Investment Planning for Fiduciaries; An Overview of the Laws That Have Governed Private Trusts
by James J. Eccleston, Esq.
o understand where we are, sometimes it is helpful to understand where we have been. That's true of trust investment law. Let's overview the past two centuries of law that have governed how advisers / fiduciaries must invest trust and retirement plan assets.
Harvard College v. Amery (1830) was a marked departure from what English common law had required. Prior to that Massachusetts court decision, the only suitable investments for trusts were government bonds and bank securities. The court created what has become known as the "Prudent Man Rule." This allowed for a broad and flexible standard for investing trust assets, "in regard to the permanent disposition of the funds, considering the probable income, as well as the probable safety of the capital to be invested."
However, that broad and flexible standard did not last long. Within two decades, courts had identified prohibited investments that were deemed speculative per se. In many states, the "Legal List Rule" required a narrow set of investments suitable for trusts, such as long term government and corporate bonds, in lieu of the Prudent Man Rule.
Nearly a century later, financial markets had become much more sophisticated. In 1942, the American Bankers Association adopted the Prudent Man Rule Statute. This was a model law that closely followed the Prudent Man Rule established by Harvard College v. Amery. While the model law allowed trustees to invest outside of long term government and corporate bonds, many did not do so for fear of liability from losses.
The 1970s witnessed major change. First, the Uniform Management of Institutional Funds Act (UMIFA) was adopted as a model rule in 1972. Many states have adopted this model law, which had responded to studies conducted by the Ford Foundation in the 1960s finding that investment portfolios were too conservatively invested from the standpoint of generating sufficient returns. The model law allowed charitable, educational, religious and government institutions to invest for "total return."
The tsunami of the 1970s, of course, was the Employee Retirement Income Security Act of 1974 (ERISA). Congress justifiably was angry at pension plan sponsors (and others) which had looted, mismanaged, or failed to adequately fund their pension plans. The federal legislation sought to end such abuses, and, instead, ensure that retirement plan assets would be held in trust for the exclusive benefit of plan participants. Additionally, ERISA has created a strict requirement that fiduciaries discharge their obligations solely in the interests of plan participants and their beneficiaries. Critical to the investment process is ERISA's requirement that fiduciaries invest as a reasonable person familiar with such matters would invest. Along those lines, ERISA requires investing prudently by diversifying plan investments so as to minimize the risk of large losses, unless under the circumstances it was clearly prudent not to do so. To add "teeth" to the law, Congress made ERISA fiduciaries personally liable for investment losses suffered as a result of imprudence.
Another major change in the law occurred in 1992, with the issuance of the Restatement 3rd of Trusts (Prudent Investor Rule). By the 1990s, the financial industry fully had embraced the principles of Modern Portfolio Theory. The "law" needed to catch up. Modern Portfolio Theory analyzes the risk and return characteristics of investment portfolios as a whole, with much less emphasis on their components, the individual investments. The 3rd Restatement defines five principles that fiduciaries must follow. These include sound diversification, considering risk and return, and balancing production of income versus protection of purchasing power. Fiduciaries also must avoid fees and costs that cannot be justified, and they must delegate authority in areas in which they do not have sufficient expertise.
In 1994, the Uniform Prudent Investor Act (UPIA) codified the Restatement. Prefatory notes state that while the UPIA primarily regulates trustees of private family trusts, its principles also bear on ERISA plans, public employee retirement plans, and charitable organizations.
The Uniform Management of Public Employee Retirement Systems Act (UMPERSA) established, as of 1997, that fiduciaries for public pensions would be held to the highest standard of conduct in the investment and management of assets. The trustee of such plans is the "highest fiduciary", and "carries the greatest burdens of care, loyalty, and utmost good faith for the beneficiaries to whom he or she is responsible."
As one can see, trust and pension fiduciaries must comply with a host of laws and practice standards. There is personal liability for fiduciary misconduct associated with private trusts. In addition, numerous government bodies oversee other conduct. Thus, under ERISA, fiduciaries of corporate retirement plans and Taft-Hartley plans must answer to the Department of Labor (DOL), the Internal Revenue Service (IRS), and the Pension Benefit Guaranty Corporation (PBGC) (for defined benefit plans). The State Attorney General oversees public retirement plans subject to UMPERSA as well as foundations and endowments subject to UPIA.
In short, fiduciaries face a legal quagmire in discharging their obligations to invest and manage trust and retirement plan assets.
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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