Many practitioners don’t realize the Uniform Prudent Investor Act (UPIA) provides two standards for managing and investing trust property.1 The standard most referenced is the general standard. It lays out a litany of requirements:
- A trustee must exercise reasonable care, skill and caution.2
- A trustee must use their special skills or expertise.3
- A trustee must understand the purposes, terms, distribution requirements and other circumstances of the trust.4
- A trustee must develop an overall investment strategy with risk and return objectives reasonably suited to the trust.5
- In developing and implementing their strategy, the trustee must consider:
- General economic conditions
- The possible effect of inflation or deflation
- The expected tax consequences of investment decisions or strategies
- The role that each investment or course of action plays within the overall trust portfolio
- The expected total return from income and the appreciation of capital
- Other resources of the beneficiaries
- Needs for liquidity, regularity of income and preservation or appreciation of capital
- An asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.6
- A trustee must diversify the trust investments, unless they reasonably determine that because of special circumstances, the purposes of the trust are better served without diversification.7
- A trustee must make a reasonable effort to verify facts related to trust investments.8
- A trustee must invest only in the interests of the trust beneficiaries—and not their own or those of third parties (including the settlor to the extent not articulated in the trust instrument).9
- A trustee must invest with impartiality among beneficiaries.10
- A trustee also may only incur reasonable and appropriate costs in investing and managing trust assets.11
- Finally, a trustee must implement their investment decisions within a reasonable time after acceptance of the trust or receipt of the trust property.12
This list is daunting. But there’s an alternative standard for trust investing that applies when a trustee delegates their investment management functions. Before the UPIA, the prudent person rule didn’t allow a trustee to delegate. The trustee had to adhere to the prudent person standard.
In allowing delegation, the UPIA created a second, much shorter and simpler standard. A trustee delegating investment management functions must exercise reasonable care, skill and caution in only the following:
- Selecting an agent
- Establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust
- Periodically reviewing the agent’s actions to monitor the agent’s performance and compliance with the terms of the delegation13
Under the UPIA, a trustee who complies with these requirements isn’t liable to the trust beneficiaries for the decisions or actions of their agent.14 In addition, an agent who accepts the delegated function assumes a standard of reasonable care in its performance and submits to the jurisdiction of the court.15 The trustee’s standard narrows. Meanwhile, the duty shifts to the agent.
Benefits of Delegating
Imagine you’re charged to host a dinner party. You have two options. You can do it all yourself. Or you can hire a caterer. If you take it on yourself, at the end of the night, you’ll be judged by all the aspects of the meal. That includes the food, drinks, preparation, presentation, staging, pairings, ambiance, seating arrangements and so on. Alternatively, if you hire a caterer, you’ll be judged only on: (1) how you select the caterer, (2) how you define their job, and (3) how you monitor their work.
Which option would you choose?
My guess is most people would hire a caterer. Even if you’re a chef (or, especially if you’re a chef), you’re likely to hire out both to avail yourself of the narrower standard and because you know you’re going to need the help.
The situation’s the same with trust investing. A trustee may not delegate functions that a prudent trustee of comparable skills wouldn’t under the circumstances. But this limit wasn’t to undermine the tilt toward delegation. Rather, it was to strike a balance between the advantages of involving an agent’s expertise and protecting against unreasonable delegation—for example, when a trustee delegates but fails to protect the trust for misconduct of its agent.16 It’s also a check against trustees creating excessive fee situations by outsourcing services that should be included under their fees.17
Five Common Pitfalls
The law encourages delegation. Yet trustees have multiple ways to mess it up. Below are several common scenarios trustees put themselves in that lead to delegation mishaps:
1. Two trustees split the job. There are two trustees. They decide one of them will pick stocks and oversee the equity side of the portfolio. The other will pick bonds and oversee the fixed income portfolio. They like this arrangement because they each feel confident in their respective responsibilities.
The problem? They’ve missed the paramount importance of asset allocation—that is, how much is invested in equities, fixed income or other asset classes. It’s always the trustee’s job to provide the parameters that go into the asset allocation strategy. Here, the trustees are also both still involved in determining the overall strategy as it forms the basis of their divided jobs. That applies both in terms of long-term asset allocation goals and tactical decisions that arise as values fluctuate and rebalancing may be appropriate.
