Satisfying the UPIA through Professional Investment Advice and the Creation of the Investment Policy Statement

This article was originally published in California Trusts and Estates Quarterly, Volume 13, Issue 4, 2008

By Christopher D. Carico |Partner

Larry K. Prutch, CFP, CIMA, Institutional Consulting Director,** and Cengiz Volkan, CFP, CIMA, Institutional Consulting Director***

I. Introduction

The Uniform Prudent InvestorAct (“UPIA”) imposes complex investment requirements on private trustees.1 Estate planning attorneys protect trustee-clients by participating in the creation of a detailed investment policy statement (“IPS”), which documents the investment process. The IPS, created cooperatively by the investment advisor, attorney and trustee, will be the trustee’s best insurance against later claims for breach of the UPIA.

II. The Attorney’s Role

Most estate planning attorneys will admit that they are not qualified to provide investment advice to a trustee-client. Implicit in legal counsel’s refusal to provide investment advice is the recognition that a professional investment advisor is required. The trustee of a substantial trust needs an advisor with a proven track record of successfully managing large portfolios, access to most financial products and markets, and the ability to educate the trustee and legal counsel about the concepts of risk, return, volatility, diversification, liquidity, asset allocation and monitoring.2 Estate planning attorneys can provide value to their clients by first checking on the experience, credentials and references of prospective advisors. Estate planning attorneys protect their clients by reviewing the IPS with the trustee, augmenting the IPS to include all of the criteria listed in the UPIA, clarifying points of ambiguity in the IPS and simplifying it to be understandable to a court on judicial review of an accounting.

III. Prudent Investing

The authors submit that in California, the prudent person rule is applied to the trustee’s investment decisions through the UPIA. The rule requires that that the trustee administer the trust with reasonable care, skill and caution under the circumstances then prevailing that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character with like aims to accomplish the purposes of the trust as determined from the trust instrument.3

A. UPIA Requires an Overall Investment Strategy Balancing Risk and Return–and the Documentation to Prove it

The foundation of the UPIA is the modern portfolio theory (“MPT”), which requires the trustee to design a portfolio that maximizes the overall return for any given level of acceptable risk.4 The UPIA governs both professional and nonprofessional trustees.5 It applies to both large and small trusts.6 It applies to the actions of the trustee, regardless of the trustee’s inexperience or ignorance.7 The trustee’s good intentions are not a defense for failing to comply with the UPIA. The only instance where the trustee is not subject to the UPIA is when the trust instrument explicitly restricts application of the UPIA.8

The UPIA provides generally that:

  1. A trust shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust . . .
  2. A trustee’s investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and returnobjectives reasonably suited to the trust.9

The UPIA therefore requires an overall investment strategy balancing risk and return.10 On examination, each specific investment is to be viewed, not in isolation, but in terms of how it fits into the overall investment strategy of balancing risk and return.11 A trustee’s ability to defend himself or herself when a specific investment fails will depend to a large degree on the adequacy of the documentation supporting the trustee’s investment decisions. In the absence of a detailed IPS, the trustee will have difficulty successfully arguing that the selected investment was suitable for the overall investment strategy.

B. An Individual Trustee Will Normally Need Some Professional Investment Advice to Meet the Complex Requirements of the UPIA

The UPIA requires that the trustee give careful consideration to the following eight factors:

  1. General economic conditions.
  2. The possible effect of inflation or deflation.
  3. The expected tax consequences of investment decisions or strategies.
  4. The role that each investment or course of action plays within the overall trust portfolio.
  5. The expected total return from income and the appreciation of capital.
  6. Other resources of the beneficiaries known to the trustee as determined frominformation provided by the beneficiaries.
  7. Needs for liquidity, regularity of income, and preservation or appreciation of capital.
  8. An asset’s special relationship or special value, if any, to the purposes of the trust or to one ormore of the beneficiaries.12

