ULC

Prudent Investor Act Summary

Trustees of trusts and like fiduciaries have been subject to rules severely restricting the types of investment modalities in which they can invest the assets of the trusts that they administer and manage.  Interest bearing instruments—safe income—of limited kinds (no junk bonds) are the limit of risk permitted or thought to be permitted under the traditional rules.  Protect the paper value of the principal at all costs is the mandate for trustees.  In addition, a trustee's performance is rated by the performance of each and every investment, singly, and not on the performance of the whole of the portfolio.  And trustees have been precluded from obtaining professional investment help.

The result for trusts is modest income production at best without regard for the erosion of a trust's assets by inflation.  Can it be that these rules miscalculate the real risk and actually jeopardize the assets of a trust rather than provide for their protection? 

The answer is yes.  And a remedy is now at hand in the Uniform Prudent Investor Act (UPIA), promulgated by the Uniform Law Commissioners in 1994.  The adoption of this act by the state legislatures will correct the rules, based on false and damaging premises, that now govern the actions of trustees.

By no means does UPIA turn trustees into unrestrained speculators.  It provides rules governing investment that, in fact, result in greater protection for the trust's assets while providing a prospect of better income.  UPIA does not encourage irresponsible, speculative behavior, but requires careful assessment of investment goals, careful analysis of risk versus return, and diversification of assets to protect them.  It gives the trustee the tools to  accomplish these ends.  UPIA requires trustees to become devotees of "modern portfolio theory" and to invest as a prudent investor would invest "considering the purposes, terms, distribution requirements, and other circumstances of the trust" using "reasonable care, skill, and caution." 

The trustee has a list of factors which must be considered in making investment decisions, including "general economic conditions," "possible effect of inflation or deflation," "the expected total return from income and the appreciation of capital," and, "other resources of the beneficiaries."  The trustee must take tax consequences of investment decisions into account.  There is a positive obligation to diversify assets "unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying."  The trustee's obligations are significant, requiring sophisticated approaches to investment that really take into account the right risk to return ratio for the particular trust.

In addition, a trustee's performance in UPIA is measured by the performance of all the assets together.  A loss with respect to a single asset does not mean that the trustee has violated his or her fiduciary responsibilities.  The act takes the truly holistic approach to investment practices. 

In return for these obligations, UPIA removes any restrictions upon the types of investment modalities which may be chosen in a trust's portfolio.  It is quite possible, for example, to hold positions in high-interest bonds (junk bonds) or mutual funds investing in such bonds, in a diversified portfolio, if such an investment meets the needs of the particular trust in light of the risk/return analysis specific to that trust.

One of the boons to trustees of smaller trusts is the ability to invest in mutual funds.  Mutual funds reduce investment risk by diversifying their portfolios.  By using mutual funds, a trustee of a trust that does not have a large enough corpus to effectively diversify its assets can enhance diversification of the trust's portfolio to limit the trust's risk of loss. 

UPIA also permits the trustee to delegate investment and management functions "that a prudent trustee of comparable skills could properly delegate under the circumstances."  Careful selection of the agent and careful, periodic review of the agent's actions are part of the trustee's responsibility when delegating authority.  An agent has a responsibility of reasonable care in conducting the delegated business of the trust.

Why is it that the prudent man rule of prior law may, in fact, jeopardize the assets in a trust?  Some of the instruments in which trustees have been able to invest have become more volatile in price.  Treasury bonds, for example, long thought to be safe investments, now fluctuate considerably in value with the fluctuation of interest rates.  The former so-called safe investment may not be so safe anymore.  In contrast, common stocks have shown consistently better returns over the years than bonds - yet trustees have been prevented from investing in common stocks.  Stocks have been historically safer investments, therefore, in diversified portfolios than bonds have been.  Trusts have been deprived of return at some greater risk by the antiquated rules that govern investment of their assets. 

By far the most insidious damage to trust assets comes from inflation.  If trustees cannot invest in modalities that exceed the rate of inflation in return, the inevitable result is diminution of the corpus of the trusts they manage.  The beneficiaries of trusts so restricted lose in all ways, both with respect to income and principal.

The UPIA provides rules that can be modified or waived in the trust agreement.  Any person who wishes to put property in trust and who wants to provide different standards of conduct for the trustee is permitted to do so under UPIA. 

UPIA provides a reasonable approach to the investment of trust assets that better meets the needs of beneficiaries while preserving trust assets.  It should become the law in every state as soon as possible.