Prudent Investment of Trust Assets
A trustee has 2 significant duties with respect to investments:
- to optimize the risk and return of the trust portfolio and
- to pay a reasonable income to the income beneficiaries while preserving principal for the remaindermen of the trust.
Historically, trusts were funded mainly with real property, and, hence, didn't require much discretion by the trustee. In a typical arrangement, the remainderman received the property after the holders of the life estate of the same property had died.
However, because most trusts today are funded with intangible assets such as stocks, bonds, pension plans, and bank accounts, the primary duty of the trustee is to manage the fund. Hence, the trustee's investment objectives have changed over time from preserving property to managing the trust property to generate more income and property appreciation.
Using Modern Portfolio Theory to Optimize Portfolio Risk and Return
Generally, a trust makes investments to enhance the principal and to provide income to the beneficiaries. Traditionally, the trustee was limited to investment-grade investments—to make only investments that a prudent man would make with his own property. Indeed, many states provided statutory lists of investments that trustees were permitted to make to shield the trustee from liability from investment losses.
The model Prudent Man Investment Act, first passed in 1940, barred speculative investments, even if they reduced the overall portfolio risk—allowing only investments that a prudent man would make, which, in the 1940's or earlier, meant avoiding risky investments. Even if the settlor expressly authorized any investment, by giving the trustee complete or absolute discretion, the trustee was still not totally immune for improper investments, especially if the trustee acted in bad faith or recklessly made the investment decision.
Modern Portfolio Theory has shown that returns can be maximized and risk reduced by selecting assets that have no or a negative correlation with the other assets in the portfolio, even if some of those assets, by themselves, are risky. However, restricting the trustee's selection to only investment-grade assets limits the trustee's ability to use the techniques of modern portfolio theory to optimize the risk-return trade-off of the trust's portfolio. Hence, the modern trend has been to assess the total portfolio return compared to the total portfolio risk rather than the return and risk of individual assets.
Since a fundamental tenet of modern portfolio theory relies on diversification to reduce overall portfolio risk, the Uniform Prudent Investor Act (UPIA), adopted in 1994, and the Trustee Act Of 2000 specify that the trustee has a duty to diversify the trust's assets. However, the degree of diversification required is fact sensitive—dependent on the purpose of the trust and the particular investments.
Modern portfolio theory also provides tools to quantify the risk and return trade-off of an investment—to determine whether the return is worth the risk. A compensated risk, which is a risk that offers a higher potential return commensurate with the risk, is deemed to be an acceptable risk, while uncompensated risk, which does not have a corresponding potential of return, is deemed unacceptable. Consequently, the trustee can avoid liability for investment losses only for taking compensated risks.
A trustee's investments are not only gauged by the investments themselves, but also by the trustee's due diligence—the investigation and decision-making process that determined the trust's acceptable level of compensated risk and to how those levels were achieved through the combination of trust investments. Professional and corporate trustees are generally held to a higher standard of care and investing due to their presumed expertise.
UPIA Objectives: the Prudent Investor Rule
The UPIA has set forth detailed standards which have come to known as the prudent investor rule that the trustee can follow to avoid liability for investment losses. Indeed, ERISA imposes the prudent investor rule on trustees managing pension funds. Specifically, the UPIA provides:
- A trustee shall invest and manage trust assets like a prudent investor — by exercising reasonable care, skill, and caution — with regard to trust objectives by considering:
- general economic conditions;
- the possible effect of inflation or deflation;
- the expected tax consequences of investment decisions or strategies;
- the role of each investment or action within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, personal property, and realty;
- the expected total return from income and capital appreciation;
- other resources of the beneficiaries;
- needs for liquidity, income regularity, and capital preservation or appreciation; and
- an asset's special relationship or value to the trust or to any beneficiaries.
- A trustee shall reasonably verify facts relevant to the investment and management of trust assets.
- A trustee who is named trustee in reliance upon the trustee's representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.
Duty to Review and Evaluate Inception Assets
Under the UPIA, the trustee has a duty to review the trust assets at the inception of the trust so that the trust property can be administered to comport with the purpose, terms, and distribution requirements of the trust. However, the law tends to favor the retention of inception assets, thus, providing exceptions to the duty to diversify:
- where diversification would increase taxes more than benefits;
- where the major assets are a family-run business or farm,
- personal assets, such as a family vacation home;
- if the trust is part of a larger investment scheme;
- or if the investment itself is diversified as with mutual funds or exchange traded funds based on an index.
Many jurisdictions hold the trustee harmless if he retained trust assets which initially funded the trust or that the settlor recommended the trustee retain. Nonetheless, the trustee still has a general fiduciary duty of prudent administration. If the trust instrument directs the trustee to retain certain trust assets, then generally the settlor's intent controls. However, some courts have ruled that diversification is necessary where there are changed circumstances that may benefit the trust even if such investment actions are contrary to the settlor's intent. If uncertainty or the lack of action may cause losses to the trust, the trustee may even have a duty to petition the court for authorization to take action, especially if 1 or more beneficiaries object to the proposed action or a co-trustee objects.
