The Prudent Investor Rule and UPIA: Intro to Trustee Investing

Fiduciaries carry a legal obligation to act in the best interest of another party. But how should a fiduciary apply this standard to investing assets? Without an understanding of the Prudent Investor Rule it may be confusing to know why certain investment decisions are made.

The origins of fiduciary investing began not with the Prudent Investor Rule, but with the Prudent Man Rule, which came into existence in 1830 through a famous case, Harvard College v Amory. The ruling opined that people in charge of other people’s money must do so with the same care, skill, and caution as if the money were their own. 

Thus the Prudent Man Rule was created to provide a framework for how fiduciaries should manage a trust’s investments, requiring trustees to apply a standard of “prudence, discretion and intelligence” in managing the individual investments of the trust. And while this framework gave merit to investment decisions, it ultimately limited fiduciaries’ decision power in fear of personal liability for one misstep. 

Another problem with the Prudent Man Rule was that it was vague in terms of what “care, skill, and caution” meant.  Trustees eventually interpreted the rule to mean that they should invest in the safest investments possible, like government bonds and CDs.  These investments were heavily impacted by the rise of inflation during the 1970s and 1980s.

Shift to the Uniform Prudent Investor Act (UPIA)

As a result, concern grew over the effectiveness of the Prudent Man Rule. It became evident that investing only in “safe” assets was actually harmful to both income beneficiaries and remainder beneficiaries. For income beneficiaries, inflation reduced their purchasing power.  For remainder beneficiaries, a lack of principal growth meant that the corpus was less valuable than it might have been.

In 1992, the Uniform Prudent Investor Rule, as part of the 3rd Restatements of Trusts, came about to fix the concerns with the original Prudent Man Rule. 

With the enactment of the Uniform Prudent Investor Act, or UPIA as it has come to be known, the Prudent Man Rule evolved into the Prudent Investor Rule which states fiduciaries still must apply the same care, skill, and caution when acting on the beneficiary’s best interest, but they now have clearer guidance on trust investing. The Prudent Investor Rule rule states:

1. Investments are to be judged in the context of the overall trust portfolio, not the individual investments
2. Trustees need to balance the tradeoff between risk and return
3. Investment restrictions are eliminated and trustees are free to invest in any type of investment that helps meet the goals of the trust
4. Diversification is mandatory
5. Investment and management functions may now be delegated to investment professionals

The shift from the Prudent Man Rule to the Prudent Investor Rule, under the UPIA, allowed the fiduciary to focus on the trust’s entire portfolio versus individual investments, making room for both income and growth of capital. 

Major Differences Between the UPIA and Prudent Man Rule

There are four key differences between the UPIA and Prudent Man Rule. 

1. Under the UPIA, the fiduciary would not be held responsible for individual investment losses as the entire portfolio is evaluated when determining prudence. This is unlike the Prudent Man Rule, which holds each individual investment separate from one another.
2. Diversification is mandatory as part of the UPIA, whereas the Prudent Man Rule only held that fiduciaries may invest in reasonable securities.
3. Fiduciaries are implored to find suitable investment options under the UPIA that range from stocks and bonds to derivatives and futures. Those following the Prudent Man Rule had a set list of “safe investments”, such as fixed income notes and mortgages.
4. Under the Prudent Man Rule, a fiduciary was not allowed to delegate investment responsibilities to a third party, like a financial advisor. Now under the UPIA, the fiduciary is encouraged to leverage the experience of third parties for investment decisions and other considerations of the trust.

Modern Portfolio Theory

At the core of the Uniform Prudent Investor Act are the principles of the Modern Portfolio Theory. This theory was introduced by Harry Markowitz in 1952 and 1959 and included three key principles that now help fiduciaries better manage their client’s portfolio. These include:

• Risk and return
• Diversification
• Correlation

The key to reducing risk was through diversification and a trustee could use correlation to determine whether the portfolio was properly diversified. 

For trustees concerned with personal liability, it can be helpful to lean on a financial advisor experienced in the complexities of the UPIA to evaluate your client’s current portfolio and provide guidance for new client investments. The advisor will help evaluate whether the portfolio is taking on too much or too little risk and whether the investments align with the goals of the trust. 

Trustee Responsibilities

The trustee is tasked with an array of responsibilities when supervising investments, including taxation consequences, trust portfolio evaluation, total return, resources for the beneficiary, needs for liquidity, special relationships of the trust, along with delegation and compliance. 

The trustee must steward the investment decisions in the best interest of their client or family members, but in order to do so they must first be well-versed on the Uniform Prudent Investor Act and the accompanying duties and legal responsibilities.

To help trustees in this journey, we’ve created an in-depth review of the Uniform Prudent Investor Act, including tidbits on the Modern Portfolio Theory, scope of delegation, considerations of the trustee, and more in our latest guide, Decoding the Uniform Prudent Investor Act. This free guide can be downloaded or bookmarked for easy access, so that you as trustee can manage investments safely and ethically while also meeting the financial objectives of the trust you support. Download now → 

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