In addition, while they may be selecting different types of securities, not doing the job doesn’t limit their responsibility for what the other is doing absent an explicit delegation. Even if we assume they’re each competent to do their side of the equation, it’s unclear whether either of them has effectively delegated anything to the other.
2. An individual and a corporate trustee. When an individual and a corporate trustee serve together, it’s often implied that the corporate trustee will manage the investments and perform much of the administrative work. Meanwhile, the individual will assist in making major decisions. But unless there’s a formal delegation by the individual, the individual remains on the hook for the investments.
The corporate trustee may reinforce the individual’s responsibility by treating the individual as their main client. On one hand, this can align with the oversight requirement of delegation. On the other hand, it can reflect the individual still being responsible for investment functions they think they’ve handed off. Without an explicit delegation, the muddled picture may be positioning the individual trustee for more responsibility rather than less.
At the same time, the corporate trustee may be in a similarly troubling position. The special skills of a corporate trustee can create a higher standard and present concerns of over-delegation. If a corporate trustee with investment capabilities is relying on the individual to guide the investments, they’re working contrary to the UPIA’s intent to capitalize on the specialized skills of the professional investor.
3. Trustee hires managers for each asset class. Trustees often think they’ve delegated all their investment management functions when they hire different managers for the different asset classes of the trust portfolio. In reality, they may have delegated little of what matters in constructing a portfolio.
They’re still determining the asset allocation of the trust. They’re also selecting the managers and deciding when there may need to be a change. These are challenging decisions that involve significant resources and expertise for the professional investors who try to tackle them.
A trustee may feel they’re doing their job by investing with reputable managers and letting them go to work. But the trustee is missing the job they’ve left for themself in setting the overall strategy and overseeing their managers in that context.
4. Trustee tries to keep it simple. Trustees sometimes take what may seem like the opposite approach to Scenario #3. They want to keep costs to a minimum, so they invest in a set of low cost broad asset class passive index funds or exchange-traded funds.
In this scenario, they may think they’ve done their job by removing the risks of active management and aligning the trust portfolio with the asset class benchmarks. But in the context of the UPIA standards, they’re still in Scenario #3. Like Scenario #3, they’ve retained responsibility for the overall strategy, manager selection and making changes along the way. The trustee may have managed the costs of the portfolio, but they haven’t managed their own risk.
If the trustee delegated to an agent the overall asset allocation of the trust, their agent could implement the same low cost approach. The trust incurs the cost of the agent, but that’s consistent with the law’s tilt toward delegation. The largest impact on a portfolio often isn’t the under- or outperformance of different funds. Rather, it’s how much one has in the different asset classes—which is what the agent would provide.
5. Trustee splits portfolio between two managers. As a final scenario, imagine the trustee does what I laid out at the end of Scenario #4. They delegate determination of the overall strategy to an agent. The trustee charges the agent with implementing the asset allocation and monitoring the performance of the different managers. The trustee also puts in place an appropriate framework to monitor the agent’s performance and adherence to scope of the delegation aligned with the terms of the trust. But instead of hiring one advisor to cover the whole trust portfolio, the trustee hires two advisors and gives them each responsibility for half the portfolio.
Assume the trustee is prudent in selecting the agents and otherwise fulfills the delegation requirements of the UPIA vis-à-vis each agent. Are they in the clear?
In general, there are two problems. First, there’s coordination. This applies to each level of portfolio construction. Tactical shifts of asset allocation could cancel each other out. There could be wash-sale issues with managers buying and selling the same securities at the same time.18 The overall asset allocation also may become out of whack. The trustee might deal with these issues by charging the two advisors to coordinate with each other. But that can run into practical issues as advisors may not be accustomed to such an arrangement, and the burden falls on the trustee to provide direction and resolve any conflicts.
