UPIA §2(b) – Duty to Monitor Risk and Return

UPIA §2(b) – Duty to Monitor Risk and Return

Duty to Balance Risk and Return

The Duty

The preamble to the Uniform Prudent Investor Act notes, “The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.”  For most trustees determining the return that was produced by the assets held in trust is a fairly straightforward exercise.

The Conundrum

Most investment managers are required to produce performance data that is compliant with SEC standards. However, defining whether the return was appropriate for the level of risk taken is more complicated.

The Bogert treatise states, “The trustee cannot assume that if investments are legal and proper for retention at the beginning of the trust, or when purchased, they will remain so indefinitely. Rather, the trustee must systematically consider all the investments of the trust at regular intervals to ensure that they are appropriate” (A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009)).

The Record

To fulfill this duty to monitor the risk and return of the trust assets, a prudent trustee acting in good faith will make the following inquiries:

Target Return

The manager’s actual return will initially be compared to the trustee’s stated return objective. This begs the question whether the trustee has taken steps to define a targeted rate of return for the assets of which they are responsible. If they have not, they are encouraged to do so. The Target Return is stated as an absolute number (e.g., 7.0%) or as a real, inflation-adjusted number (e.g., Inflation + 4.0%).

Benchmarks

No single benchmark can precisely measure the acumen or shortcomings of the investment manager. The most prudent approach is to compare the risk and return of the actual portfolio against several key performance indicators to judge whether the client’s investment objectives are being accomplished. It is rare that a benchmarking study would ever conclusively prove that the manager was either exceptional or incompetent. More often, such a study would conclude that the manager’s performance was or was not within a reasonable range of return and risk outcomes. Common benchmarks that are used in a benchmarking study are: 1) the benchmark suggested by the investment manager; 2) a Strategic benchmark which has very little sub-asset class detail; 3) a Tactical benchmark that is designed to exactly match the sub-asset class allocation of the actual portfolio; and 4) a Peer Group benchmark which is a compilation of the actual return and actual risk of an investment manager the incumbent competes against. (Download Benchmarking White Paper)

Quantitative Risks

In addition to measuring the manager’s performance against several benchmarks, there must be an evaluation of the risk that has been accepted by each manager. Some forms of risk can be discovered through statistical analysis. Often used statistical risk measures include Standard Deviation, Value-at-Risk, Beta, Sharpe Ratio, M-Squared, et cetera.  This type of analysis for a marketable portfolio can be easily done by the software the current investment manager has access to. (If they cannot do this analysis it should put doubt in their ability to balance risk and return since they are not able to monitor the risk of the portfolio.)

Qualitative Risks

Other types of risk cannot be deduced from statistical inquiry and require a more subjective analysis.

  • Lack of Liquidity: The % of the trust that cannot be liquidated within 5 business days

  • Concentration: The % of the trust held in the single largest security

  • Leverage: The % of leverage used by the trust as reflected in a debt-to-equity ratio

  • Lack of Valuation: The % of the trust assets that do not have daily valuation

Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.

Ask for Help: Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.

Download White Paper: Trust but Verify

Anodos helps trustees develop, maintain, and manage their governance processes. Our support helps trustees and plan committees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

Prudent Delegation Standard of Care: Registered Investment Advisor v. Registered Representative

Prudent Delegation Standard of Care: Registered Investment Advisor v. Registered Representative

In the same way a trustee owes duties of care and loyalty to the beneficiaries of a trust, the investment managers also owe a particular standard of care to the trust itself. A prudent trustee will determine what standard of care is owed by the money managers to whom investment duties have been delegated.

Investment professionals can be divided into two types: those professionals for whom fiduciary duties exist and those for whom fiduciary duties to their clients do NOT exist.  Unfortunately, the distinction is sometimes hard to make.  Both call themselves “Advisor,” “Consultant,” or “Planner.” Though they may use a similar moniker their duties of care are not the same.

A Registered Investment Advisor (RIA) is bound by the SEC to apply a fiduciary standard to their advice and is obligated to act only in their client’s best interest.  A Registered Representative is required by FINRA to make investment recommendations that are merely “suitable” for the client’s situation.

A prudent trustee will seek to understand the difference between the “fiduciary standard” and the “suitability standard” and know which of these two the investment professional is bound by.

The fiduciary standard requires the RIA to make recommendations that are exclusively in the client’s best interest.  The suitability standard requires an advisor to make recommendations that are suitable, but may also be in the advisor’s best interest.  Another distinguishing factor between an RIA and a Registered Representative is that the RIA is paid for their investment advice. The advice provided by a Registered Representative is incidental to their primary business – selling investment products.

A trustee is allowed to delegate investment duties to any party – an RIA subject to fiduciary standards or a Registered Representative subject to a suitability standard –  so long as the delegation is made prudently and in good faith (UPIA §9).

At a minimum, the prudent trustee will know which standard of care the investment professional is bound by.  For those of you who serve in a fiduciary capacity and are not certain of the answer to this question, we suggest you ask and document your findings.

