Explanation of the Uniform Prudent Investor Act
The Uniform Prudent Investors Act (UPIA) was a very important change in California trust law. Trustees, as well as persons who advise trustees and those who just have continuing contact with trustees should be aware of the law's effect. It puts a spotlight on investments made by the trustee and may create a large potential for lawsuits against trustees (and their advisors) who ignore the law!
Sources of Trustee Duties and Powers
In addition to the terms in each trust that the trustee must follow, most trusts include a list of powers of the trustee; these powers may be unique to each trust. The California Probate Code sets forth statutory duties for trustees (Probate Code Sections 16045-16054) as well as trustee powers (Probate Code Sections 16200-16249). Federal law also imposes the following responsibilities on a Trustee:
- Requirements to file annual income tax returns;
- Personal liability for payment of any unpaid estate tax on assets directed elsewhere, e.g., distributed to trust beneficiaries.
California's Uniform Prudent Investor Act
The California Uniform Prudent Investor Act is patterned on the Uniform Prudent Investor Act now codified in ten states. The UPIA made five basic changes in the criteria for prudent investing (some of which were already accepted in California):
1. Portfolio: The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. (For some years California has recognized a total portfolio approach to investments.)
2. Risk: The trustee's central consideration is the tradeoff in all investing between risk and return. The UPIA sets forth criteria for investment and management of trust assets and codifies modern trust investment principles.
3. Investments: Restrictions on types of investments are eliminated. The trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investment.
4. Diversification: The trustee's traditional duty to diversify trust investments is codified in the UPIA. (In California, the duty to diversify was previously recognized only in case law.)
5. Delegation: The UPIA rejected the traditional trust rule that generally prohibited delegation of duties by the trustee, especially the duty of investment of trust assets. Delegation is now permitted, subject to safeguards. Agents are now made specifically liable for not following the new law.
Criteria for Investment and Management of Trust Assets (Probate Code Section 16047)
The UPIA abandons the former premise that certain property is not a proper trust investment and must be disposed of. The trustee is specifically authorized to invest in any type of property or investment strategy consistent with the UPIA as long as the overall mix of assets is satisfactory. Decisions as to the retention and disposition of assets are to be evaluated not in isolation but in the context of the entire trust portfolio and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust. For example, a "risky" stock that may have previously been considered an imprudent investment might be part of a prudent portfolio if it provides significant potential for growth.
A change in the analysis of risk is a cornerstone of the UPIA. Risk is viewed as unavoidable. Even fixed income investments involve risk in the sense that they may lose purchasing power as a result of inflation. Risk is often desirable so long as it is sufficiently compensated. An investor can get a greater return if he is willing to accept a greater risk; for example securities, are riskier than cash, but yield a greater return.
The standard of prudence under the UPIA is not based on risk alone, but on considerations of the appropriateness of the level of risk under all of the circumstances. The UPIA seeks to compel trustees to analyze the tradeoffs between risks and returns, taking into consideration the needs and objectives of the trust. The trustee should then choose the portfolio level of risk and anticipated return appropriate to the trust.
The UPIA (Probate Code Section 16047, et seq.) outlines specific circumstances that are appropriate to consider in investing and managing trust assets:
- General economic conditions
- Possible effect of inflation or deflation
- Expected tax consequences of investment decisions or strategies
- Role of each investment or action within overall portfolio
- Expected total return from income and capital appreciation
- Other resources of the beneficiaries
- Needs for liquidity, regularity of income, and preservation or appreciation of capital
- Special relationship or value of an asset, to the trust or beneficiary
The UPIA requires a fairly formal process of information gathering -- including soliciting information from beneficiaries -- and an overall plan for achieving the investment goals of the trust. Documenting the investment strategy is clearly a good idea, since a trustee who can prove that he or she has properly complied with the statute is protected from liability from negative investment results. Probate Code Section 16051 provides that compliance with the statute is not determined by hindsight. In other words, while a trustee must act reasonably when he or she makes investment decisions; he or she is not expected to predict future events.
Duty to Diversify Trust Investments (Probate Code Section 16048)
The UPIA creates a duty in the trustee to diversify investments unless, under the circumstances, it is not prudent to do so. The reason for the diversification requirement is to reduce the risk inherent in investments. In addition, the trustee has a duty to be impartial as between income and remainder beneficiaries, as the interests of these two types of beneficiaries may conflict. The theoretical solution to this conflict is a portfolio that is well diversified and holds assets that can produce income as well as principal appreciation.
Generally the duty to diversify pertains to both the variety of industries invested in (e.g. health care, communications) and the variety of types of investments (e.g. real estate, bonds, stocks, cash). The theory is that different types of investments respond in different ways to economic and other changes and that diversification increases the possibility that losses in one investment will be mitigated by gains in others. Over time, diversification reduces the overall volatility of the portfolio.
General trust law makes it clear that, unless the trust instrument provides otherwise, a failure to extensively diversify an investment portfolio will be a breach of trust in most cases. Excessively conservative investment strategies (for example, all cash and Treasury Bills) may violate the prudent investor standard, as such investments expose the remainder beneficiaries to an inevitable reduction in purchasing power as a result of inflation.
