I FUNDAMENTALS
Definition of Wealth Management
Simply put, total wealth management is the coordination of an investor’s investment, tax, and estate needs into a comprehensive plan in order to achieve his or her financial goals. It is a consultative process used by the financial advisor to deliver value to the high net worth client. Wealth management is one of the fastest growing areas of the financial services industry. As it becomes more concentrated among the emerging affluent, high net worth and ultra high net worth population, the needs of these groups expand beyond just financial planning or asset management, and specialists will be needed to meet their demands.
Some advisors, though, choose not to get involved in the complexities of a client’s overall personal financial life, focusing instead on investments only. But the growing needs of the baby boomers are rendering such a limited viewpoint as myopic. The boomers seek help with “life-driven” financial needs, such as disabilities, estate planning and aging parents, and because they will dominate the financial services industry for the next 25 years, embracing their demographic wealth planning needs is of primary importance to both client and advisor.
Wealth management specialists come from a variety of disciplines, professions and industries, i.e., securities, accounting, insurance, banking, etc. Most offer an integrated, coordinated and comprehensive approach that provides customized financial solutions, without conflict-of-interest, and which employs collaborative, multidisciplinary methodology and multigenerational strategies.
In basic terms of identification, many wealth managers oversee the investment portfolio and select money managers, presupposing that all of the financial planning, such as insurance needs, estate planning, business succession etc. has been addressed (or will be addressed by the appropriate specialists). Many wealth managers are also charged with selecting, coordinating and monitoring a select team of tax, legal, investment, risk management, and philanthropic advisors, to name a few of the most essential professionals.
A financial advisor/wealth manager also has the responsibility of clearly explaining and defining the various aspects of wealth management to the client. Many investors are confused about professional titles and investor education is of paramount importance.
For example, most tax, insurance, or legal professionals have defined, distinct areas of practice. However, for the practitioner of wealth management services, there continues to be some confusion surrounding their services because wealth management can be either generic or specific in nature. So, by describing themselves as a financial “quarterback” whose role is to assist the client in developing a strategic plan, and then selecting, managing and monitoring such a collaborative effort, it more clearly defines the value the advisor delivers.
The enlightened advisor should present a client not only with a description of the services offered – the tactics and tools – but more importantly with a description of the strategy or methodology they embrace in assisting the client in devising, implementing and monitoring their objectives and goals.
Definition of a Comprehensive Wealth Manager
Industry consultants Cerulli Associates defines it this way: Wealth managers may be found at all types of broker-dealers and banks, but the plurality (43%) are registered investment advisors rather than registered reps. While brokerage firms are not necessarily poor environments for fostering wealth management practices, independent advisors typically have pioneered new offerings and service models in the advice market. Advisors operating under their own RIA traditionally have enjoyed grater flexibility than their registered rep counterparts. They have more freedom to design their fee schedules and service offering, factors that appeal to high net worth investors who may have problems for which there are no product placement or obvious revenue-generating solutions.
Wealth managers tend to have a broad range of professional designations and licenses. More than 17% of wealth managers have a law degree, and 17.4 % have earned the CIMA designation, 4.3% have the CFA designation, 30.4% have a CFP, and there is a heavy concentration (34.8%) of CPA and financial advisors with MBA degrees in the wealth manager segment giving these professionals an edge over their peers in consulting with affluent business owners. As is clear, advisors should invest time in either building their credentials or partnering with other professionals to achieve the range of experience and skills necessary to compete effectively in the wealth management market.
The vast majority of wealth managers serve clients with a net worth of more than $1 million, and many focus exclusively on clients with a net worth in excess of $10 million. The average practice has 175 clients, compared with more than 220 at other practices. Half of all wealth managers have fewer than 100 clients. A great benefit to the client is that the wealth manager has more time to spend on relationship management and client service.
A few obstacles to building a successful wealth management practice are:
- Not having a large enough affluent client base to justify the expensive infrastructure required.
- Team building is too time consuming or arduous.
- Advisor does not want to give up control to other team members.
- Advisor not willing to narrow focus to several limited disciplines, i.e., insurance or estate planning.
Are You a Wealth Manager?
According to wealth management expert, Russ Prince, president of Prince and Associates, only one in 10 of the 5,000 financial advisors his firm surveyed who call themselves wealth managers actually fit the profile of a true “wealth manager.” That means that 90 percent were either incorrectly identifying themselves or were not providing total wealth management services to their high net worth clients. Obviously, there is a “disconnect.”