Below is a link to a Request For Proposal questionnaire with 24 key questions that a trustee should ask and the investment manager should answer.

Download: Sample Investment Manager Request for Proposal

 

Onward,

Josh Yager, Esq., CFP®, ChFC®
805-899-1245
jyager@anodosadvisors.com

 

Anodos helps trustees develop, maintain, and manage their own governance processes. Our support helps trustees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

 

UPIA §7 re Duty to Pay Only Fair Fees

UPIA §7 re Duty to Pay Only Fair Fees

Duty to Pay Only Fair Fees“Wasting beneficiaries’ money is imprudent. In devising and implementing strategies for the investment and management of trust assets, trustees are obligated to minimize costs” (National Conference of Commissioners on Uniform State Laws).

Duty to Pay Only Fair Fees

Section 7 of the Uniform Prudent Investor Act states, “In investing and managing trust assets, a trustee may only incur costs that are appropriate and reasonable in relation to the assets, the purposes of the trust, and the skills of the trustee.”

Types of Fees

To put it in the simplest terms, there are only two types of distributions that are made from a trust: those made to directly support the beneficiary and those made for other purposes. The latter class of distribution, those that do not directly meet the trust purposes, are “costs” or “fees” associated with the administration of the trust. These fees can be organized into two classes: those paid to the trustee for the services they provide as they occupy the office and those paid to third parties to whom management and administrative functions have been delegated.

Delegatee Fees

In deciding how or what functions to delegate, the trustee must take costs into account. The role most frequently delegated by a trustee is the day-to-day management of the trust assets. At the time of the delegation and periodically throughout the relationship, a trustee is obligated to confirm that the fees being paid to the investment manager are reasonable and consistent with industry norms. This can be done by periodically gathering the fee schedules of other investment managers who provide a competing offering to the manager the trustee is currently using. A thorough fee analysis would include not only the fees the trust pays to the manager, but also the fees the trust incurs for the products or sub-managers among which the trust capital has been deployed.

Trustee Compensation

A conflict arises when the trust document is silent, as most are, about how much the trustee is to be paid.  The matter is further complicated when the trustee is a professional (like a CPA, attorney, or investment manager) who not only is appropriately compensated for their role in administering the trust, but also provides professional services to the trust.  The Uniform Trust Code, adopted by most states, gives specific guidance for fee disclosures that trustees are to make to the trust beneficiaries when the trustee wears multiple hats as the chief fiduciary and as a service provider to the trust. Developing a record of what the trustee decides to pay themselves and a rational basis for that fee amount is a critical risk mitigation discipline.

Procedural Prudence

A prudent trustee acting in good faith will create a record of who is being paid what and by whom. In many cases a simple “fee study” will suffice to create a record that the trustee both: (1) recognizes this duty to incur only reasonable costs; and (2) has taken proactive steps to fulfill this duty.

Link to  White Paper on “Fair Fees”: http://info.anodosadvisors.com/average-investment-management-fees-lp

Onward,

Josh Yager, Esq., CFP®, ChFC®
805-899-1245
jyager@anodosadvisors.com

 

Anodos helps trustees develop, maintain, and manage their own governance processes. Our support helps trustees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

 

Johnny Depp v. TMG: What are a business manager’s duties of care?

Johnny Depp v. TMG: What are a business manager’s duties of care?

business manager's duties of care

The Question: What standard of care and what attendant duties does a business manager owe to their client?

The Answer: It depends on what roles and services the business manager fulfills for their client. A good argument can be made that the business manager owes a similar fiduciary standard of care to their clients as a trustee owes to the beneficiaries of a trust.

The Lawsuit: On January 13, 2017 Johnny Depp filed suit against his long-time business manager TMG arguing that the business manager failed to act prudently and in good faith in the administration of Mr. Depp’s assets.

The Legal Principle: The outcome of this case will likely turn on what standard of care and what specific duties the business manager owed to their client. Depp has argued that the business manager owes him a fiduciary standard of care and his actions, or inaction, should be judged against the “skill, care and diligence of other business managers, accountants and financial advisors [who deliver similar services to other] high net worth individuals under similar circumstances in similar communities” (paragraph #99 of Depp Complaint).

The Argument: Clearly, it is far too early to pass judgment on the claims or counterclaims of either party. But Mr. Depp’s complaint does provide the road map that will be used to argue that a business manager owes a fiduciary duty of care to their clients. Depp proposes three legal theories: Professional Care (paragraph #99), Fiduciary Duties of an Agent/Delegatee (paragraph #106) and finally, Fiduciary Duties of a Trustee (paragraph #113).