The analysis or process required by the UPIA can seldom if ever be done without the assistance of a professional investment advisor. Balancing return and risk, the cornerstone of the MPT, is a complex, statistics-driven process. The “risk” element can be defined as the probability of failing to receive the expected return.13 Determining the acceptable level risk for the trust portfolio usually begins with understanding the trustee’s willingness to accept a decline (measured both gross and net of inflation) in the total portfolio value at various stages along the investment horizon. If the trust requires ongoing distributions to meet beneficiary needs, then liquidity becomes a primary factor and reduces the amount of acceptable risk.14 A qualified investment advisor has the training to educate the trustee and counsel through the use statistical models, based on historical performance of various asset categories in the markets, about the probable risks and returns associated with different asset allocations models, beginning at the extremes (i.e., 100% fixed income or 100% equities) and working toward the middle.

Once the trustee can articulate which levels of risk (i.e., decline) are generally acceptable or unacceptable, the experienced investment advisor can present the trustee with asset allocation models, which maximize the expected return for the given level of risk. The risk associated with the portfolio is reduced when the categories of assets within portfolio are negatively correlated to other categories of assets within the portfolio. The right analyst can de-mystify the expected returns and risks associated with each category and the model portfolio as a whole. The trustee may elect to exclude one or more of the asset categories from the model portfolio, which the trustee believes may be too inherently risky, in which case the simulations should be re-run to determine the affect of the modifications on the return and risk of the portfolio.15 The complex statistics-driven analysis of the UPIA necessitates the use of qualified investment advisor with access to the latest statistical models and simulations.16

C. UPIA Promotes the Use of Investment Experts In Certain Situations

Out of the fear of giving a negligent referral, legal counsel may be reluctant to instruct the trustee to seek immediate professional investment advice, even though counsel understands that an investment expert is needed to design a portfolio that complies with the UPIA. The UPIA has no explicit provision requiring the use of an investment advisor. Nonetheless, it specifically authorizes the delegation of investment discretion to a qualified investment advisor, from which it may be inferred that, in some cases and capacities, prudence dictates the use of a qualified expert.17

D. ERISA Plans, Subject to a Comparable Prudent Investor Rule, Use Investment Policy Statements

The standards of practice for ERISA fiduciaries generally require the preparation of an IPS. Fiduciaries governed by ERISA are subject to substantially the same prudent person rule as private trustees operate under in non-investment contexts.18 ERISA fiduciaries must act:

with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use an the conduct of an enterprise of like character and with like aims.19

ERISA’S prudent person standard is to be generally interpreted in accordance with the law of private trusts.20 Retirement plans and long-term trusts21 share the common investment objectives of meeting the current needs for retirees and income beneficiaries while protecting the purchasing power of the portfolio against inflation to meet the needs of future retirees and remainder beneficiaries, respectively. The Federal Department of Labor endorses the use of an IPS as a means by which the ERISA fiduciary may comply with the prudent investor rule.22 The failure to prepare an IPS may be an important consideration in determining whether a violation of the prudent investor act has occurred.23

In addressing the need for investment policy statements, the federal district court in Liss v. Smith states the following:

‘[t]he role the investment . . . plays in . . . the plan’s investment portfolio’ further supports the conclusion, discussed above, that plans require investment policies, for it is only against such benchmark that the determination can be made as to what the role of a particular investment plays in the overall portfolio.24

E. University Endowments Are Governed by the Prudent Person Rule and Use Investment Policy Statements

University endowments also share many of the same investment characteristics as long-term, high net worth trusts. Endowments need liquidity to meet the ongoing needs of the university, but also growth in capital to protect the purchasing power of the portfolio against inflation for future university needs. In California, the Uniform Management of Institutional Funds Act (“UMIFA”) defines the prudent person rule for university endowments as follows:25

Members of the governing board shall act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of like character and with like aims to accomplish the purposes of the institution.

