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, it's 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). Just keep in mind that the rules vary by state, and the trust, will, or other governing legal documents can have significant impact on your 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 in order to complete your goal.
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 individual investment is ever per se inappropriate. Rather, each investment is to be evaluated in the context of the overall trust portfolio.
As a fiduciary, you face risks while 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. Although you did not meet expectations, you had the correct intentions. Alternatively, you could delegate investment management to an investment professional, who is probably more familiar with the different investment options. 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:
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 John reaches the age of 28 the trust assets (corpus) are 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 each year, while protecting the 3 siblings assuring appreciation of principal? 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 maximized appreciation of principal for the other siblings. If instead you invested in growth stocks, the siblings 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 names 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 to John. 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 to 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 remainder men. 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, and one should seek advice from his financial advisors.
The moral of this tale, is that the Principal and Income Act and the Prudent Investor Act should be considered whenever investing fiduciary monies and monitored periodically thereafter.
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