The Solution: A well-designed governance process, whether for really wealthy A-list entertainers or clients of more modest size, will include the following elements:

  • Clear definition of the investment objectives including (a) the projected annual contributions and distributions of the portfolio, (b) the targeted return for the portfolio net of all fees, and (c) the desired terminal value of the portfolio.
  • Documentation of the capital owner’s unique investment principles which inform the manager’s implementation strategy.
  • The availability of monthly performance data consistent with best-practice standards from which the portfolio’s actual return and risk characteristics can be calculated.
  • A written fee agreement with the investment manager that is consistent with industry norms for a portfolio of comparable size and complexity.
  • A written declaration by the investment manager acknowledging the standard of care they owe the client (fiduciary standard or suitability standard) and any conflicts of interest that may exist between the manager and client.
  • A series of blended benchmarks with comparable risk and return characteristics against which to compare the portfolio.
Reconciling the Duty to Diversify

Reconciling the Duty to Diversify

DiversificationThe Duty

“In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so” (UPIA Section 3).

The Conundrum

When is the trust capital adequately diversified?  Is owning five single family houses in Long Beach, California diversified?  Is owning one index mutual fund that holds over 1,000 securities diversified?  And what is the trustee to do if the asset that originally funded the trust was NOT diversified?  What if the trust is funded with a single 16-unit apartment complex or a large single position of highly appreciated stock? How is a prudent trustee to reconcile their duty to diversify with the practical reality that diversification may not be in the best interests of the beneficiaries or consistent with the purposes, terms, distribution requirements, or other considerations of the trust?

The Exception to the Rule

The prudent trustee will recognize that the code allows for an exception to the general rule that the trust assets be diversified if “under the circumstances, it is prudent not to do so.” In what situation would it be prudent to NOT diversify? A few examples follow:

  1. The tax liability that would be owed upon selling the concentrated asset would excessively erode the trust capital.
  2. The loss of cash flow produced by the undiversified asset(s) could not be reasonably replaced by a more diversified portfolio.
  3. The undiversified asset(s) has a lack of liquidity or marketability making liquidation at a fair price impractical or impossible.

The Record

Whatever the rationale for NOT diversifying the trust corpus, the prudent trustee should document the basis for their decision to deviate from the maxim set by the Prudent Investor Act.  Creating the record explaining why the decision was made will help support the trustee’s claim that they acted prudently and in good faith under the circumstances.

The disciplined practice of creating a record each time a trustee’s discretionary decisions are made cannot be overemphasized. If there is no record of how or why the trustee reached a particular decision, it will be difficult for the court to extend to the trustee the protection available by the exculpation clause.

The Offer

Whether you serve as a trustee or have clients who are trustees, you understand the complexities and risks of occupying this office. In this White Paper we will explore those instances where it would not be prudent to diversity the trust assets. You will learn what constitutes diversification, good reasons for not diversifying the trust assets, and how to document the decision not to diversify.

Download: Understanding the Trustee’s Duty to Diversify

Anodos helps trustees develop, maintain, and manage their governance processes. Our support helps trustees and plan committees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

UPIA §2(c)(6) re Other Resources of the Beneficiary

UPIA §2(c)(6) re Other Resources of the Beneficiary

prudent administration for a trusteeThe Conundrum:

Question: Should the investment policy and distribution rate from a trust be informed by assets held by the beneficiary that are outside the trustee’s responsibility or control?   Predictably the answer is… it depends. However, in most cases it is fair to say, “The trustee is obligated by statute to consider other assets, income, and resources available to the beneficiary when the trustee establishes the investment policy and distribution strategy for a trust.”

The Duty:  

Many trustees erroneously believe that their responsibility and consideration begins and ends within the four corners of the trust document. But the UPIA, adopted by the vast majority of states, directs that a prudent trustee acting in good faith will take into consideration the assets, income, and other resources available to the beneficiary that are OUTSIDE the purview or responsibility of the trustee.

The Example:

Last month we were confronted with the following facts:  For over 10 years the beneficiary was entirely dependent on distributions made from a trust. The distribution rate was unsustainableaveraging over $100,000 per year on a $1.0m trust, making the eventual exhausting of the trust inevitable. Nevertheless, this level of distribution was consistent with the purposes, terms, distribution requirements, and other considerations of the trust. The trustee owed no duties to any remainder beneficiaries, and the trust was established to support the beneficiary to the standard of living of which she had become accustomed even if the trust assets were exhausted in following this directive.

Then the beneficiary received a windfall. A long held asset, a fractional interest of an undeveloped piece of land thought to be of minimal value, was sold and the beneficiary received over $1.4m in proceeds outside of the trust. The trustee’s question was, “Should I modify my historically high distribution rate due to the windfall proceeds received by the beneficiary outside of the trust?”

Absent any direction from the trust document, the trustee is directed by the Prudent Investor Act to consider resources (assets and income sources) available to the beneficiary outside the trust when determining what distribution rate should be made from the trust. In making this determination the trustee relied on California Probate Code §16047(c)(6), which specifically directs a trustee to consider “other resources of the beneficiary known to the trustee as determined from information provided by the beneficiary.”

To be sure, the beneficiary was not happy with this decision. Predictably, she preferred the trustee continue the unsustainable distribution level and deplete the trust so that she could have her proverbial cake and eat it too. But the trustee concluded that it would be inconsistent with instructions given by the grantor in the trust document and her duty to preserve and protect the trust assets to continue this distribution scheme.

This is yet another illustration of why it’s hard to be trustee.





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