It’s not uncommon for investors, including fiduciaries, to not have a full picture of what is held in their or their client’s investment portfolio. As a result, fiduciaries can run under the assumption that their clients’ portfolios might all look the same, even if they are with different advisors. As fiduciary, your first duty of care is to the beneficiary. If there are practices and decisions working to the beneficiary’s detriment, they should be addressed and amended. But what red flags should successor trustees be looking for in terms of the investable assets? We cover the 8 most common pitfalls successor trustees can avoid and how to better navigate financial decisions. 

  1. Duty to Monitor

The Uniform Prudent Investor Act (UPIA) makes it explicitly clear that successor trustees have an obligation to review the trust assets within a reasonable time. But often fiduciaries find themselves overwhelmed by the complex nature of investment strategies, so many don’t know where to begin. Let’s start with the duty to monitor. 

One of the most common pitfalls is how a trustee handles the duty to monitor the investable assets. What does having a duty to monitor mean?  Does that mean managing the portfolio, does it mean having reviews with the advisor? And how often?  Regardless, a trustee should have a process and a plan that they stick to, whether they are managing the investments themselves or overseeing an advisor.

Even when overseeing an advisor, there are some cases where a portfolio has too many positions to realistically and effectively monitor the risk in the portfolio. With too many positions it can become easy to overlook significant areas in the portfolio where there may be weaknesses. In this case it might be advisable to reduce  the number of positions to a more manageable figure. This makes it much easier to viably monitor the investments, as mandated by the code

  1. Role of Investments in Context of Overall Trust and Other Resources

Another common problem is inappropriate asset allocations. There are a variety of reasons why the asset allocations may be off, but in order to properly identify the role of the investments the fiduciary must first determine the risk tolerance of the beneficiaries. A qualified financial advisor can easily assist with determining risk tolerance. 

When determining risk tolerance there are two key factors at play: the beneficiary’s ability to take risk and the beneficiary’s willingness to take risk. One’s ability to take risk is largely based on external factors, whereas one’s willingness to take risk is much more psychological in nature and therefore is harder to define. 

When we talk about the ability to take risk with investable assets, there are really five constraints at work: 

  • Liquidity Needs: How often or how much of the portfolio needs to be paid out in distributions.
  • Time Horizon: Age of the beneficiary, specific timing provisions within the trust, or major expenditures that need to be planned for. 
  • Taxes: How trust gains are to be taxed (at the grantor or non-grantor level), . No one likes to pay the government if they don’t have to. UPIA states that a trust’s tax impact should be a key consideration of the trustee. Knowing how a trust is structured and how taxation will flow can impact the investment strategy or the types of investments used. This can also impact how often an advisor trades a portfolio due to the tax impact of capital gains or losses.
  • Legal and Regulatory Factors: What laws, such as the UPIA, or state specific probate codes, apply to the trust. In most states, the laws regulating investable assets within trusts are very similar. However, states can make unique tweaks to it.  For example, in the state of Washington, the code allows for 10% of a trust’s investments to be invested in new and unproven enterprises. 
  • Unique Needs and Preferences: There may be unique scenarios where the beneficiary has a special relationship with assets that cannot be sold or opinions on investments they, as beneficiary, want to make or avoid for social or political reasons. 

All of these investment constraints should be taken into consideration because they can affect an investor’s ability to take risk. 

When we think about an investor’s willingness to take risk, this is a much more subjective matter. One’s willingness to take risk isn’t static; it can and likely will change over time. Just like an investor’s ability to take risk, there are a number of factors in play when it comes to their willingness to take risk, like investment experience, source of wealth, inclination towards taking on debt, and personal financial goals. Aside from asset allocations, the investments themselves need to meet the risk tolerance and the needs of the beneficiary. 

As trustee, you can also review the nature of the investments themselves to ensure the level of risk is appropriate for the beneficiary. Individuals and financial professionals may typically review risk based on an investment’s volatility or the volatility of its sector. Sectors such as energy, communications and technology typically have a higher level of volatility, while consumer staples and real estate run on the lower end. However, it is important to review risk on the portfolio level. This is because a portfolio is the sum of its parts and the UPIA instructs that a trustee assess return and risk from the perspective of the portfolio’s total return.

  1. Needs for liquidity preservation vs appreciation of capital 

Another common problem a trustee might run into is a portfolio that is holding too many illiquid investments to meet the beneficiary’s liquidity needs. 

Liquidity is the ability to convert investments quickly to cash at a price close to market value. The most liquid investments are cash, monkey market investments, UST bills, and CDs, while illiquid investments are properties, limited partnerships, and collectibles. 

One of the liquidity investments that can be problematic is annuities, particularly too many annuities used for beneficiaries with long time horizons. Annuities, particularly fixed annuities, often don’t provide a sufficient level of growth and can tie up cash for a long period of time. 

