The Crummey trust and game theory: understanding the grim trigger strategy

My friend never broke curfew during high school. The consequences were too dire. His parents had threatened to cut off his allowance and scale back on helping him pay for college.

Years later I would recognize the parents’ strategy as an important game theory concept. They were playing what is known as a grim trigger strategy, a strategy of eternal punishment resulting from a single provocation or “trigger.”

We all use or attempt to use grim trigger strategies on occasion. In general, a grim trigger strategy sounds like the following: “I’ll play nice with you as long as you do the same. But if you ever betray me–even once–then I’ll never forgive no matter how much you apologize.”

The strategy is usually discussed in classrooms in the context of the iterated Prisoner’s Dilemma. The example is interesting but it requires technical math like infinite sums and discount rates. By the time many of us get the math done, we’ve lost much of the intuition.

So instead I will keep things grounded by discussing an example from estate planning. Amazingly, the grim trigger strategy is an essential idea for why a certain kind of trust works.

One problem in estate planning

Imagine a parent wants to transfer wealth to his 18-year old child in a tax-effective manner. The simplest way to transfer money tax-free is by giving a gift. Under current IRS tax laws, the parent could give up to a certain amount ($12,000 in 2008) without incurring taxes.

But there is a potential problem with this transfer. The gift becomes the child’s money and can be spent however the child sees fit. Many parents rightfully fear young children would waste the money. The issue is not having complete control. For many, it would be sufficient to let the child grow up a bit, to say age 25 or 30, to be mature and have perspective. Unfortunately, adding such a condition would disqualify the gift from its tax exclusion. The IRS wants to make sure the gift is a real rather than a tax-sham and so it is specified the child needs to have “present interest” in the gift as opposed to “future interest.”

The present interest condition creates a situation that can unravel quickly. A parent might only want to give money to a child that would responsibly save it. But in a one-shot game, an irresponsible young child will always choose to spend the money. We end up in a situation where parents don’t give and children don’t get, far from the desired outcome of marking money for the future.

Is there any way to get to a better outcome? That’s the idea behind a trust the Crummey family created.

The Crummey trust

People have tried many schemes to earmark money for the future but still qualify for the gift-tax exemption. Eventually the Crummey family in the 1960s came up with a trust setup that was ruled to be legal and now bears their name.

Here is the history and the idea of the trust:

In the late 1960s, Mr. and Mrs. Crummey tried to get around the present interest gift tax limitations.They created a trust for the benefit of their children, but with a new idea.The trust provided that the beneficiaries would be given notice of any gift to the trust and the beneficiaries would then have a limited right to withdraw the gifted assets for a specific number of days.If the beneficiaries did not exercise their rights of withdrawal within the time allotted, “¦ gifted assets would thereafter be locked in the trust. [to be sensibly distributed when the children are older]

Mr. and Mrs. Crummey took the position that these gifts were a “present interest” because each beneficiary had a present right to withdraw the funds for a limited period of time. The annual gift tax exclusions for the gifts to the trust would be available. No gift tax would be due. The IRS did not like this idea and challenged the Crummeys. Fortunately for us, the IRS lost hands down. [source, minor formatting mine]

The idea can be viewed as more than a tax scheme and as a reflection of equality. In some sense, a parent with a young child should not be at a disadvantage in estate planning compared to a parent with an older, responsible one. The Crummey trust makes this possible.

The grim trigger in Crummey trusts

Although the Crummey trust limits the withdrawal period and the amount one can withdraw, there is still one potential hitch in the plan. The children do have present interest and can spend the money.

What will keep them from spending wastefully? This is where the grim trigger strategy comes into play.

It’s hard to imagine anyone being able to easily resist the lure of free money, but a little consideration reveals a simple way to persuade your children or grandchildren to leave the money alone. If you have a large enough estate to make annual gifts to family members, odds are good that you’ll also leave a substantial amount of money to them later, whether during your lifetime or after your death. By making it clear that anyone who elects to exercise his or her withdrawal right should never expect to receive another penny from you, you’ll usually persuade everyone to exercise some self-interest and leave the money in the trust. After all, $12,000 could be a drop in the bucket compared with what any person might eventually receive. (source)

The grim trigger strategy serves as a deterrence and punishment for early withdrawals and irresponsible spending. Most parents should be able to make the strategy believable because they have a long history of showing kids they can and will enact punishment.

Some caveats to a grim trigger strategy

While a grim trigger strategy can be effective, the downside is that it is completely unforgiving. It makes no exceptions for honest mistakes or youthful indiscretion. Imagine one of your children at age 15 withdrew money and wasted it but at age 25 felt repentant about it. Do you continue to be unforgiving?

This problem and others are discussed by economist Robert Alexrod. In a fun application of computational game theory, Alexrod set up a tournament in 1984 to test various strategies for a repeated Prisoner’s Dilemma (a game with incentives similar to the repeated gift-giving game). Grim trigger did not fare very well. In the first round it ranked 7 out of 14 submitted entries. In the second round, it ranked 52 out of 62 submitted entries.

Here is what Alexrod thinks about the strategy:

In sum, Grim Trigger seems like a good idea, but isn’t. It does offer the maximal incentive for the other player to completely avoid defection. But if the other player doesn’t know that it is facing Grim Trigger, it can’t adjust its behavior until it is too late.

Any experimentation (or noise) will end in trouble for both sides. Thus in a world of more or less sophisticated players where you can observe the other’s behavior but can not know its strategy in advance, Grim Trigger is likely to be a poor performer. (source)

Key lessons

• A grim trigger strategy can encourage cooperation
• It’s crucial the other side knows you are playing grim trigger
• The biggest problem is that a grim trigger strategy is unforgiving
• A Crummey trust is an instructive example where someone might use a grim trigger strategy