The provisions of the trust may expand or restrict the prudent investor rule. This means that the trustee may not be required to follow certain aspects of the UPIA, if the trust instrument allows this and the trustee is following the trust terms in good faith. For example, many trusts allow the trustee to retain trust property received from the trustor (the creator of the trust) even if such investment does not constitute a diversification. Typically, this might include the retention of sentimental assets such as a residence or a family business. It is imperative for the trustees to carefully review the trust instrument to see if it has unusual investment requirements or waiver of normal investment rules. For example, some very cautious trustors may limit investments to cash or government-backed securities.
Delegation of Trustee Duties (Probate Code Section 16052)
Under traditional trust rules a trustee was prohibited from delegating acts that the trustee could reasonably be required to perform personally. This rule generally meant that a trustee could delegate ministerial duties (i.e. clerical or administrative duties) but could not delegate discretionary duties (i.e. acts that a business person would consider important and within his or her own capacity so that he or she must perform such acts personally). For example, under the traditional rule, the trustee of a trust holding investment real property might delegate day to day property management duties to an agent, but must retain decision making as to major repairs, lease terms and sales.
The UPIA reverses the prior law and specifically allows a trustee to "delegate investment and management functions as prudent under the circumstances." (Probate Code Section 16052.) The change in the trust law was motivated by changes in investment vehicles.
Traditionally, trusts were created to hold ancestral land. Trust administration required little experience or authority by the trustee, who was mostly a mere stakeholder. The trustee held the land for the use and benefit of one generation, and arranged for the land to be passed on to the next generation. By contrast, today's trusts often serve as sophisticated investment vehicles in complex markets. The diversity of modern trust investments requires a level of skill and knowledge beyond that of most individual trustees (and even beyond some institutional trustees).
Underlying the UPIA is the "modern portfolio theory" of investments -- a radical reordering of the acceptable modes of investment. Under modern portfolio theory, investment performance is evaluated on the basis of the performance of the entire portfolio, rather than the performance of a single investment. This theory seeks to minimize risk by encouraging the diversification of investments. This emphasis on overall performance and diversification requires a high level of expertise by the investor, one that many individuals do not have. (This is a reason that, in selecting a trustee to manage the trust, the trustor should consider the skills and knowledge of the named individuals to be sure they can handle the job of trustee appropriately.)
ProbateCode Section 16052 specifically requires that, in delegating investment and management functions, the trustee must exercise care, skill and caution in:
- Selecting the Agent;
- Establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust (an engagement letter is recommended); and
- Monitoring the agent's performance
Trustees who relinquish investment control under the UPIA limit their liability for the acts of agents with regard to investments, as long as they carefully carry out the above duties.
The UPIA creates duties and liabilities for the investment agent. The agent has a duty to exercise reasonable care to comply with the terms of the delegation. By accepting the delegation of a trust function from the trustee, the agent submits to the jurisdiction of California courts. However, since most brokerage account agreements include a provision which requires disputes to be resolved by arbitration, there is a question as to the applicability to brokerage houses of the requirement that the agent submit to the court's jurisdiction.
Duty to Review Trust Assets (Probate Code Section 16049)
In order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust and the requirements of the UPIA, a trustee is required to review the trust assets and make and implement decisions concerning the retention and disposition of assets within a reasonable time after accepting a trusteeship or receiving trust assets. For new trusts, a "reasonable time" is not yet determined, but it probably will not exceed one year.
Documentation of Decisions
In fulfilling its delegation duties, the trustee should document each decision, including investment decisions, and include such documentation in the trust records. Investment and delegation decisions should be memorialized at the time they are made.
A Trustee can significantly limit his or her liability by sending beneficiaries a memorandum regarding proposed decisions and obtaining their consent prior to the investment or delegation.
In selecting an investment advisor, the trustee should interview several advisors and articulate in the trust record why one advisor was chosen over the others. A local probate judge has stated that he would be looking for trustees to keep a regular written record of their actions. Therefore, it is advisable for trustees to make an annual written report to reflect that the investment portfolio has been reviewed and careful thought has been given to all investment decisions and other actions.
Tips For Following the UPIA
1. Read the trust instrument to see if diversification or other normal investment rules are specifically waived or if unusual investment rules are set out.
2. The trust instrument controls - even if it says to invest only in Treasury Bills.
3. Check to see if assets originally owned by the trustor may be kept, including non-productive assets.
4. Many Family Trusts specifically provide that the welfare of the surviving spouse is paramount in making investments; check to see if this applies. However, it is not clear that this waives the diversification requirement -- probably not! -- although it may be effective to waive the requirement for balance between the income beneficiary and the remainder person. If the trust does not favor the income beneficiary over the remainder persons, then the surviving spouse, as trustee, may have to sell some high income assets to purchase growth assets in order to benefit the children.
5. The trustee should have a written plan for investment of the trust assets and make a written analysis of the existing assets and the basis for retention.
6. A waiver of accounting in the trust does not obviate the need for a written investment plan.
7. Obtaining written approval of current and future trust beneficiaries to the investment plan may avoid future lawsuits.
Should You Modify Your Trust?
Consideration should be given to amending revocable trusts to waive all investment requirements, spell out the paramount goal of benefitting the surviving spouse (without regard to remainder persons) and to add a specific provision waiving any need for diversification. However, if children from prior marriages are remainder persons, it may be appropriate to let the normal rules remain in place.
For trusts that are no longer revocable, and which do not have sufficient provisions to make the welfare of the surviving spouse paramount, consider seeking a court modification of the trust while the remainder persons are loving children rather than money hungry grandchildren or surviving spouses of children.