Most, if not all, public universities in California use an IPS to guide their board’s investment decisions for pooled endowments.26

F. ERISA and Endowments Share the Objectives of Private Trusts

The procedural prudence standards for the UPIA are comparable to those for ERISA and university endowments.27 The

Trust Law governing private trusts in non-investment contexts requires that the trustee use the same “care, skill and caution” that a prudent person would use “in the conduct of an enterprise of like character.28 Given the “like” investment objectives of the ERISA plans, university endowments and private trusts, the reasons supporting the use of investment policy statements by ERISA plans and university endowments should be equally applicable to private trustees.29

G. CIMAs and CFAs Are Required to Use Investment Policy Statements

The UPIA requires the construction of a diversified portfolio, maximizing the total return for the given level of acceptable risk. The higher the return is for a given level of risk, the more “efficient” (prudent) the portfolio is. Chartered Financial Analysts (CFAs) and Certified Investment Management Analysts (CIMAs) are among the most qualified investment advisors. The “standards of practice” instituted by the certifying organizations for CFAs and CIMAs mandate the creation of a written IPS for each investment portfolio.

In its “Standards of Practice,” the Chartered Financial Analyst Institute requires that each CFA:

incorporate the client’s risk tolerance, return requirements and all investment constraints . . . into a written investment policy statement (IPS). Without identifying such client factors, members and candidates cannot judge whether a particular investment strategy us suitable for a particular client. Such an inquiry should be repeated at least annually and prior to material changes to any specific investment recommendations or decisions on behalf of the client.30

Similarly, in its Standards of Practice, the Investment Management Consultants Association requires that each CIMA:

profile each client to determine rate-of-return objectives, risk tolerance, time horizons, and tax status. Initial and ongoing recommendations shall be based upon the client’s goals, both as originally determined, and as they change over time.31

IV. The UPIA Requires a Process, Not a Result

While the UPIA does not require any specific investment result in terms of an achieved rate of return, it does require that the trustee follow a detailed process or analysis in designing an investment portfolio, referred to as “procedural prudence.”32 If the fiduciary goes through the full process, then the fiduciary will not be held liable for an investment which, in hindsight, performs poorly.33

A. The Attorney Should Simplify and Document the Process for the Client

An attorney’s duty to protect a client extends to potential claims under the UPIA. To be effective as trust counsel, attorneys must first understand and then explain to clients the process required of trustees by the UPIA. The language of the UPIA is complex and beyond the common experience of most nonprofessional trustees. The initial draft of the IPS is generally prepared by the investment advisor, but may contain investment jargon common to the industry but beyond the understanding of the trustee. Legal counsel can assist their trustee-clients by ensuring that the IPS reflects a careful consideration by the trustee of each of the critical UPIA criteria. Legal counsel adds value by modifying the language of the IPS to make it clear and understandable to current and prospective trustees, as well as the court which may later scrutinize the trustee’s investment strategy in a contested accounting proceeding.34 To ensure the trustee has fully engaged in the process required by the UPIA, the IPS should memorialize the trustee’s careful consideration of each of the eight criteria listed Probate Code section 16047(c).

B. The IPS Creates a Framework for Evaluation of Portfolio Performance

A trust attorney’s best opportunity to add value to the investment process comes during the creation of the IPS. The IPS clarifies the relationship between the fiduciary, investment advisor and trust assets. It also creates the frame work for future evaluation of the investment recommendations and their performance by setting benchmarks, usually in the form of market indices.35 Because the IPS will be used, among other things, to “grade” the recommendations of the investment advisor, the participation by the trustee’s legal counsel in the drafting of the IPS ensures a certain level of independence in setting term performance benchmarks. Typically, the IPS for a long-trust should address most, if not all, of the following:

  • purpose of the IPS,
  • objectives of the specific trust, as it relates to current and future beneficiaries,
  • investment horizon,
  • current and anticipated economic trends and market assumptions,
  • trustee’s tolerance for risk and volatility,
  • investment return objective (i.e., target), often expressed as the annualized rate of return, net of fees and net of inflation,
  • permitted asset categories,
  • prohibited asset categories,
  • allocation parameters (by percentage) for different asset categories,
  • initial target allocations,
  • reasoning supporting such allocations,
  • reasoning supporting the use of active money managers or passive index funds for the asset classes,
  • bench marks for measuring the performance of the entire portfolio and for measuring the performance of the different asset classes,
  • rebalancing guidelines to limit the risk by asset category,
  • due diligence exercised by the trustee in selecting an investment advisor (or committee of advisors) to help construct and monitor the portfolio as a whole,
  • level of discretion given to the portfolio’s investment advisor and to outside money managers,
  • responsibility for monitoring the performance of money managers and passive investments, and
  • frequency and content of portfolio reviews.

C. The IPS is the Operational Manual for Trust Investments

The IPS acts as the operational manual for the trustee’s current and future investment decisions. It is a living document. The IPS must be broad enough to anticipate and withstand a variety of changing conditions, without the need for constant revision. It must also be specific enough to: (i) provide guidance during times of market uncertainty to avoid emotion-driven investment decisions, (ii) allow for meaningful evaluation of the portfolio’s performance against generally accepted benchmarks, and (iii) show the trustee’s consideration of the UPIA investment criteria.

D. The Investment Advisor Should Educate the Trustee and Attorney Before Finalizing the IPS

Before the IPS is finalized, the experienced CFA, CIMA or other qualified investment advisor should have educated the trustee and attorney about: (i) the historical performance (i.e., expected rate of return) of the various asset categories using different time horizons, (ii) the historical volatility (i.e., risk) associated with each asset category over each time horizon, and (iii) the historical correlation between asset categories. The investment advisor should be able to provide statistical examples of the historical performance of diversified, passively invested portfolios, ranging from conservative to aggressive. Armed with this information, the trustee, legal counsel and the investment advisor can together create an investment policy statement that provides clear guidelines to the investment advisor about investment expectations and ensures that the trustee has gone through the process needed to comply with the UPIA.

E. Periodic Reviews

The trustee and financial advisor must meet periodically36 to review the performance of the portfolio and ensure continued compliance with the IPS. California’s UPIA explicitly requires periodic reviews to monitor the performance of the trust investments and financial advisors.37 When the needs of the beneficiaries or general economic conditions have caused a change in the trust’s investment policy or objectives, the IPS should be modified to reflect the changes. Before the revised IPS is approved by the trustee, legal counsel should be consulted to review the revised IPS with the trustee to make certain that the basis for the change is fully understood by the trustee and to recommend points of clarification.

V. Conclusion

With few exceptions, trustees of private trusts need the advice of qualified financial advisors to design portfolios that comply with the UPIA. Although the Act does not require that the trustee achieve any specific investment result or return, it does require that the trustee exhibit procedural prudence in the investment process. Estate planning attorneys can assist their clients in satisfying procedural prudence by directing them toward qualified financial advisors with experience in designing portfolios compliant with the UPIA. Legal counsel adds value by reviewing the IPS (and later modifications) with the trustee to ensure that (i) the trustee understands the IPS, and (ii) the IPS expresses a careful consideration by the trustee of each of the investment criteria cited in the UPIA.

Endnotes

*Carico Toomey Associates LLP, Manhattan Beach Back

**Citi Family Office, Rolling Hills Estates Back

1. The UPIA was drafted in 1994 by the National Conference of Commissioners of Uniform State Laws, and adopted in California as Probate Code §§ 16045–16054. The statutes for the purposes of this article are essentially the same. While direct citations in this article to California’s UPIA will be to the applicable section of the Probate Code, and generic references to UPIA in the text refer to the UPIA as adopted by California, specific citations to comments of the original UPIA in the endnotes will use the letters “UPIA” in the citation. Back

2. Because ERISA plans are also subject to the prudent investor rule, suitable analysts for large private trusts are often those also managing pension funds. Back

