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?
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 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:
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.
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.
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:
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.
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:
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.
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