It is assumed the reader has already reviewed our articles on Wills and Trusts.
The investment losses and trustee experiences of the 1970s was the beginning of the end for the traditional prudent person rule in American trust investment law. This time period showed that long-term bonds were not a financial asset that could be held in portfolios without regard to risk; so-called "one-decision" stocks were not immune from severe price corrections; and inflation and losses in purchasing power were important considerations in long-term investing.
The magnitude of the losses in financial assets during the 1970s became the catalyst for the widespread acceptance of modern theories of risk and risk management in the 1980s. Also, these circumstances were the impetus for change in fiduciary investing in many jurisdictions in the 1980s, including California, that culminated in the promulgation of the Restatement (Third) of Trusts (Prudent Investor Rule) in 1992 [hereinafter Restatement Third]. For trustees and asset managers responsible for investing trust assets in the 21st century, the 1970s illustrate the rationale for the principles of prudence and total return objectives in the subsequently drafted Uniform Prudent Investor Act (1994), herein “UPIA,” California Probate Code §§ 16045-16054 (1996).
At the beginning of the 1970s, long-term bonds were the preferred investment by pension funds, trust portfolio managers, and insurance companies. Under court applications of the prudent person rule, stocks, because of their volatility and speculative history, were viewed by many trustees as having an unacceptable risk of financial liability in the event of investment losses. While these investors recognized that long-term bonds were more volatile than short-term fixed-income securities, bonds offered a higher return with what was perceived as significantly lower risk or volatility than stocks. To a pension fund or trust with fixed obligations for an extended period of time, bonds were an attractive investment.
This view dramatically changed during the unanticipated sharp rise in inflation and interest rates throughout the 1970s. With inflation on a trend basis moving from 4 percent in 1971 to 14 percent at the end of the decade, bond portfolios suffered huge losses. Also distressing to these investors was the fact that the inflation or risk premium for owning bonds proved to be totally inadequate to protect the purchasing power of these fixed-dollar assets. The combined loss in principal and purchasing power made long-term bonds in a rising inflation and interest rate environment just as risky as stocks, but without the higher total returns to compensate for these risks. For conservative minded fiduciaries and investors that were invested primarily in bonds, the magnitude of these losses was a devastating experience.
The 1973-1974 bear market in stocks was an equally devastating experience for equity investors. As a bear market correction of the mutual fund excesses of the late 1960s, the Dow Jones Industrial Average declined 45 percent in less than two years, and only one out of every fifty mutual funds had a positive record at the end of 1974. And many stocks on the speculative American Stock Exchange suffered losses of 80 percent or more.
Even professional money managers and bank trust departments reported alarming losses. Many portfolio managers had been seduced by the idea that certain stocks were immune to severe declines in prices, and could be held in their portfolios on a long-term basis because of their growth fundamentals and value. Following this investment strategy, professional and individual investors rode the disastrous 1973-1974 bear market down with virtually fully invested positions.
In response to the magnitude of these losses, federal legislation recognized the need for a change in direction in pension fund investing, and adopted a new fiduciary prudence standard in the Employee Retirement Income Security Act of 1974 (ERISA). This flexible standard became the model for alterations in the prudent person rule in several states that were attempting to update their standards for fiduciary investing.
Several concerns from the 1970s investment experience would dominate the transformation of the prudent person rule into the modern prudent investor rule. The horrendous losses suffered in many portfolios were due in large part to the concentration of assets in only one asset class. Portfolios comprised primarily of bonds or a limited number of stocks were especially vulnerable during this period. The lack of adequate diversification in these portfolios was viewed as the culprit.
After the 1973-1974 bear market, the popular market indexes moved in a broad trading range for a long period of time. Active management strategies to "time the market" were in vogue during this period as an attempt to outperform the market and as an approach for risk control. These efforts were not successful for most investors, including most professional money managers. When transaction costs and other expenses were factored into the returns, the results proved to be unrewarding. This experience led to the wide acceptance in the 1980s of passive investment strategies that were designed to match rather than outperform a broad benchmark market index. Cost controls and tax considerations relative to portfolio turnover and expected return also became an integral part of the developing prudence standard.
