Yeah, everyone knows all about modern portfolio theory and all that stuff. Yawn. But an amazing number of people still think they can live on CDs for 25+ years of retirement - where's your inflation hedge? Individual trustees rarely seem to use investment policy statements (IPS) - try to catch an institutional trustee without one! Every family investment FLP/LLC is formed solely for non-tax reasons (well that's what you tell Judge Laro), yet how many even have an IPS? Well, its time to give your wealth manager a hug, get an IPS for each investor: every trust, LLC or other investment entity. Give some respect to the Prudent Investor Act (PIA) (not as in Zadora). The rules vary by state. The trust, will or other governing legal documents can have significant impact on planning. Each investor's circumstances are unique and impact the conclusions.
PIA governs how assets owned in trusts, estates, guardianships and other fiduciary relationships (trusts) are invested. Previously a fiduciary was required to invest to preserve principal. PIA recognizes modern portfolio theory, including the need for diversification and allocation of investment dollars amongst asset classes to maximize total return (capital appreciation, dividend and interest payments) while minimizing risk. Sitting on T-bills won't work, but an allocation to bonds, stocks, international bonds and equities, etc. in accordance with a plan that considers relevant goals and circumstances will. But another part to the puzzle is needed.
Modern portfolio theory suggests that with properly diversified investments the rate of return can be maximized while minimizing the risk for that target rate of return. Under the Prudent Investor Act no investment is ever per se inappropriate. Rather each investment is to be evaluated in the context of the overall trust portfolio.
You face risks as a fiduciary making investment decisions. If the portfolio performance is less than some industry benchmark, you could be held personally liable for the differential. Ouch! Avoid this liability by having an IPS - an investment policy statement. This is a detailed document demonstrating why and how the investment plan was selected, and the reasonableness of the plan at inception. If you comply with the requirements and have considered all relevant factors you should avoid liability because the Prudent Investor Act is a process, not a performance guarantee. Alternatively, you could delegate investment management to an investment professional. This does not obviate you of all responsibility to monitor the investment professional, but does give you protection. Have periodic (annual or quarterly) meetings to review the IPS, investment results, etc. If the trust is organized in a state, like Delaware, which permits "direction" of investment management, the investment professional will assume almost all responsibility. This is a safer approach.
If there a special relationship of the asset to the purpose of the trust, to the grantor, or the beneficiary, such as a closely held business, it must be addressed. The Prudent Investor Act generally requires a diversified portfolio unless the trust specifies otherwise. Trust language could state whether the business should be held, when it can be sold, and under what conditions. Any concentrated asset position (family business, prime real estate holding, significant position in a public company) should be addressed in the governing documents.
When investing trust funds, consider the following:
o What are the provisions of the governing state's law?
o What does the governing document require? If you are a trustee, you must understand the terms of the trust. Meet with an attorney and review your obligations, responsibilities, authority, etc.
o What are the generally economic conditions that affect the trust and the beneficiaries? What is the likely impact on the objectives of the trust and the investment strategies of inflation or deflation? Your wealth manager can provide guidance.
o What are the expected tax consequences of investment decisions? Consult with the CPA responsible for the trust income tax planning and returns.
o What other resources do the other beneficiaries have and should they or must they be considered? What is each beneficiary's need for liquidity? If you are managing a trust for a child age 15 who will be college in three years the need for liquidity is significant and must be addressed in determining an appropriate investment allocation. You may have to poll them, depending on state law and the terms of the trust.
The flip side of the Prudent Investor Act "coin" is the Principal and Income Act. The two work hand in hand. If you have to invest trust assets in a diversified portfolio to comply with the principal and income act, how can you be fair to the current beneficiary (the recipient who receives distributions during the primary term of the trust), while remaining fair to the remainder beneficiary (the recipient who receives the assets of the trust after the current beneficiary's interest ends). The trustee's investment dilemma is to invest to generate income for the current beneficiary, while protecting principal from inflation for the benefit of the remainder beneficiary.
The problems of investing trust monies can be illustrated with an example. Aunt Edna died naming you trustee of a trust under her will for her child John. John is the "income" beneficiary of the trust. All income is to be distributed to him each year. When attains the age of 28 the trust assets (corpus) is to be divided among Aunt Edna's four children. How do you invest in a manner that is both fair to John assuring an income, while protecting the 3 sibs? The Principal and Income Act gives guidance to impartially resolve this conundrum, and rules so you can invest as modern portfolio theory requires. You could simply opt to buy high yield bonds to generate income for John. However, when the trust terminates and all children share equally in the remaining trust assets the sibs will have had their economic interest compromised because the investments that maximized income for John would not have maximize appreciation of principal for the sibs. If instead you invested in growth stocks, the sibs would love you, but John might starve.
How do you reconcile this? The Principal and Income Act may permit you to use a total return uni-trust payment. This can be illustrated with an example. Assume Aunt Edna's $1M trust pays John 4% of the trust value each year. This gives John as the "current" instead of "income" beneficiary $40,000 per year. With this type of payment, instead of having to maximize income, the trust could invest for total return which would benefit all beneficiaries. If the trust principal increased in value from $1M to $1.1M, than 4% of the fair value, $44,000, would be paid. This gives you as trustee the flexibility to invest in an array of assets to maximize overall return without having to focus on income. It takes you out of the position of having to favor the current versus the remainder beneficiary, or vice versa. All beneficiaries benefit as a total return investment philosophy is pursued.
If the uni-trust approach will solve your dilemma, how can you address this in the trust that was drafted without this provision? State law may permit you as trustee to modify an existing trust to conform it with the total return uni-trust standards. Thus, you may be able to convert an income payout trust, to a trust that pays out a stated percentage of value each year as illustrated above. The typical range of payout percentages is from 3% to 5%. Other states permit a periodic adjustment between principal and income payment in order to keep the trust payout in line with a total return investment philosophy.
There are practical issues to consider. Making a mandatory uni-trust payout creates a cash stream that a creditor could attach. It's preferable to have a discretionary trust. What is the grantor's real intent? For many by pass trusts the deceased spouse's primary interest is providing for the surviving spouse, not protecting the children as remaindermen. Wide swings in investment performance can make uni-trust payments too high or low. The answer may be to create floors and caps to smooth the amounts to be paid. Implementation can become complex.
The moral of this tale is that the Principal and Income Act and the Prudent Investor Act should be evaluated whenever investing fiduciary monies and monitored periodically thereafter.
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