Further Explanation - Prudent Investor Standard
Click on the appropriate link below for a more complete description of each requirement:
If these elements seem highly complicated, think again. Each one represents basic financial common sense; they are listed specifically to ensure thoroughness.
General Economic Conditions
It is impossible to make informed financial decisions on behalf of your ward or client if you have no awareness of what is going on in the wider economic world around you. As a fiduciary, you are not expected to suddenly become an expert in economics or to predict what will happen next in the economy. However, the decisions you make cannot be made in a vacuum. You should be sure to consider general economic conditions when making financial decisions for your ward or client.
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The Possible Effect of Inflation or Deflation
Inflation is defined as a generalized increase in the price of goods and services over time. Deflation constitutes the opposite: a generalized decline in the cost of goods and services over time. Both are important to consider when making long-term financial commitments.
Inflation and deflation control what is commonly referred to as a person’s “purchasing power.” Since a dollar is worth only what you can buy with it, if inflation reduces the value of your dollar, you may not be able to afford the things you need. Inflation is especially hard on people who live on a fixed income. As time goes by, they find they can no longer afford the things they used to. Their only recourse is to reduce their standard of living—a choice few people make willingly.
Over the past century, inflation has been the dominant trend in this country, interspersed with a few short-lived periods of deflation. The early 1980s were particularly harsh on purchasing power as annual inflation reached a high of 13.5% (as measured by the Consumer Price Index). Goods that cost $1.00 in 1980, for example, would cost $2.20 to buy in 2004.
From an investment standpoint, the only way to protect against inflation is to earn a rate of return on invested assets equal to or higher than the rate of inflation. As the assets grow in value, the income they earn grows too, thus preserving purchasing power.
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The Effect of Taxation
When you choose between two investments, it is not enough to consider risk and return only; you must also consider the impact of taxes on your decision. What looks like the better deal at first may turn out to be the wrong choice when taxes have been factored into the equation.
Taxes affect investment results directly. For example, pretend you have the choice between two investments: A) a taxable investment paying 6% interest and B) a nontaxable investment offering 5% at the same level of risk. Which one is better? The answer depends on the rate of tax. If the claimant is in the 28% income tax bracket, the tax rate would reduce the net return on the taxable investment to 4.3%. In this example, the nontaxable investment’s return would actually earn more money.
Before taxes, which choice looks better? After taxes, which choice turns out to be better?
 
Another way to compare A and B is to convert the nontaxable investment’s return to its “taxable equivalent yield.” In this case, earning 4.3% tax-free is mathematically the same as earning 6% taxable for a person in the 28% tax bracket. (Go here for a copy of the equation and more information on taxable equivalent yield.)
Tax rules are complex, and you should seek professional advice before making tax-related decisions. However, the important thing to understand is how big an impact taxes have on potential returns. Be sure to take your ward or client’s tax situation into account when making settlement decisions.
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The Role That Each Course of Action Plays in the Overall Strategy
This element of the Prudent Investor Standard means that fiduciaries must keep their focus on the overall result, rather than focusing too heavily on a single element of the plan. It does a ward or client no good if a fiduciary makes a brilliant financial decision with a small portion of the funds but makes foolish decisions with the rest.
Again, the Prudent Investor Standard expects fiduciaries to deliver the best overall result for the dependent persons. To do that, you must focus on the beneficiary’s needs and craft the resultant strategy as a whole.
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The Expected Total Return from Income and Appreciation of Capital
There are three ways to earn a return on invested funds: receive income from the investment, earn a profit via an increase in its value over time, or earn income plus an increase in value over time. Income will usually take the form of interest or dividends; increases in value are known as “capital appreciation.”
Some investments only pay income and offer no capital appreciation. A bank CD serves as a common example: you deposit $1,000 and the bank pays you interest as long as it holds your money. When the term is up, you get back your original $1,000, no more, no less.
Other investments offer capital appreciation but no income. Land is a good example here: you purchase an acre of land for $25,000 and sell it 10 years later for $30,000, earning a $5,000 profit.
Many investments offer a combination of the two. Rental property requires an original investment in the building and land, but you also expect to earn income by renting it out. Your final return on the investment will be a combination of the income earned and the capital appreciation.
Neither form of return is inherently better than the other; the correct choice will depend more on an assessment of the investor needs combined with an examination of the risk/return characteristics of the various investment choices. Buying growth stocks that pay no dividends for a person who needs current income is a poor fit if that person needs money to live on—you can’t buy groceries with potential future profits. On the other hand, growth stocks might be just the thing for someone who needs no current income but wants maximum long-term capital appreciation.
In many situations, a balance must be struck. If wards or clients cannot make this decision for themselves, fiduciaries must do it for them.
