Prudent Investor Act and Principal and Income Act: Planning Primer

Must Knows for all Estate Planners

The Prudent Investor Act that has been enacted in various forms in most states has changed the laws regarding investing assets owned in trusts, estates, guardianships and other fiduciary relationships. Previously, a fiduciary was required to invest solely to preserve principal. The current law recognizes modern portfolio theory, including the need for diversification and allocation of investment dollars amongst a wide array of asset classes, in order to maximize total return (capital appreciation, dividend and interest payments) while minimizing risk.

The Principal and Income Act is really the flip side of the Prudent Investor Act. How can you invest trust assets in a diversified portfolio while being fair to both beneficiaries?

• a current or income beneficiary (the current recipient who receives income during the primary term of the trust), and
• a remainder beneficiary (the recipient who receives the assets of the trust or estate after the current beneficiary's interest ends).

Uncle Joe died, naming you the trustee of a trust under his will for his child Samantha. Samantha is the income beneficiary of the trust. All income is to be distributed to her or for her benefit (e.g., tuition) each year. When Samantha is 25 the money gets divided among all the children. How do you invest in a manner that is both fair to Samantha assuring an income flow, while protecting the other children by maintaining the principal? The Principal and Income Act gives you guidance to impartially resolve this conundrum, and allows you to invest as modern portfolio theory requires.

CPAs, attorneys and financial planners, regardless of career paths, are frequently named as fiduciaries. It is likely that you will be named by family, friends or clients as a fiduciary. You are expected to have the expertise to understand how to carry out your duties.

The Prudent Investor Act - What it is and What it Means

The Prudent Investor Act is a reaction to antiquated views of how investments should be handled. In the past, laws generally dictated that a trustee had to preserve the principal of the assets that they were responsible for. However inflation is a significant factor, and can erode underlying principals. Thus, merely preserving principal is inadequate. The trustee's investment dilemma was to invest both to generate income, and to protect principal from inflation.

Modern portfolio theory is based on the fact that utilizing many investment markets is efficient, and therefore, the decision of which asset categories an investor selects to invest in is more important than the selection of specific assets within a category. For example, the allocation of a portion of a portfolio to small cap equities is more important than the choice of a particular stock. Research has demonstrated that over 90% of the risk of a portfolio can be explained by the allocation of dollars to different asset categories. If a portfolio is properly diversified, the rate of return can be increased without raising risk, or alternatively, the rate of return can be maintained while reducing risk.

The Prudent Investor Act allows fiduciaries to invest based upon modern portfolio theory. No investment is ever, per se, inappropriate. Rather, each investment is to be evaluated in the context of the overall trust portfolio. This also increases the responsibility, required expertise, and risk to you as serving as a fiduciary.

The Prudent Investor Act varies by state, so that you must review the specifics of the law in your state. This is not simple in a mobile society, since many trusts are shifted from state to state and may have connections to different states. There is also a host of other matters which you as a fiduciary must consider:

• What are the provisions of your state's law, including any applicable case law or ruling that elucidates the typically broad and general language of the statute?
• What does the governing document require? If you are an executor, you must understand the terms of the will. Meet with the attorney for the estate or trust and have them review with you your obligation, responsibility, and authority.
• What are the general economic conditions that affect the trust and the beneficiaries?
• What are the expected tax consequences of investment decisions?
• What is the likely impact on the objectives of the trust and the investment strategies of inflation or deflation?
• 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 attend college in three years, the need for liquidity is significant and must be addressed in determining an appropriate investment allocation.

Finally, you must understand the risks that you face 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. There are two ways to avoid this liability.

First, draft an investment policy statement, a detailed document demonstrating why and how your investment plan was selected, and the fairness of the plan at inception. If you comply with the requirements and have considered all the factors, you should avoid liability. This is based on the fundamental principal of the Prudent Investor Act that investing is a process, not a performance guarantee.

The second approach, which is a major innovation in fiduciary planning, is that you can delegate an investment to an investment professional if investment is not your area of expertise. This does not obviate you of any responsibility to monitor the investment professional, but does provide you with protection.

