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Prudent investor rule.

Under the Uniform Prudent Investor Act of 1994, the prudent investor rule replaced the prudent person rule (the prudent person rule is also known as the prudent man rule). A majority of states have now enacted some form of the prudent investor rule.

With its focus on minimizing risk, the prudent person rule forces trustees to adopt conservative fixed-income approaches to investing trust assets. Such a conservative approach may well be appropriate for the small-to-mid-size trust whose primary function is to provide support for the current beneficiary (e.g., a marital deduction trust for the support of a surviving spouse, as in the chart on page 29). However, with larger trusts, application of the rule often results in underperforming investments and dissatisfied life and remainder beneficiaries (amusingly referred to as the trustee's duty to "disappoint equally").

State Principal and Income Acts further compounded the problem. These statutes defined "income" to include dividends, interest, and rents, but not capital gains. As a result, investment decisions were often driven by the character of the return, rather then the rate of return (e.g., trustees could distribute to income beneficiaries interest from low-yield certificates of deposit, but were prohibited from using capital gain from highly appreciated stock). The Uniform Principal and Income Act of 1997 gives trustees the authority to allocate principal to income, but it has not been adopted in many states.

Under the prudent investor rule, a trustee is required to develop an overall investment strategy having risk and return objectives reasonably suited to the trust and its beneficiaries. The trustee is to be judged by considering the performance of the portfolio as a whole, rather than individual investments. Although the trustee may delegate investment functions, there remains a duty to review and monitor overall performance. Consistent with modern portfolio analysis, the trustee may invest for capital appreciation in a diversified portfolio of equity and growth stocks. A reduction in the risk of loss is achieved by a reasonable diversification of investments. Because the trustee has a positive duty to reduce investment costs, passive investment strategies are permitted (e.g., the purchase of indexed mutual funds). It is appropriate for the trustee to seek to maintain the beneficiaries' purchasing power, and the tax implications of trust investments and distributions may be considered. Clearly, the flexibility provided by the prudent investor rule enables a trustee to better serve all beneficiaries and sizes of trusts.

Some planners have suggested that a total return unitrust can take maximum advantage of this flexibility. As with the charitable remainder unitrust, the total return unitrust requires the trustee to pay a fixed percentage of the trust principal to the life beneficiary each year. See the discussion of the total return unitrust on page 556.

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Title Annotation:Terms & Concepts
Publication:Field Guide to Estate, Employee, & Business Planning
Date:Jan 1, 2010
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