Fiduciaries of all types are under scrutiny for implementing practices that are in the best interest of beneficiaries of the trust they manage. Liability can extend beyond business to personal liability and trustees need to be armed with knowledge of where things can go wrong. Because the duties of a trustee are often complex and unique, it is imperative that the trustee familiarize themselves with the responsibilities and risks before taking on this important role. 

Before we get into best practices on how to protect the trustee, let’s first outline the three primary reasons for litigation related to investments

Reasons for litigation related to investments

  1. Assets are unproductive

The California Probate Code, §16049, states “within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee shall review the trust assets and make and implement decisions concerning the retention and disposition of assets, in order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust, and with the requirements of this chapter.”

A natural place for the trustee to begin their duties is by first reviewing the estate assets. This gives the trustee complete insight into all the assets outlined within the trust and helps them identify which assets are productive and which assets are unproductive. They will be constantly evaluating the disposition of the estate and implementing changes that minimize risk and positively impact the beneficiaries. 

The trustee may narrow in on questions like:

  • Has the trust been funded and invested?
  • Are the assets diverse? 
  • Is the overall structure sound?

The code goes on to state that “among circumstances that are appropriate to consider… [is] the possible effect of inflation or deflation” … and “the expected total return from income and the appreciation of capital.”  

For those with limited to no experience as a trustee or even those who are professional fiduciaries, the financial component and its associated risk drive home the need to secure a professional advisor that can navigate economic and market conditions and provide a full portfolio analysis to ensure assets are indeed productive. 

  1. Large losses are suffered

Excessive fees and a portfolio that isn’t properly diversified can lead to large losses. A beneficiary’s ability to tolerate risk must be considered in determining the allocation of assets across asset classes.

Just as the trustee reviewed the trust assets and implemented changes to correct any unproductive assets, the trustee should assess the trust for any continuous or potential large losses. 

First, check the asset allocation. Understanding correlation will help you master portfolio diversification. If the asset correlation range is between 0.6 to 1.0 there is work to be done. Low or negative correlation must be associated with a decent return to be considered a well-diversified portfolio. Ensuring the investments of the trust are diversified will reduce volatility of the portfolio and improve risk-adjusted performance. 

Now that your portfolio is diversified, let’s move on to identifying risky investments. There are safe investments, like checking deposits, money market deposits, and certificates of deposits. Then there are risky investments, like options and swaps. Consider outlining the trust’s investments on a scale of safe, moderate, and risky. By doing this you’ll get an accurate picture of the entire investment strategy and whether you need to ramp up or pull back on risky investments. 

The probate code does, however, state that “in making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so.”  Under certain circumstances, the trust is better served without diversifying.  For example, it might be necessary to consider the tax impact of diversifying concentrated stock positions. 

Trustees also have the responsibility to defray expenses.This includes annual operating expenses, management fees, accounting costs,and taxes.  With regard to management fees and annual operating expenses, trustees should ask questions about costs during the advisor interview process about the expense ratios of investments they use and frequency of trading,  since excessive activity in accounts can increase trust accounting fees.

  1. Public benefits are breached 

Government benefits must also be considered in acting in the best interest of beneficiaries.  Public benefit entitlements could be impacted by events that trigger means testing for beneficiaries. Personal income and asset levels, for example, could reduce the amount of social security benefits a beneficiary is entitled to. In certain cases, this is acceptable.  In other cases, it is not.  Avoiding the impact of a reduction in social security benefits would fall under a trustee’s duty to protect beneficiaries.  

The best strategy to use to protect government benefits will depend on the beneficiary’s individual needs. Factors to consider include the time horizon of the planning period, the age of the person needing care and benefits, and much more. One or more methods might be utilized and an experienced estate planning attorney can design the best strategy to include any of tools below:

  • Gifting assets to family members
  • Annuity purchases
  • Certain long-term care insurance policies
  • Third party trusts, such as a supplemental needs trust
  • First party trusts, including a special needs trust or a pooled trust

For example, any gifts made within five years of applying for Medicaid nursing home services may penalize your application and benefit eligibility. In addition, first party supplemental needs trusts are generally only available for disabled individuals younger than 65. After that age, a trustee would need to explore a different type of trust to protect the assets.

Special needs trusts have particulars of their own that are worth mentioning here.  Specific income and asset amounts could exceed limits that would ultimately cause a reduction in government benefits.  Special needs planners are aware of such limits and employ strategies to protect special needs consumers’ eligibility for government benefits.  Furthermore, the payment of certain expenses could trigger a reduction in benefits.  

