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New Rules Return Flexibility To Fiduciaries

After more than 100 years, the Uniform Prudent Investor Act (UPIA) and similar prudent investor rules have opened up a whole new world of investing for fiduciaries.

Traditional “prudent man” standards — which were as antiquated as their name — prohibited trustees, executors and similar fiduciaries from making any investments that were deemed too risky, requiring them instead to seek the presumed safety of U.S. Treasury obligations and other highly secure debt instruments. Fiduciaries who sought more growth-oriented investments did so only when specifically authorized or required by their trust agreements, or otherwise proceeded at their own risk. A fiduciary who violated the prudent man standards could be forced to reimburse a trust for any investment losses, even those resulting from routine stock market fluctuations.

As a result, many trusts missed the great stock market run-up of the past two decades. Even after the bear market of the past three years, those trusts have performed far worse than typical well-diversified portfolios. This situation made fiduciaries and beneficiaries equally unhappy, which led to the recent about-face in the law.

The old standard all but ruled out any investments in stocks, options, mortgages, foreign securities and joint ventures. Today, thanks to the new law, it may be a fiduciary’s duty to invest in most of these asset classes. Rather than measure a trustee’s performance on an investment-by-investment basis, the new rules recognize that a trustee should be judged on how well he or she manages the trust’s total portfolio.

This significant change—that asset classes on their face are not prudent or imprudent—resulted largely from the investment community’s acceptance of modern portfolio theory. This approach to investing attempts to construct an appropriate portfolio by considering the relationship between risk and return. Modern portfolio theory holds that some investors, including some trusts, have a greater tolerance for short-term fluctuations or long-term losses than others, and they can afford to take more risk in search of better returns.

Modern portfolio theory also holds that unsystematic risk, which is the risk of price change because of the unique circumstances of a specific security, can virtually be eliminated from a portfolio through diversification. A diversified portfolio will have winners and losers, but the risk of catastrophic losses such as a corporate bankruptcy can be diversified away.

The UPIA’s five specific objectives are: 1) to consider the entire portfolio, rather than individual investments, when judging the prudence of the fiduciary’s investments; 2) to focus the fiduciary’s attention on the trade-off between risk and return; 3) to do away with restrictions on certain types of investments; 4) to incorporate the requirement of diversification into prudent investing standards; and 5) to provide the fiduciary with the ability to delegate investment and management functions.

Basically, the fiduciary now must diversify and be sensitive to risk and return. A fiduciary may choose not to diversify if he or she reasonably determines that the trust would be better served without diversification. This situation could arise if there were a significant amount of stock with extremely low basis or if the objective is to retain control of a family business. Returns correlate strongly with risk, but the tolerance for risk varies with the purpose of the trust and the circumstances of the beneficiary. Obviously, the risk tolerance for a trust that must provide cash for a surviving spouse’s support is different from that of a trust that is intended to accumulate wealth for a child who has already been well provided for.

What else must a fiduciary do to be a prudent investor? A fiduciary should manage and invest assets with reasonable care while keeping in mind the purpose, terms and distribution requirements of the trust. The trustee should consider other circumstances including, but not limited to, the general economic environment; the effects of inflation and deflation; expected return from income and capital appreciation; other resources of the beneficiary; needs for liquidity, regular income, and preservation of capital; tax consequences; and the special relationship or value of an asset. In addition, a trustee must manage and invest the assets solely in the impartial interest of the beneficiaries.

Another change in the law empowered fiduciaries to delegate. In fact, some cases may require delegation, such as when the fiduciary does not have investment management knowledge or when a professional fiduciary lacks experience in a particular type of investment. However, the fiduciary’s obligation to be prudent does not end with delegation of investment and management responsibilities. A fiduciary must use care when selecting a manager, must establish the terms of the delegation and periodically review the agent’s actions. Compliance with the prudent investor rule is judged in light of the facts and circumstances that existed when a decision or action was taken, not in hindsight.

Thirty-six states and the District of Columbia have formally adopted the UPIA.

This does not include states such as New York and Florida that were ahead of their time and passed substantially similar laws before the UPIA was written by the National Conference of Commissioners on Uniform State Laws and approved in 1994. When a state adopts the UPIA and similar rules, the new standards generally apply to all trusts existing on or created after the effective date except those that explicitly opt out.

As we are often told, history repeats itself. The UPIA has restored the flexibility intended by Massachusetts Supreme Court Judge J. Putnam, who wrote the first version of the prudent investor rule when he decided the case of Harvard College and Massachusetts General Hospital v. Francis Amory in 1830. He wrote, “All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”

Client Service Manager Rebecca Pavese, based out of Atlanta, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 2, “Relationships With Adult Children;” Chapter 3, “Planning For Incapacity;” and Chapter 7, “Grandchildren.”

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