Trustee’s Purchase of Three Deferred Annuities Curiously Held Not to Be a Breach of Trust


In re Amendment and Restatement of Revocable Living Trust of Alfred J. Berget

EXECUTIVE SUMMARY:

Although this is a very close case, it probably should have been reversed. A corporate trustee probably, almost definitely, loses. The inherent problem of the lay trustee, who can easily be hornswaggled by a Svengali-esque and often incompetent financial advisor, could well lie at the heart of this case. The investment in deferred annuities was, in my opinion, per se improper, and the court should have so held.

The weighting of the underlying investments inside of the deferred annuities strikes me as way too aggressive too, and I believe that the investment strategy not only harmed the income beneficiary in the long run, it did a disservice to the principal beneficiaries too, who are innocent. The income beneficiary probably received too much due to the fanciful “formula” for determining income, a method that has no basis in fact. How any professional could take a position and advise someone that “70% of quarterly principal gains is income” is beyond me, other than to say that those professionals perhaps also should have been defendants.

 

In this appellate court decision, the Minnesota Court of Appeals gets as close to reversing a trial court without doing so in a case involving a challenge to the investment propriety of deferred annuities in a trust. In this decision, the appellate court maintains the trial court’s determination that the lay trustee’s actions in purchasing the deferred annuities was not a breach of trust because she relied on the advice of an investment professional. The appellate court expressly limits its own decision to the facts of the case, and, at several points, questions the investment strategy before affirming on the basis of scope of appellate review.

FACTS:

In 1996, the grantor established a revocable living trust. Grantor amended the terms of the trust instrument in 2005 to provide income for his sole surviving adult child after his death. Grantor appointed himself trustee during his lifetime and appointed a first cousin to serve as trustee after his death.

The trust instrument provided that, during grantor’s lifetime, he had discretion to pay any amount of income or principal to himself. The trust instrument provided that, after grantor’s death, the trustee “shall pay to [the child] seventy percent (70%) of the net income of this trust at least quarter annually,” and “[t]he remaining thirty percent (30%) of the net income of this trust shall be added to principal.”

The trust further provided that, after the child’s death or permanent admission to a nursing home, the trustee was to then pay all of the net income of the trust to grantor’s four grandchildren, two of whom are children of the child beneficiary, and two of whom are children of a pre-deceased child of grantor. The trust instrument gave the trustee broad discretion to invest in “property of any kind,” including “securities of any nature.” The sole successor income beneficiary of a now irrevocable trust alleged that the trustee breached fiduciary duties relating to the investment of trust assets and the distribution of income.

Grantor died in November 2006 at age 68. At that time, the child was 43 years old, and the eldest grandchild was college-aged. After grantor’s death, the assets of the trust consisted of approximately $1,100,000 in cash.
At the time of her appointment, the cousin trustee had not previously served as trustee of a trust and did not have any training or experience with investing money. She co-owns a company that installs, maintains, and repairs on-site sewage treatment systems, and she manages the office staff. Shortly after grantor’s death, his widow sent a handwritten note to the cousin trustee, saying: “Contact Dave [Bjorklund]. He’ll know what to do.”

Bjorklund had been a self-employed financial advisor for 35 years, selling life insurance and other financial products. Bjorklund had provided financial services and sold products to grantor during his lifetime. Before his death, grantor had informed the cousin trustee that Bjorklund was his financial advisor, and asked the cousin trustee to use Bjorklund because he trusted him and because Bjorklund “had done well for him.”

The cousin trustee met with Bjorklund in January 2007. Bjorklund prepared an investment plan and presented it to the cousin trustee later that month. Bjorklund recommended to the cousin trustee that she use $800,000 of the trust’s liquid assets to purchase three variable deferred annuities. Bjorklund testified at trial that grantor had utilized variable deferred annuities during his lifetime and had told Bjorklund that he wanted the same investment vehicle and strategies to be utilized by the trust.

The cousin trustee followed Bjorklund’s recommendation by purchasing three variable deferred annuities, in the amounts of $300,000, $300,000, and $200,000. With Bjorklund’s advice and assistance, the cousin trustee invested the three premium amounts in a Mellon Capital Management fund, which was comprised of individual stocks. The annuity contracts specified that the performance of the underlying investments would determine the value of the annuities. Dividends and interest would not be disbursed to the trust but would be reinvested.

Annuity payments would not begin until the “income date,” January 10, 2054 (over 40 years away), but the cousin trustee could withdraw funds before that date. By paying additional fees at the outset, cousin trustee obtained the right to withdraw a certain amount before the income date without accruing early withdrawal fees and to guarantee the return of $600,000 of the initial premiums without regard to the performance of the underlying investments. After settling the estate and satisfying certain liabilities, the trust was comprised of the three annuities and approximately $198,000 in cash.

With Bjorklund’s assistance, the cousin trustee used the remaining cash to establish a brokerage account by which the trust invested in mutual funds and ten stocks that are included in the Dow Jones industrial average.
The cousin trustee began making payments to the child income beneficiary in April 2007 based on her calculation of the net income of the trust. The cousin trustee’s method of determining the amount of income from the annuities was based on advice she received from two professionals: the attorney who helped the grantor establish the trust and Bjorklund.

To determine the amount of income from the annuities, the cousin trustee referred to the increase or decrease in the value of the annuities’ underlying investments during each quarter-year. If there was an increase in the value of the annuities during a particular quarter, the cousin trustee considered the amount of the increase to be income. After considering the income received from other assets and the trust’s expenses, the cousin trustee paid the income beneficiary and plaintiff an amount equal to 70% of the trust’s quarterly gains as income.

