Prudent Investor Rule

The prudent investor rule is the duty, imposed by state trust law, that a trustee who invests and manages trust assets must do so with reasonable care, skill and caution, as a prudent investor would for the entire portfolio, taking into account the purposes and terms of the trust. New York's statute captures its core: "The prudent investor rule requires a standard of conduct, not outcome or performance." Virginia's enactment describes it as "a default rule" that the trust instrument may alter. Virginia enacts it in an article titled the Uniform Prudent Investor Act, and New York also calls it the prudent investor standard.

The portfolio, not the holding. The rule's defining feature is that a trustee's decisions about individual assets are evaluated, in Virginia's words, "not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust." A volatile stock fund can be a prudent part of a diversified trust portfolio, and New York's statute states that "no particular investment is inherently prudent or imprudent." What is judged is the process and the fit.

What a trustee must weigh. New York lists the considerations, to the extent they are relevant: the size of the portfolio, the nature and expected duration of the trust, liquidity and distribution requirements, general economic conditions, the possible effect of inflation or deflation, the expected tax consequences of investment decisions and distributions, the role each investment plays in the portfolio, the expected total return including both income and appreciation, and the beneficiaries' needs for present and future distributions. Virginia's list is similar.

Diversification and initial assets. Virginia's statute requires a trustee to diversify the trust's investments unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying. New York's requires the trustee, within a reasonable time after the trust begins, to decide whether to keep or sell the assets the trust started with. A trust that receives a large block of one company's stock or a family business therefore presents a real question for the trustee, and a trust document that wants the asset kept should say so.

Delegation and costs. A trustee may delegate investment management, but under New York's statute must use care in selecting the manager, setting the scope and terms of the delegation, periodically reviewing the manager's performance and compliance, and controlling the overall cost. The same statute permits costs in general only to the extent they are appropriate and reasonable in relation to the trust's purposes, assets and the trustee's skills.

A default rule the document can change. Virginia's statute allows the trust instrument to expand, restrict, eliminate or otherwise alter the rule, but a general clause letting the trustee invest "in such assets as the trustee, in his sole discretion, may deem best" does not waive it. The instrument must expressly show the intent, for example by referring to the "prudent man" or "prudent investor" rule, by authorizing "speculative" investments, or by authorizing the trustee to hold a specific asset such as a closely held business.

Who is bound, and a different federal standard. The rule binds trustees, and states can extend it to other fiduciaries: Virginia's definition of trustee for this article includes an agent under a written power of attorney and an adult holding property for a minor under the Uniform Transfers to Minors Act. Workplace retirement plans are governed instead by ERISA, which requires plan fiduciaries to act with the care, skill, prudence and diligence "that a prudent man acting in a like capacity and familiar with such matters would use" and to diversify plan investments unless it is clearly prudent not to. The two standards share a vocabulary and an emphasis on process, but they come from different law.

In practice, a trustee meets the rule by following and documenting a process.

1. Read the trust document for its purposes, its distribution terms and any provision expanding, restricting or waiving the rule.
2. Review the starting assets within a reasonable time and decide what to keep and what to sell.
3. Set an investment strategy with risk and return objectives suited to the beneficiaries, the trust's expected duration and its distribution needs, which can be written down in an investment policy statement.
4. Diversify, unless there is a documented reason the trust's purposes are better served without it.
5. Control costs and monitor, including any investment manager the trustee hires.

For example: a trust holds $1,000,000, of which $700,000 is one company's stock inherited from the person who created the trust, and must pay income to a surviving spouse and then pass to two children. A 40% fall in that stock would cost $700,000 x 40% = $280,000, or 28% of the trust. Spread across a diversified portfolio holding 5% in that same stock, a 40% fall in it costs $50,000 x 40% = $20,000 from that stock alone, or 2%. Unless the trust document directs the trustee to hold the stock, the rule's diversification duty points toward the second portfolio, and keeping the concentration would need a reasoned, recorded explanation, such as a large tax cost of selling weighed against the risk.

Pros

• Judges trustees by a prudent process rather than by hindsight about returns.
• Allows any type of investment that fits the portfolio, rather than a fixed list of safe assets.
• Requires diversification, which protects beneficiaries from a single large loss.
• Lets trustees hire professional managers, provided they choose and monitor them carefully.

Cons

• A process standard is harder to apply and to enforce than a bright-line rule.
• Diversifying a concentrated or family asset can trigger taxes or conflict with what the family expected.
• Waiver and modification depend on the exact words of the trust and on state law, which varies.
• It does not govern workplace retirement plans, which follow ERISA's separate standard.