W. Scott Simon
Sometimes fiduciaries and other groups ask me to give them an introduction to modern prudent fiduciary investing. Despite the nature of these sometimes ponderous, pontificating presentations–not to mention my inherent lawyerly drone–most in the audience are (or at least appear to be) genuinely interested in what I have to say. So I thought that a wider audience of advisors reading my column would have an interest as well.
Modern prudent fiduciary investing–not any official term, but simply my own–is derived from two works that have been introduced within the last quarter century. The first is the 1992 Restatement (Third) of Trusts (Restatement), which I think of as the bible of trust investment law in America today. It’s a massive, multivolume legal treatise that examines the common law and state statutes in the field of trust law as it exists in the 50 states and restates them as broad legal principles. (The “common law” is judge- made law based on custom and judicial precedent in contrast to statutory law, which results from passage of a bill by a state legislature and its enactment into law as a statute upon a governor’s signature.) The Restatement provides many examples of prudent and imprudent investing, with accompanying analyses and discussions.
Because of the rise in importance of Modern Portfolio Theory in the late 1960s and the resultant significant changes in the investment practices of fiduciaries, the Restatement was introduced to update the 1959 Restatement (Second) of Trusts, which updated the original 1932 Restatement of Trusts. (Modern Portfolio Theory also underpins the investment standards required of fiduciaries under the Employee Retirement Income Security Act of 1974.)
The Restatement sets forth the underlying rationale of the rules that are now part of the Uniform Prudent Investor Act–the other work underpinning modern prudent fiduciary investing. The UPIA was introduced in 1994 as a model act that states could adapt and enact into law. The 23-page UPIA and its commentary draw upon and codify the essential principles of investment prudence laid down by the Restatement. The UPIA has been enacted into law (nearly verbatim in most cases) by virtually all states plus the District of Columbia and the U.S. Virgin Islands.
The Restatement and the UPIA stand together at the center of modern prudent fiduciary investing. (My 2002 book, The Prudent Investor Act: A Guide to Understanding, is an exploration and discussion of modern prudent fiduciary investing– all neatly compiled into a mere 135,000 words.)
Over the past five years or so, there’s been an increasing number of references to the Restatement and the law of trusts in litigation concerning (primarily) 401(k) plans governed by ERISA. For example, a unanimous U.S. Supreme Court held in Tibble v. Edison International (2015) that a fiduciary “has a continuing duty–separate and apart from the duty to exercise prudence in selecting investments at the outset–to monitor, and remove imprudent, trust investments.”
Tibble’s reference to “trust investments,” of course, is to assets held in trust for participants in their 401(k) plan accounts. But trust investments are also present in a wide variety of other situations such as assets held in private family trusts, assets held in trust by nonprofits ranging in size from small to giant endowments and foundations, and assets held in trust by statewide public employee retirement systems. All these pools of money–whether hundreds of thousands or hundreds of billions of dollars–are governed by the common law principles of trust law. And the best source to understand such principles today is laid out in the Restatement and its progeny, the UPIA.
There are a number of duties required of fiduciaries under the UPIA, but I think the three most critical are: (1) determine the risk/return trade-off of a portfolio; (2) control inappropriate and unreasonable portfolio costs; and (3) diversify portfolio risk. These duties are also required of fiduciaries under the Restatement, as well as ERISA.
Section 2(b) of the UPIA states that the trade-off in all investing between risk and return is identified as the fiduciary’s “central consideration.” Very few fiduciaries satisfy this duty because they focus on only one side of the risk/return trade-off–return–and ignore the other side–risk. This makes some investment fiduciaries susceptible to the come-ons of nonfiduciary-product peddlers who sell, for example, on the basis of track records: “Our product did really well/spectacularly/outstandingly over the past three/five/10 years, so naturally it will do well in the future.” A prudent fiduciary must look at both sides of the equation in determining the risk/return trade-off of a portfolio. (Even those relatively few fiduciaries who do look at risk don’t delve into the difference between “compensated” risk and “uncompensated” risk, a subject that merits its own column.)
The second critical duty required of fiduciaries under the UPIA (section 7) is to only incur costs that are appropriate and reasonable. Commentary to section 7 states: “Wasting beneficiaries’ money is imprudent … trustees are obliged to minimize costs.” To be clear, this doesn’t mean that fiduciaries are required to offer the lowest cost product or service. Rather, it means that they are required to minimize costs but only after they are determined to be appropriate and reasonable in relation to the value of the product or service for which they have been expended.
The third critical duty required of fiduciaries under the UPIA (section 3) is to diversify the investments of a trust portfolio unless it is reasonably determined that, because of special circumstances, the purposes of the portfolio are better served without diversifying. (In my July 2017 column, I wrote of a case where I testified as an expert about the special circumstances that justified a one-stock portfolio–which is about as nondiversified as you can get.)
Generally, though, the rule is to diversify, because, as noted by the Restatement, sound diversification is fundamental to risk management and is therefore ordinarily required of fiduciaries. Nobel laureate Harry Markowitz, the father of Modern Portfolio Theory, expands on this: The essential problem faced by all investors is uncertainty–that is, risk–which is the central factor at work in financial markets. Decisions about portfolio investments are therefore made under inherent uncertainty.
Investment uncertainties include the future in general and the unexpected–both good and bad–news that it brings such as which investments or investment managers, and so on, have outperformed (or underperformed). The antidote to these uncertainties is broad (across the asset classes that comprise a portfolio) and deep (within each such asset class) diversification of portfolio risk. John H. Langbein, the reporter for the UPIA and the Sterling Professor of Law and Legal History at Yale University Law School, explains: “One of the central findings of Modern Portfolio Theory [is] that … huge and essentially costless gains [can be obtained by] diversifying [a] portfolio thoroughly.” Indeed, more than one commentator has said that thorough diversification is the only free lunch in all of investing.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.