Best Practices for Protecting the Trustee 

For both professional fiduciaries and family trustees, the expectations and risk associated with a trust can feel insurmountable. Lets dive in to best practices trustees can follow to help protect themselves from investment related risk. 

Build a Network

Surrounding yourself with a solid inner circle of professionals is at the top of our best practices list. After being named trustee, the individual should assess whether there are any role gaps that need to be filled or any existing professional relationship that needs attention. 

There are essentially six need-to-know people that stand out as must-have when building out your team: financial advisor, estate planning attorney, accountant, probate real estate agent, aging services provider, and successor trustee. This stacked team will help keep the trustee in check and delegate the responsibility of managing the trust among a panel of experts. 

Selecting a Qualified Investment Advisor 

Making a decision to secure an investment advisor that will manage assets in compliance with the UPIA is a trustee’s first line of defense as described in Section 9(c).

According to what we see in Section 9(c), a trustee may delegate investment and management functions to a trusted fiduciary subadvisor as protection from liability. There are advisors who a trustee can subcontract their duties to as sub-advisor. In addition, there are fee-based advisors and fee-only advisors.  It is imperative that a trustee use diligence and care in selecting partners who will manage clients under a trustee’s fiduciary standard of care.  Fee-only fiduciary advisors appear to be the best choices for such mandates.

The probate code suggests “the trustee shall exercise prudence in the following:

(1) Selecting an agent.

(2) Establishing the scope and terms of the delegation, consistent with the trust.

(3) Periodically reviewing the agent’s overall performance and compliance.”

A trustee may initiate a comprehensive due diligence evaluation of an advisor by visiting a firm’s broker check page.  A trustee can also find the right questions to ask advisors in the SEC Regulation Best Interest (Reg BI) and Client Relationship Summary (CRS) Form. Considering these two resources is a good place to start in the due diligence process.

Governance Model and the Investment Policy Statement

After an advisor is selected, an ongoing due diligence process must be conducted in the delegation of investment duties to an advisor.  Probate code reads that a “trustee’s investment and management decisions, respecting individual assets and courses of action, must be evaluated 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.”  It is interesting to note here that the trustee’s decisions are under scrutiny.  

To protect their interests, trustees should work from a comprehensive Investment Policy Statement (IPS) and implementation plan for beneficiaries. An IPS helps outline the investment goals and objectives between client and advisor.

One of the most underrated and often forgotten about components of acting as trustee is organization and documentation. Beyond the IPS, the trustee should be mindful to document, record, and retain as much information related to the trust as possible.

Regular Account Reviews

Since the selection and retention of an advisor remains the responsibility of the trustee, the second line of defense is the ongoing evaluation process of advisors.  A decision regarding the retention or replacement of a trusted advisor should be the result of a disciplined process. 

To the extent of the quality of their due diligence processes, a trustee is protected. A good review process includes, but is not limited to the following:

  1. Review Account Performance
  • What time period is covered and is reported performance net or gross of expenses?
  • Is the account performance commensurate with performance of the broader market?
  • Was the volatility of the account reasonable?
  • Discuss and document any key investment decisions that were made for the portfolio.
  1. Discuss the Investment Policy Statement
  • What changes have occurred with the beneficiary?
  • Are there any large expenditures that needed to be planned for?
  • Discuss adjustments or changes needed for the Investment Policy Statement and the financial plan.
  1. Outlook for the Portfolio
  • Discuss economic and investment outlook and strategy for managing the account.

Regular account reviews also help address poorly performing investments. In advance, trustees should establish a plan should investments go sour.

  1. Compare performance against a suitable benchmark
  • Fiduciaries are encouraged to determine an appropriate benchmark with the advisor upfront
  1. Identify which investments underperformed
  • Have the advisor document rationale for investment decisions at inception as well as throughout the management process
  • Determine the role of the underperforming investments in the context of the overall portfolio
  1. Determine strategy for recovery or other available options
  • Outline scope for the underperforming investment to recover
  • If realizing a loss, review opportunities to net against capital gains, if appropriate

Protecting the trustee from litigation boils down to few best practices for handling investments. The old adage “failing to prepare is preparing to fail” seems fitting here. Each of these best practices will help you better protect the trustee as they carry out their role.

Helping professional fiduciaries, trustees, and estate planning professionals with the financial complexities associated with estate planning is our speciality. As a fee-only, SEC-registered investment advisor we specialize in asset management, helping our clients navigate the unique aspects of trustee investing and UPIA compliance. If you’re looking to get started with an investment advisor bound to the same fiduciary standards as yourself, we invite you to connect with us for a no-obligation introductory meeting. We look forward to connecting with you!

How to chose an advisor as a trustee

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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.