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Other Resources of the Beneficiary
In establishing a settlement distribution plan, you must consider whether resources exist outside the settlement that could be beneficial and then factor them into the plan. If at all possible, the settlement plan should be designed to complement the injured person’s existing financial resources. Be sure to research all outside sources of income and other assets.
Some important “other resources” are easily overlooked. One common example is eligibility for government assistance programs. Is your ward or client already receiving Medicaid or Supplemental Security Income (SSI) benefits? Is preserving eligibility for these benefits a high priority? Questions of this kind are highly technical, so if you suspect they apply in any way in your case, retain an expert to advise you.
Don’t forget that in most states parents owe their children financial support for ordinary living expenses through the age of majority. To the extent parents have assets or income that may be applied to cover these expenses, it is inappropriate to spend a minor ward or client’s own money on them.
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The Need for Liquidity, Regularity of Income, and Preservation or Appreciation of Capital
Liquidity describes the ease with which an asset can be converted into cash. Money in a checking account is considered highly “liquid” because you can walk right into the bank and withdraw it. Real estate, on the other hand, is considered “illiquid” because it can take weeks, months, or even years to sell. Each person needs a balance of actual cash and readily available cash. You must always take the need for liquidity into account when making settlement decisions.
Regularity of income is self-explanatory: if a person needs income, how often is it needed? In the absence of a regular paycheck, many people need income at least monthly. Sometimes quarterly, semiannual, or annual payments will suffice. You need to specify how often your ward or client needs the income in the plan you put together.
Preservation or appreciation of capital relates somewhat to the risk/return issue discussed earlier. In the settlement context, capital is the original amount of money a person stands to receive from the settlement. From that date forward, different situations will call for different strategies. From an investment standpoint, a goal of preserving capital is different from a goal of increasing wealth.
Generally, a trade-off exists between level of income and opportunity for capital appreciation. Long-term bonds pay current income but offer no growth; stocks, on the other hand, pay no income but offer opportunities for sizable long-term capital appreciation.
Preservation of capital is a more conservative objective, but it may not be suitable for all beneficiaries. In an inflationary environment, a person who needs income for the long term will slowly begin to lose purchasing power if assets are only “preserved”—kept at the same dollar value. In order to maintain their standard of living, people must achieve some level of real growth to offset inflation. You must determine which of these two objectives is most suitable for your ward or client.
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The Duty to Verify Facts Relevant to Your Decisions
Since another person is relying so heavily on your prudence, when you serve as a fiduciary, you accept a duty to exercise “due diligence” in the performance of your various tasks. In other words, you must take reasonable steps to confirm that the facts presented to you are indeed what they have been represented to be.
The word “reasonable,” of course, is subjective, and no “Uniform Reasonable Decision Act” exists to help define it further. So it’s up to you to show a healthy skepticism about all things presented to you that affect your ward or client, and you should make an independent effort to confirm what you are told.
Even if you choose to be a “sucker” with your own money—giving in response to email schemes or investing with companies promising to “double your returns with zero risk”—you have no such luxury with a beneficiary’s money.
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The Requirement That Assets Be Diversified
Diversification is such a key element of the Prudent Investor Standard that it occupies its own section in the Act. When fiduciaries get into trouble, it is often as a result of a failure to diversify assets.
In investing, there is no eliminating risk, only managing it. The classic strategy for managing risk is to spread it out by holding a mixed bag of investments. This is the old “never put all your eggs in one basket” theory. Since all investments entail some level of risk and no one can tell where the next unpleasant surprise will come from, it just makes sense to put money into different assets to distribute the risk.
Bear in mind that you must diversify not only within a given asset class but also between the classes themselves. An asset class is defined as a group of investments with common investment characteristics—say all bonds or all stocks. It helps to hold bonds from more than one issuer in case that one issuer goes bankrupt. But that does you no good if something occurs that devalues all bonds (like an increase in interest rates). Therefore, the prudent investor always diversifies assets within asset classes and between them.
If you decide not to diversify, be aware that you may have to prove you had a "compelling reason” to justify your decision. Few exist in modern investing. In the vast majority of situations, fiduciaries who fail to diversify assets assume an unjustifiable risk—both for the claimants and for themselves. Be guided accordingly.
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The Duty to Incur Only Appropriate and Reasonable Costs
This is the “other people’s money” clause. Since you are controlling a ward or client’s money and many of your decisions will involve the payment of fees and other costs, the Prudent Investor Standard prohibits you from overpaying. Paying above-market rates for goods or services wastes the claimant’s money and thus violates your duty to preserve his or her capital.
The precise definition of “appropriate and reasonable” is again left undefined. This puts the burden of proof on you should anyone challenge expenditures you approved.
For expenses of any size, it is wise to research the market, to solicit competitive bids, and to save the paperwork. This will not only ensure better prices but will also document your attention to this important fiduciary duty.
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