Duty to Lower Expenses and Avoid Unnecessary Costs
To maximize the return of the trust, a trustee also has a duty to avoid unnecessary costs, including investment expenses and inflation risk, and to consider the tax consequences of any transaction.
Under common law, trust funds had to be strictly segregated from other trust funds. However, small trusts incur larger transaction costs, so the modern trend has been to allow trustees—especially corporate trustees, such as banks and trust companies—to merge small trust funds to lower transaction costs and to allow greater diversification of the merged portfolio.
Delegation of Investment Management to Professionals
The trustee has a duty to delegate for financial assistance in making investment decisions if the trustee is not competent to make investment decisions himself.
The revised 1997 Uniform Principal and Income Act (UPIA 1997) §9 allows a trustee to delegate investment and management to investment professionals, providing that the trustee shall exercise reasonable care, skill, and caution in:
- selecting an agent;
- establishing the scope and terms of the delegation, consistent with trust objectives;
- and periodically reviewing the agent's actions to assess performance and compliance with the terms of the delegation.
In return, the agent owes a duty to the trust to exercise reasonable care to comply with the terms of the delegation and must submit to the jurisdiction of the state in which the trust is located.
Impartiality Allocating Principal and Income Among Beneficiaries
Generally, life beneficiaries of the trust are entitled to trust income while the remaindermen are entitled to trust principal. Under the 1962 Principal and Income Act, income was considered to be interest, rent, cash dividends in stock, net profit from business, and a fraction of royalties. Principal was considered to be trust property, including sales proceeds, insurance proceeds, and stocks splits and dividends because they had to be retained to maintain the same proportion of ownership in the company.
The trustee has a duty to be impartial—which does not mean equality unless the trust document provided so—but requires that the trustee can—and must—only take into consideration the settlor's preferences, as expressed in the trust document, and the interests or needs of the beneficiaries, if the trustee was given discretion to disburse benefits according to those trust objectives. If the trustee was given discretion, then he has a duty to make inquiries necessary to carry out trust objectives. So if a trustee is required to disburse benefits based on the needs of the beneficiaries, for instance, then he has a duty to periodically inquire into the needs of each beneficiary so that the trust objective can be accomplished.
Another problem arises in trying to maintain impartiality between the income beneficiaries and the remaindermen. The trustee may not be able to select the best investment opportunities because of the concern of providing adequate income to the income beneficiaries while maintaining the safety of principal for the remaindermen.
Historically, the trustee had a duty to invest property so that it produced an income for the income beneficiaries while protecting the principal for the remaindermen. Investments that generate a large income tend to be risky while safe investments generate little income. Hence, beneficiaries holding a present interest in the trust generally wanted higher income over safety of principal, while remaindermen wanted the protection of principal so that there was something left when their future interest became possessory.
To give the trustee the maximum flexibility to invest trust assets so as to maximize returns, UPIA 1997 gives the trustee the discretion—unless the settlor provided otherwise—to allocate the total return of the trust to income and principal without regard to whether the return was traditionally defined as income or principal, and the trustee has a duty to re-allocate the investment return if it would be fairer to the beneficiaries.
For instance, if growth property has appreciated significantly but has generated little income, then, upon its sale, the trustee has a duty to reallocate some of the sale proceeds to income, especially if there is a large divergence between principal appreciation and the income that it generated, to compensate the income beneficiaries.
Conversely, if income property is losing value, the trustee must sell it in a timely manner; otherwise the remainderman would be entitled to some of the income to compensate for their loss of principal. The trustee who fails to withhold income generated during the delay may be liable for the difference.
Unitrusts: Allocating a Set Percentage of Trust Principal to Income Beneficiaries
A unitrust is a special type of mandatory trust that simplifies the allocation of income and principal by giving the income beneficiaries a specified percentage of the value of the trust principal every year. This allows the trustee to invest the income to maximize the total return of the trust without worrying about impartiality between the income and principal beneficiaries.
Because the trust principal can vary during the life of the trust, a common solution to quantify the principal is to use a 3-year moving average of the trust principal and multiply it by the unitrust percentage rate to calculate the actual income that will be paid to the income beneficiaries.
Under federal tax laws, income and principal are treated according to the adjustment power or the application of the unitrust percentage provided it is sanctioned by state statute and the amount deemed income is within 3 to 5% of the total value of the trust.
At least 45 states and the District of Columbia have adopted all or portions of the 1997 UPIA, with its adjustment power and stated goal of harmonizing principal and income accounting with prudent investing. Most states also have statutes that allow a trust to be converted to a unitrust as a means of serving the same principle.