The surprising acceleration in inflation during the late 1970s and its impact on "safe" investments created an ongoing concern for long-term pension and trust investors. Thereafter, their fiduciary responsibilities would always include a consideration of inflation risks and the protection of the portfolio's purchasing power. To meet this standard of care, it was recognized that fiduciary investors would need to take higher levels of risk in their portfolios to preserve purchasing power. Thus, modern theories of risk and return and contemporary investment practices for capital growth replaced the prohibition against "speculative" risk-taking that was the cornerstone of the prudent person rule for more than one hundred fifty years.
THE BASIC LAW OF THE PRUDENT INVESTMENT RULE
The Uniform Prudent Investor Act requires trustees to comply with the highest standard of care in making and monitoring investments for their trusts. The Prefatory Note to the UPIA states that “the tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.” The "heart of the Act," UPIA, Section 2, Probate Code § 16047, directs trustees to consider specific circumstances that “commonly bear on risk/return preferences in fiduciary investing.” Official Text of UPIA, Comment, Section 2. And the Restatement Third makes it clear that portfolio return expectations are related to risk; the expected return from an investment or investment strategy must be adequate for the risk of loss; and trustees must determine an appropriate level of portfolio risk for the purposes and circumstances of their trusts.
This focus on risk in the prudent investor rule requires trustees to consider all circumstances that may affect the trust assets and expected return for individual investments and the total portfolio. “Risk management is concerned with more than the failure of collection and the loss of dollar value. It takes account of all hazards that may follow from inflation, volatility of price and yield, lack of liquidity, and the like.” Restatement Third, § 227, Comment (e).
Trustees also have a "continuing responsibility for oversight of the suitability of investments already made as well as the trustee's decisions respecting new investments." Official Text of UPIA, Comment, Section 2. "Accordingly, in selecting an investment with due prudence, the trustee must examine and weigh numerous factors about the asset and the trust circumstances with care and skill, and with an eye toward an overall level of caution or conservatism appropriate to the trust at the time the investment is made." Restatement Third, Comment (e).
The nonexclusive list of circumstances in the prudent investor rule that are appropriate for trustees to consider in investing and managing trust assets details the extent of their duties of care and skill. Economic conditions and the possible effect of inflation or deflation require an in-dept analysis and active surveillance by trustees. These circumstances are always relevant to the trust and its beneficiaries, because economic conditions determine portfolio growth and expected total returns, inflation reduces the real value of returns and the purchasing power of the trust estate, and deflation endangers trust income and principal.
The arguments in this compliance guide are that the prudent investor rule requires trustees in 2006 to distinguish between speculative-demand economic conditions based on excess liquidity and asset price inflation that significantly increase volatility and liquidity risks, from real, sustainable economic growth that supports long-term investments. And the possible effect of inflation or deflation should be viewed as not only relating to broad price trends in the overall economy, but also to the growth and adjustment price cycles in stocks, bonds, real estate, and commodities.
Compliance with the prudent investor rule is determined in light of the facts and circumstancesexisting at the time of the trustee's decision or action and not by hindsight. UPIA, Section 8, Probate Code 16051. Several practical considerations immediately stand out for trustees with respect to this compliance standard.
First, trustees must consider all facts and circumstances in their decisions or actions that a prudent investor would consider. This is an objective and not a subjective standard, which tells trustees that there are compliance risks if they ignore relevant information. Thus, in an information economy dominated by the media, the Internet, and Federal Reserve Board transparency, attorneys for beneficiaries can always argue that information or circumstances the trustee overlooked or ignored were relevant to the investment management of trust assets, and could have prevented or limited investment losses if included in the trustee's decision or action.
Second, trustees must avoid making errors in analyzing the facts and circumstances under their duty of skill. Their analytic approach must be reasonably supported in concept, and they should view information on risk and return from different perspectives and sources to account for all outcomes. In prudent investing, trustees are required to make sound judgments for all of their duties to comply with the prudent investor rule.
Third, trustees should recognize that a permanent record of facts and circumstances, including historical facts and real-time information on the price of assets, always exists on the trustee's ongoing compliance timeline for judging their conduct and performance. Trustees, therefore, cannot claim judgment by hindsight when the record indicates that relevant information they had a duty to consider with care and skill existed before the event or loss.