Industry training firm, Paragon Resources, lists the various titles of financial advisors and the typical client and asset size of each category:
Stockbroker or bond broker
Target client size:
$10,000 to $1 million + Build position; find something to believe in; sell it to as many people as possible.
Financial advisor or consultant
Target client size:
$10,000 to $1 million +
Job description varies from unadulterated product pusher to true consultant.
Registered Investment Advisor or money manager
Target client size:
$100,000 to $100 million+
Manage portfolios for a fee; may use individual securities, funds, or combo.
Investment management consultant
Target client size:
$100,000 to $100 million+
Use the investment management consulting process: investment policy, asset allocation, manager search, and performance measurement. Emphasize modern portfolio theory to construct “efficient” portfolios.
Financial planner
Target client size:
$25,000 to $5 million +
Use a planning process to develop a road map for client’s financial needs, including: budget, college, debt, estate, insurance, investments, retirement.
Wealth management consultant
Target client size:
$5 million to $100 million+
Address all areas that affect an individual’s (or family’s) wealth, including asset accumulation, protection, preservation, distribution, and debt management.
Primary goal shifts to “create and protect,” with an emphasis on protect.
Adapted from the “Evolution of the Advisor Business Model” Copyright Paragon Resources, Inc. – www.ParagonResources.com
What are the Criteria?
First, as a wealth manager, an advisor must gather enough financial and personal information from the client to tailor the products, services and strategies to that client, rather than simply picking them “off-the-shelf.” This requires connecting with–and understanding–clients on an interpersonal level that’s well beyond the industry standard.
Since no single advisor has the expertise to address every client need, being a wealth manager also means it is almost certainly necessary to find a team of financial specialists who can help. What wealth management means for clients — and why it’s so appealing to them — is that each client is seen as unique. That’s the way the affluent like to think of themselves, and it is why they are put off when treated as if though they are less than special. Having a team of experts helps address this challenge.
Cerulli Associates outlined the criteria for wealth management in a 2005 report called “Reaching for Utopia.” Here is how they defined the service.
Client Characteristics: To qualify, each client must have at least $1 million in net worth and generally more than $5 million.
Business Model: The organization employs a team practice model in which each advisor has an area of specialization (such as investment management, insurance, tax strategy, estate planning) and all advisors share clients. Alternatively, the service is delivered by a sole practitioner with a demonstrated ability to deliver complex wealth management strategies. Typically, the practitioner has multiple professional designations that establish competency in core wealth management subject areas.
Service: The provider (advisor/wealth manager/team) offers a complete range of financial planning services, with an emphasis on complex wealth management and transfer issues, including stock option planning, advanced estate and trust planning, risk management and charitable giving.
The Target Audience for Wealth Management
According to an industry survey conducted by Phoenix Companies, it is reported that investors interested in total wealth management are younger. For example, 41 percent of those interested in this advisory model are under 55. Add survey responses from those aged 55 to 59, and support for this model jumps to 65 percent.
They are more interested in a long-range, formal financial strategy as well. Eighty-one percent of those who might work with a wealth manager said they like to plan their finances five to 10 years ahead. They are much more dependent on their advisor, too, and of those interested in wealth management, only 19 percent agreed with the statement, “I rarely seek professional advice when it comes to making major financial decisions.” This number jumps to 60 percent from those who don’t think they need a wealth management advisor.
The study suggested that only 22 percent of those who want to work with a wealth advisor said they make their own decisions regarding money and investments without consulting professionals. 77 percent of supporters said they acted on or followed advice from their primary financial advisor.
This survey targeted high net worth individuals with $1 million in investable income (not including a primary residence). A whopping 61 percent said they were at least somewhat interested in wealth management. When projected against the 6 million high-net-worth households in the country today, that translates to 3.66 million families, a great number of individuals that can be helped by a knowledgeable wealth manager and/or wealth management team.
Who are the Wealthy and What are Their Needs?
According to the U.S. Census Bureau, at the end of 2000 the U.S. had 105 million households which, collectively, controlled liquid assets of $12.9 trillion. The top 0.1% of households (those with over $10 million) controlled 16.3% of liquid assets ($2.1 trillion excluding the impact of retirement funds).
What do these statistics mean to the wealth manager of today?