Business Interests under the Prudent Investor Act

Is there a special relationship of the asset to the purpose of the trust, to the grantor, or the beneficiary? This must be addressed for every closely held business, where a trust holds a significant concentration of a business. The Prudent Investor Act generally requires a diversified investment portfolio with allocation to various asset classes. If 80% of the trust assets consists of an insurance policy or stock in a close business, the diversification rules could undermine the purpose of the trust.

These issues should be addressed at the planning stage, so that the trust instrument expressly permits that specific assets be held. It may authorize you to hold a particular business, but not mandate that the asset be held, because that would prevent you from selling the asset in case it became essential. Thus, the language should state when it can be sold and under what conditions. Too often, people with concentrated asset positions, whether it be a family business, a prime real estate holding, or a significant position in a public company, do not address this in their documents. If you are the fiduciary, or a CFO for the business, these issues must be addressed.

Principal and Income Act

Now that the Principal and Income act has been explained, the issue of how to actually implement this in a fiduciary context is an issue addressed by the Principal and Income Act.

The problems of investing trust monies can be illustrated with our hypothetical example of planning for Samantha's trust:

• While Samantha was a minor, you could have simply opted to buy high yield bonds. Her trust would generate income to her and it could be distributed to her under the provision of the trust that requires you to distribute income quarter annually to, or for (e.g., directly pay for tuition), the beneficiary. However, when Samantha attains the age of 25, all the children share equally in the remaining trust assets. The other children will very likely have had their economic interest substantially compromised, because the investments that maximize income do not typically maximize appreciation or principal. Thus, the children receiving the 'remainder interest' (what is left after the trust ends) are hurt.
• If instead you invested all trust monies in growth stocks, the minor child until age 25 may receive virtually no income. This could be devastating to Samantha, and contrary to the grantor's intent. Meanwhile, the other siblings, as remainder beneficiaries, would benefit.

How do you, as the fiduciary, reconcile these irreconcilable differences? The Principal and Income Act provides several concepts.These concepts are critical to understand when helping clients plan for trust provisions, advising fiduciaries, and more importantly for you as a CPA or attorney serving in a fiduciary capacity as a trusted advisor or family member.

In order to implement the total return investing concept advocated by modern portfolio theory, trusts should be structured differently than merely paying income to an income beneficiary and then distributing the balance to the remainder beneficiary.A preferable way would be to use a total return uni-trust payment.This is best illustrated with a simple example.

Assume Uncle Joe's million dollar trust is set up for Samantha so that 4% of the trust's value each year is paid as a current distribution. This would give Samantha (the 'current' beneficiary) up to age 25 a payment of approximately $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 $1,000,000 at inception to $1,100,000 in the second year, than 4% of the then fair value, or $44,000, would be paid out. 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.

Given the advantages of this approach, how can you address this in a trust that has already been drafted and does not include this? Many state laws permit you as the trustee to modify an existing trust to conform it to the total return and uni-trust standards. Some state laws permit you to convert an income payout trust, illustrated in the hypothetical example, 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%. Although these rates may seem low to some, a payout of 3% to 4% is approximately the figure that is reasonable to maintain the inflation adjusted value of the principal for the remainder beneficiaries when the current beneficiary's interest ends. Other states permit a periodic adjustment to the principal or income payment in order to keep the trust payout in line with a total return investment philosophy. So, it is critical to not only understand the terms of the governing trust document, but what state law provides for as well.

Practical Issues to Consider in Implementing Prudent Investor and Principal And Income Act Concepts

While the above examples clearly seem to favor a total return trust approach and a uni-trust distribution method, the reality is complicated. The following are a number of practical issues that must be evaluated:

• Asset protection from malpractice claims, law suits, and other risks is a critical goal of almost every individual, especially professionals, business owners, and the wealthy. A total return investment philosophy is consistent with this, but creating a mandatory uni-trust payout is not.Mandating a fixed payout creates a certain cash stream that a creditor could attack. It is preferable to have a discretionary trust, where the trustee could determine the details of a distribution. While this eliminates certainty of distributions to the beneficiary, such an ephemeral distribution is more difficult for a claimant to attack.
• Family dynamics are critical to trust development, and they often change. If a husband sets up an inter-vivos (while alive) QTIP (marital) trust for his wife, and names his brother as trustee, the mandatory income payout may be fine to meet the marital deduction rules. However, if the marriage later ends in divorce, the now ex-wife will have to extract income payments from her antagonistic ex-brother-in-law. Converting the trust to a uni-trust payout under state law, perhaps mandated as part of the divorce proceeding, could solve the problem. To protect and benefit children of different marriages, a uni-trust payment may be an ideal way to eliminate much of the discretion and protect all interests.
• Family business interests are key to planning. If a trust will include solely family business interests, you must provide to what extent, and whether that business should be retained without the need for diversification. With some beneficiaries involved in a family business and others not, this is critical to address. Coordinate with the underlying governing documents of the entity, such as a shareholder's agreement, etc., so that its cash flow is intended to be distributed to all beneficiaries, and it is not diverted in its entirety by a child involved in the business. Where trusts may be comprised as part of business interest and part of other assets such as marketable securities, it is often helpful to provide the ability to divide trusts into separate trusts, so they can each be managed differently.
• Fiduciaries can face a daunting task, even with the apparently simple and logical sounding discussion above. If a trust owns non marketable assets, such as real estate, how can this be valued? Even many investment partnership interests are difficult to value. Applying the Principal and Income Act requires that these assets be fairly valued every year in order to determine a payout. What mechanisms might be provided in the trust to avoid complexity (e.g. simplifying assumptions), undue cost (e.g. value every other year), and adversity concerning the valuation process (e.g., independent appraisal firm).
• What is the grantor's real intent? This is the heart of all of these issues, and is often ignored in the theoretical discussions of the benefits of using modern portfolio theory or uni-trust payouts. Most spouses that set up trusts for the surviving spouse under their wills do so primarily to protect the surviving spouse. Saving estate taxes is often secondary. These goals need to be clearly stated in the trust, so that you as the fiduciary will have guidance as how to act with respect to both investments and distributions. It is possible with a second marriage, or with a special needs beneficiary (learning disabled), that a different approach might be desired. However, it is key in all these instances, for you as the trustee to document the trust's goals.
• If you decide that the right approach is to make an election under state law for a uni-trust payment or an adjustment to principal or income, depending on your state law, should you have the beneficiary sign off?Even if the state law doesn't require this and provides a level of protection, would you be comfortable making such unilateral decision without the approval of the beneficiaries?If you decide not to have them approve it, do you give them notice of the rationale behind your decision, or is it better to remain silent to avoid giving them ammunition to create a challenge?
• When structuring a trust, will wild swings in investment performance create unreasonable payments, to a current beneficiary versus a remainder beneficiary, or vice versa? Will significant changes over periods of time in the inflation or deflation rate have an adverse impact that needs to be counteracted? The answer to some of these issues is to create floors and caps (maximum or minimum amounts) on the amounts to be paid to either the current or remainder beneficiary. Some advisors advocate incorporating inflation adjustments into the amount to be paid to the current beneficiary. When this is done the calculations and definitions become complex.How does one define 'inflation'? Which index should be used? What happens if that index is no longer published 20 years from now?

Conclusion

As society continues to become more complex, and individuals become more conscious of protecting assets from growing divorce rates, malpractice, litigation, and uncertainty over taxes, the use of trusts should continue to proliferate. When trust assets are invested, understanding the implications of the Principal and Income Act and Prudent Investor Act is vital to every accountant, attorney and financial planner. Whether you are involved in consulting with clients, advising industries as to how this affects their personal planning in the very corporations you are working for, or you are being named in a fiduciary capacity as a trusted friend, family or advisor, these are issues you will face at some point in your career.

Caution: The above discussion is general and basic. There are significant nuances to each state's laws governing these issues. The terms of every trust, will or other legal document involved are not only unique, but depending on state law and the circumstances involved, may have a varying and potentially significant impact on the planning. Therefore, consult competent legal, tax and investment counsel, before implementing any planning.