The Prudent Investor Rule requires Fiduciaries to take modern theories of investment into account when deciding how to invest assets of a Trust.
Under prior law, the Prudent Man Rule provided that a fiduciary was to invest Trust assets in the manner that men of prudence, discretion, and intelligence use in managing their own affairs, considering the probable income as well as the probable safety of the capital to be invested.
The Prudent Man Rule has been changed to the Prudent Investor Rule which takes into account modern portfolio theories of investing.
The modern theories of investing recognize that investing Trust assets only in interest-bearing instruments (CD’s, Treasury Bills, etc.) exposes the Trust’s principal and income to “inflation erosion”. Inflation erosion occurs because returns received from the interest-bearing instruments are offset by a reduction in spending power that results from inflation.
In addition, income from interest-bearing instruments are distributed to income beneficiaries and provide no growth to the principal. Where investment decisions provide insufficient growth in the principal, inflation has the effect of decreasing the spending power of the principal.
As a result, a fiduciary may be found to have been negligent in its duty to the beneficiaries of the Trust by not considering inflation. Further, if the principal does not grow to offset inflation, income yield will be stagnant, thereby harming the income beneficiary.
The new Prudent Investor Rule recognizes that inflation must be considered in order to preserve capital. A portfolio limited to interest-bearing investments does not deal with inflation, and thus violates the Prudent Investor Rule.
This erosion from inflation affects the duty of a fiduciary to treat the income and remainder beneficiaries impartially. The fiduciary may not, without reason, ignore the eroding effects of inflation on the principal, while maximizing the income earned by the Trust.
Investing in solely interest-bearing investments tends to have this effect and may amount to a breach of the fiduciary’s duty of impartiality.
Also, investing the assets of an Trust solely in growth investments, which increase principal but fails to provide payments to income beneficiaries, may be a breach of the fiduciary’s duty of impartiality, unless circumstances justify the partial treatment.
Prudent Investor Rule requires investors to diversify portfolios.
The Prudent Investor Rule requires the fiduciary to minimize diversifiable risk through portfolio diversification.
A properly diversified portfolio leaves only market risk, which, at the proper level, allows growth at a rate meaningfully greater than inflation.
A decision to not incur any market risk is not permitted under the Rule, because it is a decision to ignore inflation. The new Rule allows a fiduciary to delegate decision-making responsibilities and may even require a fiduciary to seek assistance where the fiduciary does not have the skills to maintain a properly diversified portfolio.
The new Rule provides that a fiduciary’s duty to make property productive will include securing a return to the principal as well as income production, with these competing interests being balanced in a way that is appropriate to the particular Trust.
Thus, in circumstances where the income beneficiary is dependent on the Trust for money, it may be appropriate to produce more income for the income beneficiary at the expense of producing a return on the principal.
The opposite may be true for an income beneficiary who does not depend on the income received from the Trust. But in either case, inflation and its deflating effects on the principal must be taken into consideration and balanced accordingly.
The courts look to the conduct of the fiduciary at the time of investing to determine if the fiduciary is liable.
The court will look to the fiduciary’s conduct at the time the investment decision is made to determine if a breach of duty by the fiduciary has occurred regarding investment decisions.
In determining the amount of liability for improperly invested accounts, the new Rule compares the performance of the portfolio in question to how it would have performed if it had been appropriately invested.
In conclusion, the new Rule regarding the investment of Trust assets requires the fiduciary to consider the effects of inflation and other modern portfolio investment theories in its investment decisions.
This requires the fiduciary to produce a diversified portfolio which allows both growth to the principal while still providing the appropriate amount of income to income beneficiaries.
This requires fiduciaries who are not sophisticated investors to seek professional advice on how to invest the assets of the Trust in a way that satisfies the new Prudent Investor Rule requirements or be subject to possible liability.