The other problem is the horse race. One advisor will always be outperforming the other. And eventually one of the managers may clearly outperform the other. These aren’t necessarily bad problems. The trustee has created an additional point of evaluation for the managers and hedged the risk of a single under-performing manager. But having two horses creates an additional layer of decision making retained by the trustee. The trustee needs to monitor that decision and have a framework to analyze it.
Avoiding the Issues
A trustee can avoid many of the common pitfalls for delegation by following two standard practices for working with an investment professional.
Conduct a request for proposal (RFP). A trustee considering a delegation of investment management functions should conduct an RFP process with due diligence on multiple managers. The trustee can’t delegate understanding the terms, purposes and circumstances of the trust. But the trustee can endeavor to find a field of three or more advisors who have experience working with trustees of irrevocable trusts like the subject trust. While it’s easy for a trustee to find themself connected to an inappropriate manager via an existing relationship or single referral, it’s more difficult to gather a group of three or four inappropriate managers—if the trustee makes sure they all have experience working with similarly situated trustees.
Having created a field of appropriate candidates, the RFP allows the trustee to focus their selection on more specific issues of investment philosophy, performance, fees, firm background, management structure and relationship services. The RFP process is also how the trustee shows they have acted prudently in selecting their agent.
Investment policy statement (IPS). Assuming the RFP process produces a suitable advisor, the normal practice should be for the advisor to develop an IPS with the trustee. The IPS provides guidelines for the manager’s activity. Or, phrased in terms of the UPIA standard, it defines the scope and terms of the delegation.
The starting point for an IPS should be the goals and purposes of the manager’s engagement. For a trustee, that equates with the purposes and terms of the trust. The IPS should also address the review process for the agent’s activities. This may include regular statements sent to the trustee, meeting cadence, performance benchmarks and a framework for review of the IPS itself. A well-crafted IPS fulfills the second prong of the trustee’s delegation standards and sets the path for the third prong of ongoing monitoring.
For many managers, an IPS is a regulatory requirement for all clients. As a result, a trustee typically won’t need to prompt an IPS discussion. But a trustee should be attentive to make sure the purposes and terms of the trust are properly communicated to the manager and captured in the IPS. A trustee should also be attentive to the form of the manager’s IPS to make sure the IPS aligns with a trust as opposed to an individual or other type of client. Finally, the trustee should make sure the IPS includes a periodic review process to monitor the manager’s performance in terms of both established benchmarks for the portfolio and the manager’s adherence to the parameters set forth in the IPS.
Fulfill Responsibility
A trustee’s goal in investing trust assets shouldn’t be to make money. It should be to fulfill their responsibilities as a trustee. Under the UPIA, the most straightforward means to do so in many cases will be to delegate their investment management functions to an agent. As investing, planning, trust law and client needs continue to evolve, trustees and their attorneys should consider delegation an essential tool to serve both the trustees and their beneficiaries.
Endnotes
1. Starting in 1995, the Uniform Prudent Investor Act (UPIA) has been adopted by 45 states and the District of Columbia. Exceptions are Delaware, Florida, Kentucky, Louisiana, New York and Pennsylvania; however, investment standards also apply in those states. In addition, the Uniform Trust Code includes an article with no content, so that the UPIA may be included. While some jurisdictions have their own version of the UPIA or different standards for trust investments, I’ve used the UPIA as the standard for this article. For text and more information, seewww.uniformlaws.org/committees/community-home?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9.
2. UPIA Section 2(a).
3. UPIA Section 2(f).
4. Supra note 2.
5. UPIA Section 2(b).
6. UPIA Section 2(c).
7. UPIA Section 3.
8. UPIA Section 2(d).
9. UPIA Section 5.
10. UPIA Section 6.
11. UPIA Section 7.
12. UPIA Section 4.
13. UPIA Section 9(a).
14. UPIA Section 9(c).
15. UPIA Section 9(b) and (d).
16. Ibid.
17. The trustee’s duty only to incur reasonable and appropriate costs also applies to delegation. Section 7; Section 9 (Comment–Costs).
18. Under Internal Revenue Code Section 1091, losses from the sale or other disposition of stock or securities are disallowed if the taxpayer acquires substantially identical stock or securities within 30 days.