“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).
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:
- The tax liability that would be owed upon selling the concentrated asset would excessively erode the trust capital.
- The loss of cash flow produced by the undiversified asset(s) could not be reasonably replaced by a more diversified portfolio.
- The undiversified asset(s) has a lack of liquidity or marketability making liquidation at a fair price impractical or impossible.
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.
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.
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.
Josh Yager, Esq., CFP®, ChFC®
Anodos helps trustees (ERISA, individual, and endowment) save time, reduce their personal risk, and fulfill their fiduciary duties. We do this by helping the trustee conduct audits of the money managers to whom investment duties have been delegated. Fiduciaries have an affirmative duty to provide ongoing and independent oversight of the money managers. What makes us unique is that we do not manage money or sell insurance. Doing fiduciary audits, benchmarking studies, and performance attribution is all we do.
We do what trustees should do, but don't know how
Anodos develops and maintains an investment governance process for trustees so that their fiduciary duties are fulfilled.