Unfortunately, this top market ($10 million +) has only 268,000 members and, therefore, has limited potential for advisors due to the small number of households in this category. Generally, large brokerage firms identify the mass affluent markets as households with between $100,000 and $1 million in investable assets, leaving households with under $10 million in investable assets underserved.
According to the Merrill Lynch Cap Gemini/Ernst & Young “2003 World Wealth Report,” the wealth of the high-net-worth category is expected to increase at an average annual rate of 7% over the next five years, totaling approximately $38 trillion by the end of 2007. This projection takes into account the slow growth in wealth over 2001 and 2002 caused by the three-year bear market. Even in 2002, the number of global individuals with more than $1 million in financial assets grew by 200,000. A very abundant market indeed, but one that will require a new approach toward active professional participants and financial managers.
Industry experts estimate that only one-third of wealthy individuals’ assets is professionally managed, and bank trust departments hold half of that total. This means a majority of these individuals are either managing their wealth themselves, have put their financial plans ‘on hold,’ or are being advised by someone not thoroughly qualified in the area of asset or wealth management. These potential assets are virtually untouched, according to an often-quoted industry report by researcher Sanford C. Bernstein & Co, and the individuals who hold them will need a consultant or wealth manager more than ever as the transfer of assets reaches staggering levels over the next decade.
For advisors aiming to counsel the affluent through wealth management strategies, getting inside the mind of a millionaire is the ultimate goal, but getting to know each and every prospective client is a daunting task. A former marketing professor, author Thomas J. Stanley, in his best-selling book, “The Millionaire Mind,” surveyed 1,300 millionaires.
According to Stanley’s study, the average multi-millionaire is a 54-year-old man who has been married to the same woman for 28 years and has three children. Nearly half are business owners or senior corporate executives. When asked, almost none of them credit their success to being smart. They say the keys to success are honesty and discipline, getting along with people, having a supportive spouse and, of course, working hard.
That said, advisors must understand what these attributes mean to these principled affluents in order to establish or strengthen relationships with them. The old and tired approach of trying to reach the ultra high-net-worth individual by providing them with some type of product solution is backwards. These individuals want and need an extension of themselves, someone they can trust overseeing their assets. They want an advisor with the same or similar belief system, a good understanding of their station in life, knowing what their financial needs are now, and what they may be in the future.
Successful wealth managers work with the ultra high-net-worth first from the vantage point of being a family counselor and then an asset counselor–in other words, understand the dynamics of the affluent family first, then follow with an understanding of their spending habits and, finally, a comprehensive examination of their assets and recommendation of investment vehicles through an overall financial plan.
The wealthy want best-in-class advice and ongoing counsel, and are willing to pay for a superior level of service. They are expecting a better platform of products, a team of experts to serve all levels of wealth management concerns, and a disciplined investment consulting process. A greater focus on intimacy and problem-solving will lead to a deeper client connection, which can, in turn, lead to a stronger relationship, greater profitability per client and more referrals.
II BENEFITS/FEATURES
The consultative nature of wealth management ensures loyalty and trust between the advisor and the client. Because the process of wealth management is about solving a client’s financial problems as well as creating financial opportunities, it goes a long way toward creating the bond that is important to establishing long-term financial relationships.
The client enjoys having his or her assets in a central environment and the benefit of multiple specialists overseeing the many aspects of their wealth. Clients are also comfortable in knowing that their wealth manager receives asset-based fees and retainers in lieu of product commissions (Cerulli Associates reports that 90% of revenues derived are from sources other than commissions.) As mentioned earlier, a significant benefit to the client of working with a wealth manager is the quality of time spent on relationship management and service, performed by the primary advisor and/or the team members.
According to a recent industry survey, financial advisors who were coached on a one-to-one basis to become wealth managers reported that not only were their clients more satisfied with the service they received and the performance of their investments, but the advisors’ profits rose by at least 35 percent in the first year — after expenses and including the cost of the coaching. Advisors also reported that they received high-end referrals, most often from accountants and private client lawyers who worked with the affluent. Another advantage to the advisor is that wealth managers often capture more assets to manage from existing clients after having established why their being a wealth manager makes a difference to the client.
Another benefit of comprehensive wealth management is that it enables financial advisors to understand not only the client’s complete asset picture, but also the liability picture as well. After a thorough evaluation of the client’s financial and investment affairs, the advisor(s) can bring expertise to bear, when appropriate, to restructure assets, rebalance the portfolio, and to review the Investment Policy Statement (IPS) whenever lifestyle or goals change for the client, in a manner that is advantageous to the client.