Finally, new information and changed circumstances that affect the suitability of investments, the tradeoff between risk and return in investments, and the trust's risk management strategies, will force trustee to reexamine their assumptions and make new decisions or take actions to buy, retain, or sell trust assets. In an evolving global economy dominated by risk, information, and asset price speculation, the modern trustee must be an active portfolio manager or closely monitor the activities of agents or advisors to manage breach of trust and liability risks.
For example, in 2006, there are relevant facts and circumstances that trustees should consider at the time of their decisions or actions to comply with the prudent investor rule. Excess liquidity conditions during the economic recovery after the collapse of the stock market bubble of the late 1990s, not only created a housing boom that dominated the economy in 2003, 2004, and 2005, prolonged monetary accommodation also resulted in a global liquidity and speculative boom in all asset classes and commodities during this period. Put another way, a 1 percent federal funds rate level of monetary accommodation successfully generated high levels of economic activity, household spending, and asset price inflation during the economic recovery, but the economic and financial consequences of this risky strategy to eliminate deflation in the economy after the boom-bust episode of the late 1990s were emerging in 2006 and the wise trustee kept that in mind in making future investment decisions.
Business and investment cycle history proves that when market participants push asset and commodity prices on a momentum basis to unsustainable levels that deviate substantially from historical growth rates, as is typically the case in boom periods and price bubbles, these speculative episodes threaten the economy, jobs, and the investments of long-term investors. The argument in this compliance guide is that in light of the uncertain economic conditions and potential magnitude of inflation or deflation risks inherent in these circumstances, the bar for prudent conduct had been raised substantially for all trustees in 2006.
"But do we have the capability to eliminate booms and busts in economic activity? Can fiscal and monetary policy acting at their optimum eliminate the business cycle, as some of the more optimistic followers of J.M. Keynes seemed to believe several decades ago? The answer in my judgment is no, because there is no tool to change human nature. Too often people are prone to recurring bouts of optimism and pessimism that manifest themselves from time to time in the buildup or cessation of speculative excesses. As I have noted in recent years, our own realistic response to a speculative bubble is to lean against the economic pressures that may accompany a rise in asset prices, bubble or not, and address forcefully the consequences of a sharp deflation in asset prices should they occur." Former Chairman Alan Greenspan, Monetary Report to Congress, July 18, 2001.
So, while a slowdown in the rate of appreciation for homes is one adjustment outcome for the housing market, severe adjustments in home prices or an actual collapse in the most overpriced housing bubbles as was the case in other real estate corrections in the past, are other outcomes that are within the trustee's standard of care as a prudent investor. "At this point, the available data on the housing market, together with ongoing support for housing demand from factors such as strong job creation and still-low mortgage rates, suggest that this sector will most likely experience a gradual cooling rather than a sharp slowdown. However, significant uncertainty attends the outlook for housing, and the risk exists that a slowdown more pronounced than we currently expect could prove a drag on growth this year and next." Testimony of Chairman Ben S. Bernanke, before the Joint Economic Committee, U.S. Congress, April 27, 2006.
The point is trustees as prudent investors should consider all outcomes and threats that could affect economic growth and the value of the trust estate. And prudent trustees do not buy or retain assets at price levels in which the risk of loss outweighs the opportunity for gain over the longer term.
Trustees cannot ignore the fact that price in a market economy does not always correlate with real growth and investment value. When price indicates speculative excesses and crowd behavior in the economy and financial markets, these risk circumstances will force trustees to make decisions or take actions in accordance with their oversight, risk/return tradeoff, and risk management duties to avoid taking excessive risks or bad risks with trust funds.
Accordingly, the sell-off in stocks and commodities in May-June 2006 after the speculative run-up in prices in early 2006, could signal the possibility that greater caution and weakening asset values will result in a boom-bust outcome as this decade unfolds that harms trust assets and investments. These volatile conditions in the economy have complicated compliance with the prudent investor rule and put trustees in a hazardous compliance situation in 2006 and beyond. Trustees and their advisors are required to manage exceptionally high price and liquidity risks when nobody knows, including the Federal Reserve Board, the magnitude of these risks that are specifically mentioned in the prudent investor rule. Disputes over the trustee's conduct are inherent in these trust circumstances, because investment losses are likely to occur during a greater than expected adjustment in the economy and asset prices.