  1. Duty to Diversify the Investments of the Trust

Generally speaking, trustees are mandated to diversify the investments, but the most common way this standard may be compromised is portfolios with too much exposure in a specific asset or sector. 

This pitfall may not always be obvious when reviewing the trust’s financial statement. A trusted financial advisor can help break down the portfolio by sector and weight to determine if there are any opportunities to better diversify the portfolio. 

Another common issue with lack of diversification has to do with portfolio holdings that are highly correlated to one another. The UPIA states that management of the investable assets should adhere to modern portfolio theory (MPT). MPT involves using diversification to reduce the volatility of the portfolio and ultimately enhance risk adjusted returns. When investments are highly correlated, they produce a duplicate effect and provide minimal benefits of diversification. A more well balanced, diversified portfolio should display much lower levels of correlation in order to reduce volatility. Reducing volatility can make risk easier to manage.

  1. Consider Effect of Inflation or Deflation

One way this requirement is neglected is by holding too much cash in checking or savings accounts for an extended period. With the current average FDIC savings rate of 0.06% and the highest price increase of goods in the last 33 years, cash sitting in a checking or savings account is essentially losing its value to inflation. It’s crucial to protect against inflation in order to protect the assets over the long term. 

  1. Assets Managed in Sole Interest of the Beneficiary

Frequently, fiduciaries may have accounts with advisors that are not being managed under a fiduciary standard. While this isn’t necessarily a major problem, there is the concern of liability. If fiduciaries are working with a broker, they should at least be aware that the broker may not have discretionary investment authority. This means the authority and liability of all investment decisions ultimately lies with the fiduciary. 

If a fiduciary wants to ensure the investments are being managed under a fiduciary standard, they should look at the existing management agreement and investment policy statement for clues. This should hopefully make the relationship clear; but if not, the fiduciary can also ask the advisor these questions to better understand how the assets are being managed. 

  1. Only Incur Costs Appropriate and Reasonable in Relation to the Assets

There are a variety of places you can find excessive costs, but one of the more difficult things to spot is the fund expense ratios in the portfolio as they are not typically included within the statement. Fund expense ratios can vary depending on the type of fund strategies, fund company, and the types of securities that they hold.

Let’s look at an example. Say Fund XYZ buys five stocks and those stocks as a whole generate a 10% return for the year. Let’s also say the expense ratio is 1.25%. As a holder of the fund you don’t receive a 10% return, you receive 8.75% after the expenses are taken out. These expenses are also separate from the management fees paid to the financial advisor. Costs can add up over time due to the power of compound interest, so they do need to be monitored carefully. 

Sometimes fiduciaries aren’t even aware of what fees they are actually paying to the advisor. The fees themselves aren’t incredibly easy to spot as they might be billed in arrears or in advance and might appear on a statement quarterly.  Fees also may have tiered structures or householding breakpoints. There even might be a specific “platform fee” for technology or software the advisor uses.  During your advisor vetting process be sure to question the advisor’s fee structure and any additional management fees. 

  1. Consider Tax Consequences of Investment Decisions or Strategies

Our final pitfall centers around tax consequences of investment decisions or strategies. Hopefully when a fiduciary is working with a financial advisor, they are making sure the advisor is sensitive to some of the specific tax issues of the trust. Potential tax considerations that are often overlooked include:

  • Available deductible expenses
  • Stepped up basis
  • Grantor vs. non-grantor trust
  • Short term vs. long-term gains
  • Income vs capital appreciation
  • Mutual funds vs. ETFs – realized gains 

As we think about handling taxes, one of the most frequent pitfalls we encounter is how to manage taxes when changes need to be made in the investments. Let’s say a trustee recognizes the portfolio is not being managed in compliance with UPIA standards and a change is needed. You essentially have three options:

  1. Transfer the investments over in-kind
  2. Liquidate everything and reinvest the entire portfolio
  3. Evaluate unrealized gains and losses

Each of those options have tax considerations to work through before deciding to move forward. 

Stepping into the role of successor trustee is no easy feat. Be mindful of these 8 common pitfalls of investable assets to remain in compliance with the UPIA standards and gain greater confidence in dealing with your client’s investment matters. 

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Jeremy Lau

Jeremy L. Lau serves as Chief Executive Officer. He teaches the Investment Management course for California State University, Fullerton’s Trustee Certification Program and frequently speaks on fiduciary investing to attorneys and fiduciaries across various associations. Before joining Prudent Investors, he worked as an Executive Director in investment banking in Tokyo and Hong Kong for Deutsche Bank AG and UBS AG in structured credit and convertible bonds. He graduated in Accounting (with Honors distinction) from Brigham Young University and has earned the right to use the Chartered Financial Analyst (CFA®) and Certified Financial Planner (CFP®) designations.