that many trust fund children seem to have.

David Rubinowitz points out that incentive trusts have a couple of potential pitfalls. One is that they tend to define desirable achievements though inflexible, monetary terms, rewarding the child who embraces an educational or career path that parents favor, rather than one in line with the child’s interests. Some of these trusts even have income-matching provisions if a beneficiary achieves specific benchmarks. When considering this option, you should take into account the risk that resentments may arise if the incentive trust is used to impose your own values.

Involve Children in Decisions About Your Own Gifts to Charity

Alan Wolberg points out that encouraging children to participate in the selection of charitable recipients can foster a deep sense of responsibility and understanding of what money is and how it can affect others in a positive way.

Families often participate in lifetime gifts to charity, which are tax efficient since they decrease the size of your taxable estate. Donor-advised funds, that allow a donor to make a contribution to a charitable gift fund, may provide the donor with an immediate income tax deduction for a contribution made to a public charity. The donor can postpone the decision about which charities will receive distributions from the fund account until some time in the future, making it possible for children to participate in the decisionmaking process.

Organizations sponsoring donor-advised funds include community foundations universities, religious entities and charitable affiliates of certain financial institutions. You may find that gifting to a donor-advised fund may be an ideal way of building a charitable legacy. Volunteer work and involvement in researching potential charities can be rewarding steps within the gifting process. In addition, a number of donor-advised funds allow you to name children or other descendants as successor advisers on the account if you die or become incapacitated. This designation, in addition to active participation, may help solidify your child’s ongoing commitment to uphold your family’s charitable legacy.

Give Children a Role in the Family Foundation

If you have formalized your philanthropy by setting up a private foundation, which gives you total control over investment management and grantmaking, you can use it to provide even more extensive training for children. Their involvement can range from sitting in on meetings with investment advisers to learn how the foundation’s endowment is invested, to serving as employees or members of the foundation’s board of directors. Some families have even used private foundations as a training ground for children who are ultimately expected to take over the family’s for-profit enterprise.

Of course, neither the children nor the parents have any personal stake in the funds, Harvard’s Charles Collier notes. But here too, children can gain experience working with family investment advisers. In fact, their risk tolerance and the asset allocations that they choose in this context may be very different than it is when they are serving as co-trustees of their own trusts. Having both experiences can expand their perspective.

Create Charitable Trusts to Benefit Family and Nonprofits

Split interest vehicles, in which charitable and noncharitable beneficiaries each receive a share of the trust assets, can be an effective teaching tool. They offer “an investment component, a charitable component and a spending component,” Collier says.

People selecting a charitable trust basically have two options, that impact how the charity is provided payment, and are important for new co-trustees to understand. One is the charitable remainder trust, in which individual beneficiaries get the payout up front for whatever period of time the donor specifies—their lifetimes or a term of years (20 years is the maximum). When this income interest ends, the charity gets what’s left, known as the remainder interest. The alternative is a charitable lead trust, that basically works in reverse: the charity gets its payout up front for a specific period (15 years is typical). When this lead interest ends, the noncharitable beneficiaries, usually family members, get the remainder interest. In this case, lead trust beneficiaries, who must wait many years for their share, might take a more long-term view. Either way, Collier recommends parents make their children co-trustees, giving them a voice in who the charitable beneficiaries will be, and a hand in investment decisions. If the children have a stake in the trust, that may influence their financial choices.

Collier worked with one father who put $1 million into a charitable remainder trust when his son was in his early 20s and had just joined the workforce. He let his son know that he expected the distribution stream (five percent of the fair market value of the trust, revalued each year for the next ten years) to put an end to “the continued yammering for small amounts of money.” It was up to the son to choose the charitable beneficiary when his own income interest ended. As a co-trustee, the son was responsible for working with a financial adviser to invest the assets. This arrangement gave the son “a meaningful exposure to the investment business, and [a chance to] learn about financial concepts over time,” Collier says. Rubinowitz suggests that families can potentially use a charitable remainder trust to teach the mechanics of how these trusts work as tax-efficient giving strategies. While encouraging your children’s educational development, you may look to protect or preserve the assets involved. In doing so, you may require that the income interest be payable to yourself, rather than to your children. You can also create a separate wealth replacement trust, funded with life insurance, that would benefit your children and replace the assets given to charity. You can fund your children’s philanthropic endeavors with a highly appreciated asset that they expect the trust to sell, which may offer additional tax advantages. A similar approach can be used to fund a lead trust that would make payments to charity for a specified number of years, and distribute the assets to your children after that.

Regardless of which type of trust you choose, your children should be involved in choosing the charitable beneficiaries. With this process they receive a powerful message about the importance of giving back to the community.

Morgan Stanley and Your Family

The Morgan Stanley Wealth Planning Group works closely with your Morgan Stanley Financial Advisor to help individuals and families of substantial means to achieve their goals for wealth management, wealth protection and wealth transfer. We understand that while tax efficiency and trust structures are important, the process begins with an understanding of your goals for yourself and your family. Whether your particular issues involve financial responsibility, education or life goals, we can explore ways to prepare the next generation to be successful stewards of your financial legacy.

These materials are provided free of charge for general informational and educational purposes to our brokerage clients. These materials do not take into account your personal circumstances and we do not represent that this information is complete or applicable to your situation. We may change these materials at any time in the future without notice to you. We are not providing you with investment, tax or legal advice. You should consult your own tax, legal, investment or other advisors to determine whether the analysis in these materials apply to your specific circumstances. Particular legal, accounting and tax restrictions applicable to you, margin requirements and transaction costs may significantly affect the structures discussed, and we do not represent that results indicated will be achieved. We are not offering to buy or sell any financial instrument or inviting you to participate in any trading strategy. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.

Investments and services are offered through Morgan Stanley & Co. Incorporated, member SIPC.

© 2007 Morgan Stanley