The Uniform Prudent Investor Act clearly separates fiduciary conduct for the investment and management of trust funds from the conduct of private investors investing their own funds. The Drafting Committee of the UPIA recognized that private investors often ignore risk and buy assets solely on a price momentum basis, which explains the emphasis on long-term investment and the tradeoff between risk and return in the prudent investor rule. In fiduciary investing, the standard is how a prudent investor similarly situated would behave in light of the facts and circumstances existing at the time of the trustee's decision or action, and not how a private investor thinks and invests for his or her own account.
The argument in this part is the concepts and duties in the prudent investor rule require trustees to view the speculative excesses in housing and the aggressive speculation in the stock market and commodities in early 2006, as identical risk/return circumstances as the stock market bubble in the late 1990s, the housing mania in the late 1980s, the inflation and precious metals mania in the late 1970s, and the mutual fund mania in the late 1960s. Each of these speculative episodes affected economic conditions and harmed investment portfolios.
Since consensus views typically ignore risk and the potential magnitude of adjustment events, trustees should always consider dissenting views in their analyzes and judgments, because a strong argument can be made that a prudent investor is conceptually a contrarian under the duties of care, skill, and caution to prevent unreasonable investment losses
Increase in the ability to obtain relevant information has also increased the prudent trustee’s duties. It is important to carefully evaluate the trustee's management function in an era of information technologies and real-time surveillance of risks and returns. The compliance areas of particular concern in this regard are compliance timing and the standards for compliance determinations. It has been argued that real-time information and the trustee's oversight, risk/return tradeoff, and risk management duties have combined to significantly accelerate trustee decision-making to stay in compliance with the prudent investor rule.
In addition, all trustees should pay close attention to their diversification and asset allocation duties and strategies after a period when all major asset classes, both domestic and international, were at boom price levels at the same time. The duty to diversify the investments of the trust requires trustees to select investments that are inversely correlated in the portfolio; that is, investments that do not react the same way at the same time to the same events.
The concern for fiduciaries is a portfolio management theory developed in the 1950s or 1960s as an investment strategy to protect investment portfolios from substantial losses in long-term growth investing, may not work as expected in the 21st century when all asset classes are exposed to unusually high volatility and liquidity risks as they are in 2006. As a consequence of these circumstances, trustees may have to adjust their practices and strategies to prevent losses in many diversified portfolios that may be out of proportion to the opportunity for gain.
THE EFFECT ON SMALLER TRUSTS
Trustees of smaller trusts should be concerned with the disproportionate burden placed upon them to comply with the prudent investor rule over the longer term. Under the Restatement Third and the UPIA, the prudent person rule was updated to accommodate the growth and capital appreciation objectives of professional and corporate trustees of large diversified portfolios. "Thus, the objectives of the 'prudent investor rule' of this Restatement Third range from that of liberating expert trustees to pursue challenging, rewarding, non-traditional strategies when appropriate to the particular trust, to that of providing other trustees with reasonably clear guidance to safe harbors that are practical, adaptable, readily identifiable and expectedly rewarding."
The Drafting Committee of the UPIA addressed this disproportionate burden on trustees of smaller trusts. "The Drafting Committee declined the suggestion that the Act should create an exception to the prudent investor rule (or to the diversification requirement of Section 3) in the case of smaller trusts. The Committee believes that subsections (b) and (c) of the Act [Probate Code § 16047 (b) and (c)] emphasize factors that are sensitive to the traits of small trusts...."
This comment makes it clear that unless the prudent investor rule has been altered in the trust instrument in accordance with Probate Code 16046 (b), trustees in small trust situations must understand the same investment concepts and comply with the same duties as other trustees. This standard includes the duty to prudently delegate investment and management functions as appropriate and beneficial to the trust and its beneficiaries.
Each trust situation, however, must be considered on its individual terms and circumstances to judge the prudence of a specific course of action, investment, investment strategy, or portfolio management decision. One of the objectives of the Restatement Third and the Uniform Prudent Investor Act was to prevent what occurred under the traditional prudent person rule when court decisions were "subsequently treated as precedents establishing general rules governing trust investments." Under the prudent investor rule, the incorporation into the trustee's standard of care of duties that relate to the circumstances of a specific trust, and the abrogation of "all categorical restrictions on types of investments" that trustees can consider for their portfolios, make it difficult for a court ruling regarding the prudence of an investment or investment policy in one trust situation, to govern specific investment decisions and the investment policies in completely different trust situations.