3. Prob. Code, § 16040. Back

4. UPIA, § 2 cmt. Back

5. UPIA, § 2 cmt. Back

6. UPIA, § 2 cmt. Back

7. Bogert, Trusts and Trustees (2nd ed. 1975) § 541. Back

8. Prob. Code, § 16046(b). Back

9. Prob. Code, § 16047. Back

10. UPIA prefatory note, Objectives of the Act, (2) states “The tradeoff in all investing between risk and return is identified as the fiduciary’s central concern.” Back

11. Prob. Code, § 16047(b). Back

12. Prob. Code, § 16047(c). Back

13. The terms “risk” and “volatility” are used often synonymously. Back

14. Prob. Code, § 16047(c)(7). Back

15. The UPIA does not permit the trustee to exclude potential investments based on social responsibility or ethics, unless the trust instrument specifically authorizes such a consideration. UPIA, § 5 cmt.Back

16. For an excellent article discussing the mathematics behind the UPIA, see Moses, Singleton & Marshall, Modern Portfolio Theory and the Prudent Investor Act (2004), 30 ACTEC Journal 166. Back

17. Prob. Code, § 16052. Back

18. 29 USC § 1104(a)(1)(B). Back

19. 29 USC § 1104(a)(1)(B). Back

20. Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101, 110–111 (1989); Donovan v. Mazzola, 1981 U.S. Dist. LEXIS 17411, 17457 (D. Cal. 1981). Back

21. “Long-term trusts” are sometimes referred to as “GST Trusts,” because of their use of the generation-skipping transfer tax exemption, or “dynasty trusts.” Back

22. 29 CFR 2509.94–2(2). Back

23. Liss v. Smith (D.N.Y. 1998) 991 F. Supp. 278. Back

24. Liss v. Smith, supra, 991 F. Supp. at p. 298. Back

25. Prob. Code, §§ 18500–18509. Back

26. An excellent example of a comprehensive IPS for a most excellent university (UCLA) can be found online athttps://island.fim.ucla.edu/foundation/ InvestmentPolicyStatement.pdf. Back

27. In referring to private trusts, the UPIA § 1cmt. reads: “Congress has imposed a comparable prudence standard for the administration of pension and employee benefit trusts in the Employee Retirement Security Act (ERISA), enacted in 1974.” To the extent there are differences in the prudence standards for ERISA plans, private trusts and university endowments, ERISA plans would be subject to the slightly higher “prudent expert” standard, private trusts would be subject to the middle “prudent person” standard and university endowments would be subject to the lowest “business judgment rule” standard. Back

28. Prob. Code, § 16040. Back

29. The argument for use of an IPS becomes even more compelling as the wealth and term of the trust increases, since it more closely resembles large ERISA qualified plans and university endowments. Back

30. CFA Institute Standards of Practice Handbook (9th ed., 2005), pp. 69–70. Back

31. IMCA Standards of Practice, p. 2. Back

32. Hartog & Dirkes, California Trust Practice (Matthew Bender 2007), § 7.07[2]; Lohr & Lohr, The Fiduciary Sale: The Director’s Cut(2003), Ch. 8, Prudence & Process in Investing Fiduciary Assets, p. 55. Back Back

33. California Trust Practice, supra § 7.07[2]; Train & Melfe, Investing and Managing Trusts Under the New Prudent Investor Rule(1999), pp. 35–39. Back

34. Per Probate Code section 17006, the trier of fact in California in actions challenging a trustee’s accounting is the bench (i.e., judge) and not a jury. Back

35. Examples of some commonly used market indices are: Russell 3000 (for equity markets); S&P 500 (for large cap equities); Russell 2500 (Value Index for mid cap value equities); Russell 2500 (Growth Index for mid cap growth equities); and Lehman Aggregate Bond Index (for U.S. fixed income) Back

36. Quarterly meetings are preferred when possible. Back

37. Prob. Code, § 16052(a)(3). Back

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