When someone agrees to serve as trustee, they often understand that they have a responsibility to manage someone else’s money. What they may not fully appreciate is just how much thought Arizona law expects them to put into that responsibility. The law does not simply ask a trustee to avoid losing money. It asks the trustee to make investment decisions that are appropriate for the particular trust, its beneficiaries, and its purposes. This is known as the “Prudent Investor Rule.”
A “prudent investor” is not the same in every circumstance.
Despite the name, being a “prudent investor” does not necessarily mean putting everything in a savings account or buying only the safest investments (although it can mean that in some instances).
Imagine that a parent creates a trust for a child with a disability. The trust is expected to last for decades. The child has other resources, and the trust does not need to produce a large amount of income every month.
Now, imagine a different trust established for an 85-year-old beneficiary who depends on the trust to pay for assisted living expenses. Her cost of care is high and the trust holds all of her resources.
Now, imagine a trust established for a 45-year-old well-off adult, who has their own career and can support herself off her own income, let alone her trust’s income. Her needs up until this point have been covered by her own earnings, and she owns he own home, retirement account, and savings.
It would make little sense to assume that all three trusts should have the same investment strategy. Arizona law recognizes this.
Under Arizona’s Prudent Investor Rule, a trustee must invest and manage trust assets by considering the purposes, terms, distribution requirements, and other circumstances of the trust. The trustee must exercise reasonable care, skill, and caution. Importantly, investment decisions are evaluated in the context of the portfolio as a whole, rather than judging each individual investment in isolation. A.R.S. § 14-10902. A trustee might own an investment that, viewed by itself, appears risky. That does not necessarily mean the trustee violated the Prudent Investor Rule. The question is how that investment fits into the overall portfolio and whether the portfolio has an appropriate balance of risk and return for that particular trust and that particular beneficiary.
What Should a Trustee Consider?
Arizona law gives trustees a list of factors to consider when making investment decisions. Among them are economic conditions, inflation, taxes, the role of each investment within the overall portfolio, expected total return, the beneficiaries’ other resources, liquidity needs, and the need for regular income or preservation and appreciation of capital. The trustee must also make a reasonable effort to verify facts relevant to the investment and management of the trust. A.R.S. § 14-10902.
There is no requirement that every investment be “safe” or “completely risk averse.” Instead, the law recognizes that there is a relationship between risk and return. A trustee who keeps every dollar in cash might avoid the possibility of losing money in the stock market. But over a long period of time, inflation could substantially reduce the purchasing power of that money. On the other hand, a trustee who puts everything into speculative investments might expose the trust to an unreasonable risk of loss.
Prudence lies somewhere in between and where that point is depends on the circumstances, the trust document and who the beneficiary of the trust is.
Diversification Matters
One of the most familiar concepts associated with prudent investing is diversification. Arizona law provides that a trustee shall diversify the investments of the trust unless the trustee reasonably determines that special circumstances make diversification inconsistent with the purposes of the trust. A.R.S. § 14-10903. In other words, putting all of the trust’s assets into one investment is generally a bad idea.
But even here, there can be exceptions.
Suppose Dad creates a trust for his daughter and leaves the trust a large interest in the family business. Selling the business immediately might technically make the investment portfolio look more diversified, but it could also defeat the purpose of the trust—or the purpose for which Dad created it in the first place. The Prudent Investor Rule gives a trustee room to consider those circumstances.
The Investment You Inherited May Not Be the Investment You Keep
Another important part of Arizona’s law applies when someone first becomes trustee.
Within a reasonable time after accepting the trusteeship or receiving trust assets, the trustee must review the trust’s assets and make and implement decisions about whether those assets should be retained or disposed of. A.R.S. § 14-10904. The goal is to bring the portfolio into compliance with the trust and the Prudent Investor Rule.
This can be particularly important when someone becomes trustee after the death or incapacity of a parent.
Perhaps Mom’s trust contains a portfolio that was perfectly appropriate for Mom while she was alive. After her death, the trustee’s job may change. The beneficiaries may have different financial needs. The trust may have a different expected duration. The trust may now need to generate income—or perhaps it can tolerate considerably more volatility.
The fact that an investment was appropriate for Mom does not automatically mean it is appropriate for the beneficiaries of Mom’s trust.
What About the Family Member Who Becomes Trustee?
Many trusts are administered by family members. the Prudent Investor Rule still applies.
Being a family member does not eliminate the fiduciary responsibilities that come with being a trustee. In fact, family relationships can sometimes make those responsibilities more complicated. A trustee may be tempted to keep an investment because “Dad always liked that stock.” Or perhaps the trustee is reluctant to sell the family business because doing so feels like selling part of the family’s history. Those are understandable emotions. But a trustee’s obligation is ultimately to administer the trust for the beneficiaries.
The trustee’s personal feelings, family relationships, or attachment to a particular asset cannot replace the fiduciary analysis.
How do you be a prudent investor?
One of the things I find most interesting about the Prudent Investor Rule is that it recognizes something that is easy to forget when talking about investments: People are different. So are trusts. There is no one size fits all approach and the appropriate strategy can change over time.
The question a trustee should be asking is not simply, “Is this a good investment?” The better question is: “Is this investment appropriate for this trust, these beneficiaries, and the purposes for which this trust was created?”
If you are serving as trustee, remember that you do not have to be an investment expert (although it would be nice if you were). Arizona law permits a fiduciary to delegate investment and management functions to an appropriate investment agent, provided the fiduciary exercises reasonable care in selecting the agent, defining the delegation, and monitoring the agent’s performance. A.R.S. § 14-10907.
Most importantly, remember that prudent does not mean perfect. It means making thoughtful decisions, based on the circumstances at the time, with the interests and needs of the beneficiaries in mind.
For a trustee, that is not simply good investment advice. It is a fiduciary obligation.