In summary, trustees are expected to take advantage of the strong growth history in our economy to protect the interests of income and remainder beneficiaries. The specific sections of the prudent investor rule delineate a course of conduct they should follow to accomplish the investment goals of safety and reasonable returns in a market economy that also has a long history of speculative excesses and booms and busts. Thus, economic conditions, inflation, deflation, risk tolerance, portfolio risk level, risk/return tradeoff, diversification, investment costs, and expert advice are required considerations under the prudent investor rule.
A prudent risk analysis is the essential factor in all of these interrelated duties. In the view of the prudent investor rule, if trustees consider risk or the possibility of loss in their decisions or actions with proper care and skill, they will also exercise an appropriate level of caution in investing and managing trust assets. On the other hand, when risk and the consequences of risk are ignored or overlooked, investors typically overemphasize return in their investment behavior which often results in excessive risk taking or bad risks.
Also, if the trustee does not consider risk as required in the compliance process for one duty, the other duties that are dependent on this analysis may be affected and may not meet fiduciary standards. This could result in the trustee's conduct falling substantially below their standard of care, and raise issues of gross negligence or reckless indifference to the interest of the beneficiary.
The point is trustees have a duty to consider all outcomes and threats in their judgments after the excess liquidity/speculative-demand economic conditions that dominated the economy during the post-bubble expansion. Business cycle history shows that these conditions and the increased volatility and liquidity risks associated with the run-up in prices and speculative excesses have preceded every major adjustment in the economy and asset prices.
In practice, it will be difficult for trustees to justify their conduct and avoid liability for investment losses if their care, skill, and caution are not commensurate with the potential magnitude of adjustment risks and high-impact events. The regulatory objective of the prudent investor is to give beneficiaries easy access to the courts for review of the trustee's conduct and compliance in these uncertain economic conditions. And the courts are directed to review the conduct of everyone associated with the investment and management of trust assets. When there is a delegation of investment and management functions under the prudent investor rule, "an agent submits to the jurisdiction of the courts of this state." UPIA, Section 9(d), Probate Code 16052(d).
The jurisdictions that have adopted the Uniform Prudent Investor Act, which include California, are telling trustees that the beneficiaries do not assume all of the risk of loss in these boom-bust economic conditions. Trustees are required to grasp the magnitude of the threat in these risk circumstances under the duties of care, skill, and caution to prevent unreasonable losses in their portfolios regardless how these circumstances unfold in the future. This standard of compliance will not be judgment by hindsight; it should be the expected application of the prudent investor rule in an information economy by most courts intent on protecting the trust assets and the interests of the beneficiaries from imprudent trustee behavior.
Practical Steps the Trustee Should Take and Points to Keep in Mind.
1. The standard of prudence applies to the trust as a whole rather than to individual investments, with a realization that particular investments that would have been viewed as speculative and subject to surcharge under old law may be sensible, risk-reducing additions to a portfolio viewed as a whole.
2. The overall investment strategy should be based upon risk and reward objectives suitable for the trust. These objectives will vary widely, depending on the circumstances in each trust arrangement. A trust for an elderly widow of modest means will have a lower risk profile than a trust for a wealthy young person. However, both trusts will be concerned with preserving the real purchasing power of the trust and the effects of inflation on that power, a factor that was often ignored under prior law.
3. There is a duty to diversify unless the trustee reasonably determines that it is in the interests of the beneficiaries not to diversify, taking into account the purposes and terms of the governing instrument. The UPIA has so enhanced the long-standing duty to diversify as to fundamentally change it. While prior law also stressed diversification, it did so on a more limited basis, stressing diversification within an asset class without also stressing diversification across asset classes.
4. No particular investment is inherently prudent or imprudent. The premise of the rule is that trust beneficiaries are better protected by increasing the trustee’s responsibilities and powers than by per se restrictions or safe harbors.
5. A corporate fiduciary or paid professional advisor acting as fiduciary is accountable under a special investment skills standard.