Before the cousin trustee purchased the variable deferred annuities, Bjorklund projected that the value of the annuities’ underlying investments would increase by 10% each year. Given the cousin trustee’s method of determining income, Bjorklund projected that 70% of each year’s increase in the value of the annuities (i.e., 7% of the principal at the beginning of that year) would be paid to the income beneficiary as income, and that 30% of that increase in value (i.e., 3% of the principal at the beginning of that year) would be retained and reclassified as principal, so that the principal essentially would reset on a quarterly basis. When Bjorklund presented his plan to the cousin trustee, he prepared a document, which was introduced as an exhibit at trial, projecting that, by 2035, the total value of the annuities would be $2,250,474, which would allow the trustee to distribute more than $150,000 to the income beneficiary that year.

Bjorklund recognized that the value of the annuities’ investments would not increase in a straight line. In the first three quarters of 2007, the value of the annuities increased. The cousin trustee made payments to the income beneficiary of $13,049 for the first quarter, $25,374 for the second quarter, and $17,590 for the third quarter. But the value of the annuities decreased in the fourth quarter of 2007, and the income beneficiary received no distribution. Due to the market downturn, the present value of the annuities decreased sharply in 2008 and 2009, from $748,615.34 on December 31, 2007, to $433,141.56 on December 31, 2009. Accordingly, the cousin trustee made no distributions to the income beneficiary.

The Complaint

The income beneficiary made four arguments in favor of his case. First, the income beneficiary contended that the cousin trustee breached her fiduciary duty because she purchased three variable deferred annuities. Second, the income beneficiary contended that the cousin trustee breached her fiduciary duty because she selected primarily growth-oriented stocks as the underlying investments of the annuities. Third, the income beneficiary contended that the cousin trustee breached her fiduciary duty to pay him 70% of the income of the trust. Finally, the income beneficiary contended that the cousin trustee breached her fiduciary duty because she did not re-evaluate the underlying investments of the annuities in 2010, after a prolonged period of poor performance.

The trial court ruled in favor of the cousin trustee, and both sides appealed.

The Appellate Decision

In affirming the trial court, the appellate court made some interesting statements in its opinion, including:

Although we have some concerns about the suitability of the variable deferred annuities that [the cousin trustee] purchased in light of the purposes of this trust, we are reluctant to conclude that the district court erred by finding that a lay trustee did not breach her fiduciary duties by purchasing them after receiving and relying on professional advice from a financial advisor who previously served as a financial advisor to the grantor of the trust.

Our conclusion on this issue should be understood as limited to the facts of this particular case. In another case involving an annuity contract, a different result may be appropriate.

By concluding that the district court did not err, we do not intend to endorse the trustee’s approach.

COMMENT:

Although this is a very close case, it probably should have been reversed. A corporate trustee probably, almost definitely, loses. The inherent problem of the lay trustee, who can easily be hornswaggled by a Svengali-esque and often incompetent financial advisor, could well lie at the heart of this case. The investment in deferred annuities was, in my opinion, per se improper, and the court should have so held.

The weighting of the underlying investments inside of the deferred annuities strikes me as way too aggressive too, and I believe that the investment strategy not only harmed the income beneficiary in the long run, it did a disservice to the principal beneficiaries too, who are innocent. The income beneficiary probably received too much due to the fanciful “formula” for determining income, a method that has no basis in fact. How any professional could take a position and advise someone that “70% of quarterly principal gains is income” is beyond me, other than to say that those professionals perhaps also should have been defendants.

This situation is perplexing. Even though Minnesota is one of the few states that haven’t adopted the 2008 amendments to the Uniform Principal and income Act, given that the court didn’t even reference the Uniform Principal and Income Act, query whether the case was under-lawyered? The Uniform Principal and Income Act, specifically, Sec. 409, provides in pertinent part as follows:

(b) To the extent that a payment is characterized as interest, or a dividend, or a payment made in lieu of interest or a dividend, a trustee shall allocate it the payment to income. The trustee shall allocate to principal the balance of the payment and any other payment received in the same accounting period that is not characterized as interest, a dividend, or an equivalent payment.

(c) If no part of a payment is characterized as interest, a dividend, or an equivalent payment, and all or part of the payment is required to be made, a trustee shall allocate to income 10 percent of the part that is required to be made during the accounting period and the balance to principal. If no part of a payment is required to be made or the payment received is the entire amount to which the trustee is entitled, the trustee shall allocate the entire payment to principal. For purposes of this subsection, a payment is not “required to be made” to the extent that it is made because the trustee exercises a right of withdrawal.

The basic 10% test is a good one, and it should have been followed.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Paul Hood

CITE AS:
LISI Estate Planning Newsletter #2275, (January 21, 2015) at http://www.LeimbergServices.com Copyright 2015 L. Paul Hood, Jr. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission.

CITES:
In re: Berget Revocable Living Trust, Docket No. A13-2295 (Minn. App. December 8, 2014); and UPIA sec. 409.

About lpaulhoodjr

I am an inactive lawyer who practiced almost 20 years as a tax and estate planning lawyer. Today, I am the Director of Planned Giving for The University of Toledo Foundation. I am the co-author of four books, the sole author of another book and a frequent speaker and writer on estate planning, planned giving and business valuation.
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