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Prudent Man Rule Vs. Prudent Investor Rule

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Bill Kerst President, Community First Trust Company. He has been conducting educational seminars on IRAs, asset management, and trust management for over 15 years. He has served as the moderator for the Income Taxation of Estates and Trusts course offered by the Arkansas Society of CPA’s and provided many seminars to civic and church groups in the community. For more information, call 501-520-3660.

Fiduciaries have been around since as early as the 14th century and with the management and custody of funds by a third party, certain rules have always been in place. Trustees have often been viewed in a negative manner because they are typically put in place to preserve wealth created by one person for the benefit of another, and their decisions are often second guessed. It is simple to look back over a ten year period and say “If I were in charge, I would have done . . .” which is why there is often litigation surrounding trustees.

Trustees originally operated with this goal of preservation under the Prudent Man Rule, which is defined as the trustees’ duty to exercise such care and skill as an ordinary prudent person would exercise in dealing with his own property. There was a tremendous amount of litigation under the Prudent Man Rule, as an individual dealing with his own property can be speculative and more interested in growth. The courts often held that a trustee was not in the business of growth and should avoid speculation. The emphasis on preservation led to case law and legislation that created “legal lists.” Each asset, and not the entire portfolio, was then reviewed individually to see if it was compatible with the “list,” so the focus was not on the portfolio as a whole, but was based on the isolation of each asset to determine its appropriateness.

The birth of the Prudent Investor Rule, published in 1992, allowed trustees to take advantage of the change in sophisticated investment products, new investment techniques, theories and technology. It basically provided the ability to more effectively manage risk and return and to achieve greater diversification. The application of Modern Portfolio Theory allows a trustee to look at the risk and return in the total account rather than a review on an asset-by-asset basis. This allows a fiduciary to increase aggressiveness after considering the assets and the circumstances of an individual trust.

So why is this worth writing about? It is important to recognize that a trustee has great flexibility. That said, many clients come in today with “their investments,” the securities they like. Certain clients even place language in the document that requires the trustee to hold an investment literally FOREVER. Forever, is a long time, and there are a lot of unknowns. You cannot anticipate everything in life that will happen and the same goes for your family and your investments. What seems logical today may be completely inappropriate 20 years from now. Relative to investments, a trustee has to (1) make decisions based on an evaluation of the total portfolio, (2) promote diversification (which is fundamental to risk management), (3) analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements and other circumstances of a trust, and (4) exercise their duty to delegate matters in which they do not have experience, as other prudent investors would.

Relative to beneficiaries, the trustee must always follow the document. If it directs the trustee to consider the benefits on the development of the individual, or the harmful effects of a distribution, those are things that must be considered. Many people include language that is designed to encourage education and good citizenship, requiring the trustee to give consideration to the development of the beneficiary. In summary, you can create a trust that suits your family, yet has the flexibility to address the ever changing environment that we live in.