6. Delegation is permitted, encouraged and in some cases required. The UPIA reverses the anti-delegation rule of prior law. This change recognizes that prudent investing may require the use of outside expertise in some circumstances by both professionals and non-professionals.
7. The trustee’s liability for improper conduct will be measured by reference to the total return that should have been expected from an appropriate investment program. Thus, a positive return will not necessarily protect a trustee from liability.
The UPIA and Modern Portfolio Theory
One cannot read the UPIA, the Restatement (Third) and the commentary thereto, as well as the various state legislative histories, without concluding that modern portfolio theory is the intellectual underpinning of the UPIA.4 The UPIA is clearly the result of a consensus about the significance of modern portfolio theory and the realization that the law and the markets should have similar views regarding prudent investment practices. While the UPIA is a process-oriented rule, it is not merely procedural. Much of the investment process required by the UPIA relates to substantive tasks that require a familiarity with modern portfolio theory; a professional trustee is presumed to have this knowledge. As the Restatement (Third) makes clear, a trustee who strays from the basic tenets of modern portfolio theory must carry a burden of persuasion as to the reasonableness of his or her actions.
There are no universally accepted and enduring theories of financial markets or prescriptions for investment to provide clear, specific guidance to trustees and courts. Varied approaches to the prudent investment of trust funds are permitted by the law. This does not mean, however, that the legal standard of prudence in trust law is without substantive content or that there are no principles by which the fiduciary’s conduct may be guided or judged. A trustee’s approach to investing must be reasonably supported in concept and must be implemented with proper care, skill and caution. Furthermore, although competing theories of investment provide some conflicting signals, they also offer some consistent themes.5
Another prominent commentator has reached the same conclusion: "The field is sufficiently well-developed and scientifically grounded that no financial advisor should feel safe in ignoring its teachings."
Modern portfolio theory refers to the process of reducing risk in a portfolio through systematic diversification across asset classes and within a particular asset class. It involves the relationship between risk and reward. It assumes that all investors desire the highest possible returns while bearing the lowest amount of risk and that public markets are generally efficient. To increase the return, an investor must incur more risk.
A well-diversified portfolio minimizes the risk that a particular investment will not perform well (firm-specific risk) and leaves a portfolio exposed only to market risk. Investors without an efficiently diversified portfolio are exposed to unnecessary risk, which will not be compensated by the market.8
Thus, modern portfolio theory focuses on portfolio selection rather than simply buying securities viewed as undervalued. Having determined their risk tolerance, investors should then assemble an optimal portfolio along what is called the "efficient frontier," which maximizes potential returns at the desired level of risk.
While major advances have been made in understanding financial markets and the investment process, there are many unsettled areas. For example, there is disagreement about the degree of efficiency of public markets. Thus, modern portfolio theory and the UPIA allow for many alternative strategies.
The UPIA and the Investment Process
In a sense, the UPIA "deregulates" trust investments. The UPIA rejects generalizations and labels as inappropriate to the complicated process of trust investing. A trustee can choose any investment for a trust and not be responsible for the performance of the investments if the trustee has properly conducted the process required by the UPIA.
The UPIA assesses the trustee’s liability by the investment process, not the outcome. Under prior law, the investment process was also an important element in assessing trustee liability, but evidence of careful deliberation was usually sufficient to protect a trustee, as long as the trustee had avoided investments that could be deemed "speculative."
However, the process required by the UPIA includes important substantive elements. Unlike other process rules, such as the business judgment rule, it includes requirements as to how the business—investment management for trusts—is to be conducted. A trustee must be familiar with modern portfolio theory to conduct the process. A trustee who does not incorporate these concepts into its investment process probably will not be saved by an otherwise impressive paper trail.
UPIA Section 2(f) charges a trustee with special skills or expertise to use those skills or expertise. This is familiar law but the comment thereto implies that all professional trustees will be held to a single high standard that will not vary by location or amount of assets under management. The notion seems to be that the basic tools and knowledge necessary to manage risk in a professional manner are available to any professional, wherever located. Smaller organizations in rural locations will probably be held to the same standards as their larger counterparts.