Wealth management gives the advisor a process to shift the focus from things he or she can’t control (like portfolio performance) to things he or she can control—like ensuring that the client’s assets and income are adequately protected, making sure the client’s debt is being managed efficiently, and doing everything to minimize the effects of income and estate taxes. These are the things that really matter when it comes to creating and protecting wealth.
What is the Process of Wealth Management?
Total wealth management is generally considered to be a four-step process: Accumulation, Preservation, Leverage and Distribution. In his highly acclaimed book, The Wealth Management Index, author Ross Levin discusses each category and offers questions that advisors can ask clients to better understand them and to accelerate the wealth management process. It also shows advisors how to better serve the high net worth client by asking the appropriate questions and offering custom solutions.
An advisor needs to take into account a client’s particular life phase, such as whether they are in a “wealth accumulation” phase or retirement distribution phase. It’s important to look at four areas of a client’s life: life history and background; current life transitions; goals; and the principles that guide their life and money.
Similarly, in formulating an investment policy statement (IPS) for a client (the first step in the consulting process for asset management), the advisor recognizes the three phases in the “money life” of a person: accumulation; preservation; distribution. Each category requires an advisor to help determine which types of investment vehicles and asset classes are most appropriate.
Accumulation: The phase in which the client, generally in his or her 20s to 50s, is working to accumulate wealth. In the early stages, however, this person is also thinking about buying a home, raising a family, etc. Insurance needs are higher. Risk tolerance is usually higher. Time frames are longer.
Preservation: The client (mid-50s to mid-70s) is working to preserve a current or desired lifestyle, personal freedom and independence as long as possible. For example, the client does not want to be a burden to his or her children. Women, in particular, worry about being widows, running short of money and having to lean on or live with their children, a circumstance to be avoided. Risk tolerance is lower.
Distribution: The client (usually age 65 to 70 plus) has accumulated enough wealth so that there is little to no fear of outliving assets. The client ponders how to allocate wealth, either by contributing to charities, placing funds in trusts, or setting money aside for children or grandchildren. The reduction, or elimination, of estate taxes is a consideration. This phase is strongly influenced by a person’s emotional, philosophical, and religious attitudes.
Below is a sample guide that explains the process and that can be used as a template and customized for each client. Study the questions and the solutions, and add your own as deemed appropriate for your own clients.
A. PRESERVATION – Asset Protection
Do you have an appropriate amount of life insurance, consistent with an articulated philosophy?
- Develop a philosophy.
- Implement the philosophy.
- Do estate tax analysis.
Have you protected yourself against catastrophic loss due to long-term care, property losses, and liability issues?
- Establish parameters regarding property/casualty insurance purchase.
- Make decisions regarding long-term care insurance.
- Decide whether asset transference or re-titling is appropriate for liability or long-term care concerns.
Are your business interests adequately covered?
- Verify appropriate business form.
- Perform evaluation.
- Establish keep/sell agreement.
- Determine funding for death and disability.
B. PROTECTION – Disability and Income Protection
Do you have too much or too little disability protection given assets/income and will it pay you if you are unable to work?
- Assess income needs if disabled.
- Discuss the option of self-funding.
- Implement or self-insure.
Did you receive income from all sources (earnings, gifts, social security, pensions) that was expected this year?
- Discuss expected income and timing this year.
- Establish income items for which client may exert timing discretion.
- Encourage client to apply for all eligible benefits.
Did you spend according to plan?
- Develop the cash flow plan.
- Manage back to the model.
Did you use all reasonable means to help reduce your taxes?
- Prepare a tax estimate and determine marginal federal income tax bracket and benefits of straddle between years.
- Review/implement appropriate income tax reduction strategies.
- Provide stock option planning.
- Evaluate charitable planning, asset transference, and investment tax minimization.
C. LEVERAGE – Debt Management
Do you have sufficient borrowing access and at the best available rates?
- Investigate free credit available.
- Negotiate rates and guarantees/covenants.
Is your current ratio better than 2:1 and is your total debt reasonable as a percentage of assets?
- Determine whether current ratio is better than 2:1.
- Review overall debt use relative to assets and income.
Have you managed your debt as expected?
Is your debt tax-efficient?
D. ACCUMULATION – Investment Planning
Is your asset allocation appropriate?
- Develop coherent investment philosophy.
- Determine the investment policy.
- Rebalance to the investment policy.
