Prudent Investor and Principal and Income Act Primer

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:

• What are the provisions of the governing state’s law?
• What does the governing document require? If you are a trustee, you must
  understand the terms of the trust. Meet with an attorney and review your
  obligations, responsibilities, authority, etc.
• What are the generally economic conditions that affect the trust and
  the beneficiaries? What is the likely impact on the objectives of the trust,
  and the investment strategies of inflation or deflation? Your wealth
  manager can provide guidance.
• What are the expected tax consequences of investment decisions? Consult
  with the CPA responsible for the trust income tax planning and
  returns.
• 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 be college in three
  years, the need for liquidity is significant and must be addressed in
  determining an appropriate investment allocation. You may have to poll
  them, depending on state law and the terms of the trust.

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.