The UPIA’s protection from liability depends upon the trustee’s ability to demonstrate that it has met this heightened standard. A trustee is at risk, even with a positive return, if the trustee cannot demonstrate that it conducted a thorough and ongoing process for each trust, incorporating the current standards in the investment management industry (including risk and return assessment and efficient portfolio selection).9
It is important to recognize that this process imposes considerable new responsibilities on professional trustees, and is a significant departure from prior law.10 A professional trustee should not remain in the business unless it has the resources required by the UPIA process and that it can prove its compliance.
The UPIA recognizes that the key task of the trustee is to manage risk in order to realize the trust’s objectives.11 The UPIA Official Commentary states that Section 2 is "the heart of the act" and that it is intended to sound "the main theme of modern investment practice, sensitivity to the risk/return curve." Prior law emphasized the avoidance of risk but modern portfolio theory has established that, without risk, there will be no rewards. The UPIA requires a trustee to take on the level of risk appropriate to the trust and to manage the risk.
Under the UPIA, risk is managed through efficient diversification. Trust law has long required it. However, prior law required little more than not putting all your eggs in one basket. UPIA Section 3 greatly enhances the duty of diversification. It is clear that the Restatement (Third) and the UPIA require that diversification be systematic and that it eliminate uncompensated risk.12
Prudence is not self-evident under the UPIA. Section 8 states that the trustee’s liability will be assessed "in light of the facts and circumstances existing at the time of a trustee’s decisions and not by hindsight." Thus, the trustee must be prepared to carry a burden to justify each investment in relation to a portfolio strategy that the trustee has developed as suitable for the risk level appropriate to each particular trust.
THE THREE STEPS IN THE INVESTMENT PROCESS
The trustee’s investment process under the UPIA can be viewed in three steps. The trustee must first evaluate the needs and purposes of the trust and determine the appropriate risk level. The trustee must then decide on an appropriate long-term investment policy suitable for that level of risk. Finally, the trustee must implement that policy through a strategy of selecting individual investments.
Some trusts require income, while others are oriented toward total return. As trusts differ considerably in their risk-bearing capacities and needs, a trustee must determine the appropriate risk profile for each trust through a detailed and systematic process. The plain language of the UPIA compels this conclusion. Section 2 requires that the trustee consider the "purposes, terms, distribution requirements and other circumstances of the trust" and develop "an overall investment strategy having risk and return objectives reasonably suitable to the trust." It provides a non-exclusive list of the factors a trustee must consider: general economic conditions, possible effects of inflation or deflation, expected tax consequences of investments and distributions, the role of each investment in the portfolio, the expected total return of the portfolio, and the liquidity and income needs of the beneficiaries. While trustees have always been charged with a familiarity with the purposes and needs of a trust, the UPIA increases that duty.
A trustee cannot simply label a trust as having a "conservative" risk profile and proceed accordingly. It must conduct and document a process to gather, record and analyze information about each trust’s time horizons, cash flow needs, risk aversion, tax status, intentions and other factors, not only at the trust’s inception, but on an ongoing basis. A primary purpose of this exercise is to generate the information necessary for a trustee to determine the "efficient frontier" for each trust.
Asset allocation is the long-term structuring of a portfolio to achieve particular objectives over an extended period of time.14 It is the investment policy that precedes investment selection. Every investment can be classified within a certain asset class. Whether explicit or implicit, every investment is part of an asset allocation. Every investment is the result of a determination that the asset class is itself appropriate for the portfolio.
The trustee makes long-term policy decisions in the asset allocation process about the types of investments appropriate for the purposes and risk profile of each trust. As asset classes have quantifiable risk characteristics, just as individual investments do, it is a distinct process from the selection of individual investments.
There are various views about asset classes but they would seem to include
Large-cap, medium-cap and small-cap equities
Foreign equities with the same subdivisions but further subdivided by region and market development
U.S. government and agency obligations (all debt instruments would be further subdivided by maturity)
Tax-free municipal debt
Foreign sovereign debt
U.S. corporate debt (investment grade and high-yield)
Foreign corporate debt
UPIA section 2’s requirement that the trustee develop an "overall investment strategy" to "incorporate risk and return objectives reasonably suitable to the trust" and UPIA Section 3’s enhanced diversification requirement underscore the importance of the asset allocation process under the UPIA. The starting point of diversification is the consideration and selection of asset classes appropriate to the risk profile of each trust.
