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Guidelines for Making Prudent Investment Decisions

When the creator of a trust is living, they can manage their trust and invest it however they wish. When a named trustee assumes control of a trust, however, they have a number of investment obligations and duties. A trustee’s obligations are set forth in The Uniform Prudent Investor Act (UPIA) and include making prudent investment decisions, diversifying trust assets, keeping administrative costs down, and being impartial with respect to the current income beneficiaries and remaindermen.

A trustee must make prudent investment decisions

Under the UPIA, a trustee is obligated to invest trust assets with the care, skill and caution of a prudent investor, and to design an investment portfolio that optimizes returns and acceptable risks (“Modern Portfolio Theory” or “MPT”). Exceptional investment skills are not required, merely average intelligence and the discretion to make sound investments. To do this, the trustee must consider the following:

  • General economic conditions
  • The effects of inflation and deflation
  • The expected tax consequences of their investment decisions or strategies
  • The role of each of their investments and actions within the overall trust portfolio
  • The total expected return from income and capital appreciation
  • The beneficiaries’ other resources
  • The needs for liquidity, regular income, and the preservation or appreciation of capital, and
  • Any particular relationship or value of an asset to the trust or to any of the beneficiaries.

There is no specific requirement for a particular investment return, but prudence must be exhibited in the course of the investment process. Under the revised Uniform Principal and Income Act of 1997, a trustee may delegate their investment strategy and individual decisions to qualified financial advisors, and they generally do so. A trustee must, however, carefully select their advisors, and continually evaluate their decisions and overall investment performance.

A trustee must diversify trust assets

The UPIA also states that a trustee must employ an investment strategy that suits the purpose of the trust and which balances risk and return. Part of this requirement is the duty to ensure proper diversification of investments and due diligence in the management of the trust corpus.

Trust investments are viewed as a whole, and a trustee will generally not be liable if a single asset performs poorly. Furthermore, a single speculative investment is unlikely to be an issue if it is small and facilitates the diversification of the trust assets. A prudent trustee should have documentation showing that the investment was part of an overall, successful investment portfolio.

If the trust directs the trustee to retain specific assets, such as a house or a business, the trustee is generally not obligated to seek out more productive investments. However, if circumstances change that may affect the interests of income or remainder beneficiaries, courts in some jurisdictions have held that the trustee should seek out other investments that better meet their fiduciary duty of prudent investing (see Part III).

A trustee must keep costs down

Trustees are obligated to minimize investment expenses and risk, and to keep both administration costs and taxes down. Note that trust companies serving as trustees are usually permitted to combine the assets of different small trusts to facilitate lower costs and diversification of investments – of course, all while keeping track of whose money is whose!

In Part III, we will conclude our series on the Prudent Investment of Trust Assets with a discussion of impartiality to the income beneficiaries and remaindermen.

Role of the Trustee

When Edna Sue Pate was appointed trustee of her 10 year-old grandson’s $100,000 college fund in 2003, it is unlikely that her relatives knew about her gambling addiction. Or perhaps they thought that her grandmotherly instincts would nevertheless make her a reliable protector of her grandchild’s money.

As far as we know, “Gambling Granny” is still on the run and the $97,000 she stole from her grandson will never be recovered. This sensational story only made headlines for a few days, but the consequences for the child are likely to last a lifetime. The importance of choosing your trustee wisely cannot be overemphasized – and if someone has asked you to serve as their trustee, do not accept the role unless you are prepared to properly manage the funds entrusted to you.

The role and powers of a trustee

A trust instrument provides instructions for management of trust assets during the capacity, incapacity and following the death of a trustee. In the case of a revocable living trust, the owner (also known as grantor or trustor) usually serves as the initial trustee, and names successor trustees who generally have all the power of the initial trustee to manage the trust assets.

Named trustees, however, must manage the trust in accordance with the trustor’s instructions and rules that govern the prudent investment of trust property. Trustees could be sued by the beneficiaries if they fail to:

  • Adhere to guidelines for asset management and expenditures during the trustor’s incapacity and following their death (e.g., buying and selling property, making investments for the benefit of the trust),
  • Follow instructions relating to the distribution of trust assets to the trustor and other beneficiaries of the trust, and
  • Prepare periodic accountings of their management activities.

Investing as a prudent person would

In the past, trusts were comprised mainly of real property, so the trustee was required to do little other than maintain it for a time and then transfer it to the beneficiaries. Today, however, trusts are funded with bank accounts, stocks, bonds and other investments, and trustees are charged with not merely safeguarding trust property but also managing it in a way that it appreciates and generates income.

The idea of setting forth rules for prudent investing by trustees followed the 1830 Harvard College v. Amory verdict. In Amory, the court stated that a trustee is obligated to conduct trust business in the same manner that “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.” The common law Prudent Man Rule (also known as the Prudent Person Rule) thereafter held that unless the trust instrument specifically states what types of investments are permitted, the trust assets should be invested by the trustee as a “prudent man” would invest his own property, taking into consideration preservation of capital, reasonable income, as well as the interests of the beneficiaries.

The majority of states have now adopted the Uniform Prudent Investor Act (UPIA), which we will cover in more detail in Parts II and III.