You can do whatever you want with your money and assets but when charged with caring for another person’s money and assets, a body of law provides guidance on how you should proceed. Enter the Prudent Investor Rule.
I am not talking about financial planners and wealth management companies, though both are ostensibly charged with caring for a person’s money. I am talking about those in positions of power with the direct authority to manage assets independent of the person for whom they are managing money.
Trustees of trusts are required to invest and manage assets as a prudent investor. RCW 11.100.020. Nonprofits are generally required to invest and manage assets as a prudent investor. RCW 24.55. Insurance companies must invest and manage float prudently. RCW 48.13.031. Exchange facilitators must invest and manage assets prudently. RCW 19.310.080. Guardians must invest and manage assets as a prudent investor. RCW 11.100.015. And though the rules have slight variations, this article explores the common thread among the various prudent investing laws.
So, what is the Prudent Investor rule and why is it important?
The Prudent Investor Rule was adopted by Washington state and comes from the Uniform Prudent Investor Act (UPIA)– a product of the Uniform Law Commission and promulgated in 1994. UPIA and the Washington equivalent require these fiduciaries to adhere to Modern Portfolio Theory and to invest as a prudent investor would invest “considering the purposes, terms, distribution requirements, and other circumstances of the trust” using “reasonable care, skill, and caution.” Source: Uniform Law Commission. Modern Portfolio Theory was developed by Harry Markowitz in 1952 (for which he was later awarded the Nobel Prize in Economics). It is a mathematical framework for a portfolio of assets that maximizes return relative to risk. As of 2018, the vast majority of states have adopted the Prudent Investor Act and the corresponding use of Modern Portfolio Theory developed by Markowitz. Source: Uniform Law Commission.
The scope of the Prudent Investor Rule generally applies to those people or entities that are acting in some kind of fiduciary capacity as stated above. A fiduciary is anyone that is legally required to act in the best interest of the person or persons the fiduciary is serving. It is a duty that can be distinct from acting as the person being served would act. The opinion of the principal or beneficiary is helpful though not determinative. An example helps to explain the concept. Assume John is the eldest son of his widowed mother and that, for example, she either places money into trust with John as the trustee or John becomes the guardian of her estate. Assume that Mom loves the company ABC and had all her stocks in ABC (or all her assets in other concentrated positions to include concentrations such as gold, treasury bonds, CDs, or just cash).
John may wish to honor his mother’s investment philosophy by maintaining the concentrated position in ABC. The problem is that such a move would likely be a breach of his fiduciary duty to his mother to act as a prudent investor under the Prudent Investor Rule.
And, in the event the portfolio suffered loss (i.e. ABC went down in price) then John could be liable for breaching this fiduciary duty. On the other hand, if John constructed a portfolio in accordance with the Prudent Investor Rule and the assets went down in value, John would likely not be liable for the loss as he has performed in accordance with his duty. The loss in the portfolio is not as critical as the composition of the portfolio.
The Prudent Investor Rule generally requires that the assets included in a portfolio to be evaluated not individually and in isolation, but instead as part of the broader portfolio as a whole and as part of a broader investment strategy where the risk and return are suitable for the use of the funds. The fiduciary generally must consider the following relevant information in constructing a portfolio:(a) General economic conditions; (b) The possible effect of inflation or deflation; (c) The expected tax consequences of investment decisions or strategies; (d) The role that each investment or course of action plays within the overall portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (e) The expected total return from income and the appreciation of capital; (f) Other resources available; (g) Needs for liquidity, regularity of income, and preservation or appreciation of capital; and (h) An asset’s special relationship or special value, if any. See e.g RCW 11.100.020.
Simply choosing to invest the funds, without attention to these other matters, is insufficient. The statute specifically lays out the criteria the fiduciary should employ to set up the fund, choose investments and investment advisors, and the factors to consider in the ongoing management and investment of the funds. Those considerations should be stated and recorded in one form or another (sometimes in an Investment Policy Statement and/or the minutes of the fiduciary or the board or investment committee). If you or someone you know is in such a position of power, the best practice is to seek advice from a qualified professional on compliance with the Prudent Investor Rule.
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* Licensed, not practicing.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.