There is significant economic research concluding that most of the return of investments in a particular asset class is a result of the basic decision to invest in that asset class. The added value by the selection of a particular asset within the class is minimal.
While delegation of the investment function may sometimes be appropriate, it seems unlikely that a professional trustee could delegate evaluation and asset allocation in ordinary circumstances, given UPIA Section 2(f)’s professional trustee standard and UPIA Section 7’s requirement that the trustee minimize costs. Thus, "asset allocation" is one of the trustee’s principal responsibilities under the UPIA. A prominent law professor who acted as reporter to the UPIA project is of the same view:
Increasingly, the main work of the fiduciary investor will be what has come to be called asset allocation. The trustee will form a view of the needs, resources, and risk tolerances of the beneficiaries of the particular trust. The trustee will then decide what proportion of the portfolio to invest in what classes of assets. These choices will take the form of allocating the trust assets among large, diversified portfolios, primarily mutual funds and bank common trust funds.
No particular asset class is mandatory, nor are there a minimum number of asset classes that must be considered. However, the trustee’s process should at least reflect consideration of alternative asset classes. While a trustee could invest in a single asset class, the trustee must be prepared to justify that decision. Informed diversification and risk management means more than just multiple baskets. The trustee must also determine the right amount to put in each basket.
Asset allocation is not just a pie chart illustrating the categories of a portfolio. It should be a formal, ongoing recorded process which, based on the trustee’s considered evaluation of each trust and the principles of modern portfolio theory, guides the selection of investments for the trust’s portfolio to its "efficient frontier." Intuition, unsupported conclusions and mere labels will not meet the standards of the UPIA.
Prior law looked at each investment in isolation while the UPIA looks at the entire portfolio. While the trustee can invest in "any kind of property or type of investment consistent with the standards" of the UPIA, each investment must have a role in a well-diversified, efficient portfolio. Thus a trustee cannot simply buy securities it believes to be undervalued unless it has considered (and recorded in some meaningful way) how those securities fit into the portfolio plan based on an evaluation of the needs and purposes of the trust. Thus, under the UPIA, investing is part of a process rather than an independent function.
Since optimal diversification may require participation in large portfolios, a professional trustee may be required to use pooled investments in certain circumstances.
Significant diversification advantages can be achieved with a small number of well-selected securities representing different industries and having other differences in their qualities. Broader diversification, however, is usually to be preferred in trust investing. Broadened diversification may lead to additional transaction costs, at least initially, but the constraining effect of these costs can generally be dealt with quite effectively through pooled investing. Hence, thorough diversification is practical for nearly all trustees.
There is, as of yet, little case law regarding the UPIA. Because of its significant changes from prior law, it is possible that it may take some time for the case law to develop. However, the Restatement (Third), comments to the UPIA, ERISA case law and other formative materials provide a wealth of background as to its intended purposes.
The UPIA sets a more demanding process-direct standard for professional trustees than that of prior law. While the trust investment process has always been important, the UPIA adds substantive elements. A paper trail will be of little value unless it reflects an understanding and consideration of risk in accordance with the basic tenets of modern portfolio theory. The UPIA should protect a trustee who observes this process but puts at risk a trustee who does not, regardless of the success of the portfolio.
A Final Thought
A substantial percentage of the American workforce are either direct or indirect participants in the securities markets. This has come about in a period when the domestic equity markets in particular have risen dramatically. It would be a fool’s errand to expect that this growth will continue indefinitely. At such time as the inevitable correction occurs, it is not unreasonable to assume that the methods used by financial intermediaries—be they investment advisors, trustees, financial planners or brokers who dispense investment advice in return for compensation—will be examined retrospectively. In all likelihood, the standard to which their conduct will be held will be the UPIA.
Obviously, it is not sufficient that hindsight might suggest that another course might have been more beneficial; nor does a mere error of investment judgment mandate a surcharge. Our courts do not demand infallibility, nor hold a fiduciary to prescience in investment decisions. Further, a non professional trustee is likely to be held to a lower level of performance than the professional trustees.
Nevertheless, the wise trustee will take a far more active role in investment analysis and decisions as described herein. That is the lesson and warning of the new rules being formulated by statutes and case law.