How did your actual rate of return compare with the expected rate (CPI plus target percentage)?
Were your annual contributions or withdrawals at target?
Was the portfolio tax-efficient?
Have you set aside enough cash for purchases to be made in the next three years?
- Forecast cash needed in the next three years.
- Raise cash in advance of the need.
E. DISTRIBUTION – Estate Planning
Does your will reflect your wealth transfer issues?
- Develop detailed outline of client objectives.
- Facilitate drafting of will (all necessary documents.)
Are your assets titled correctly and have you set up appropriate beneficiary designations?
- Review beneficiary designations of assets.
- Evaluate what types of retirement accounts need to be established, split, or gifted to charity.
- Review ownership of assets.
Have you established and funded all necessary trusts?
- Explore the use of trusts as a financial planning tool.
- Establish those trusts deemed appropriate.
- Maximize funding of trusts as required.
Do you need or have necessary planning documents (power of attorney, health care doc, living will)?
- Discuss the aspects of decision-making powers in case of incapacitation, life support and final wishes.
- Establish written procedures for family to execute those wishes.
Have you made your desired gifts for this year?
Remember, most high net worth clients want an integrated wealth and asset management process. The key word is process. It is this process that sets an advisor apart from the rest, how that advisor blends the precepts of estate, tax, investment and financial life planning into a strategic overlay. It is the process that distinguishes the client presentation, fact-finding and “data mining,” formulation of a plan, actionable recommendations, plan execution and monitoring.
The wealth management mission is to enhance the client’s probability of achieving defined goals and objectives — both the quantifiable and un-quantifiable. “Money life” phases are affected by transitions, for example, having children, providing education, key religious and cultural events, caring for aging parents, job or career changes, divorce, accidents and illness. Life phases and transitions may overlap. A client may keep accumulating wealth in the “preservation” phase, for instance, and transitions may occur at any time. “Positive transitions,” like marriage and children, tend to occur early in life; “negative transitions” such as degenerative illness, often occur later in life as a function of the aging process.
A trusted advisor needs to know what the client may want beyond financial peace of mind: a second career, spiritual goals, charitable interests, legacies for survivors and the continuing family line. They may wish to fund trusts, endow causes, build cultural edifices, create foundations, educate, enlighten and inspire.
These are the “soft issues” regarding their life and their assets. What is needed are questions that go beyond basic data gathering forms and other paperwork, probing deeper areas beyond surface simplicities that will set one wealth manager apart from their competition. These are “psychographic” questions that explore a client’s life goals, family, charitable interests, leisure and recreation desires, and legacy concerns.
This is sometimes called holistic wealth management.
III SUITABILITY
Financial advisors have a fiduciary responsibility to maintain the highest standards of care while working with their clients. For those who specialize in wealth management for their affluent clients, higher-level skills sets are required to assess and implement the various investment, tax and estate planning strategies. For the high net worth, ultra high net worth, and the family office markets, most industry professionals believe wealth management is not only suitable, but necessary for the accumulation, preservation and distribution of an individual’s (or family’s) assets. The important aspect of suitability concerns the experience and skill level of the wealth manager, and how an affluent individual or family can evaluate and choose the professional best suited for their situation.
Of course, the ideal to strive for is that both the wealth manager and the client are suited for each other…for the long term.
Wealth management starts with building trust. If an advisor truly wants to understand a client and build a long-term wealth management relationship, it’s important to know, for example, that individual’s beliefs about saving, spending and donating money. It’s also important to know if, and why, their risk tolerance is low. Advisors also need to understand how the aging process affects their clients. Historical events such as 9/11, bear market episodes, market volatility and financial services industry scandals impact how investors view their assets. Getting to know clients on a more personal level by discovering their attitudes and experiences is an important step in determining the overall wealth management plan for them.
For example, if an advisor wants to uncover hidden assets and unarticulated needs, a “soft” approach can be taken during the client questionnaire process to really “know the customer” (Rule 405) and determine suitability for the eventual disbursement and/or placement of assets.
IV RISKS
One of the risks advisors face when starting a wealth management practice is to try to do all of the various tasks and services themselves. To do the job well, most advisors turn to outside experts for their clients’ needs beyond investment management. So, for most wealth managers, using outside experts is essential, even though some advisors feel it can be difficult to find professionals with their same level of service, experience and integrity that they provide their own clients.
Another risk is in taking on a client who doesn’t need or want wealth management services, simply because the client “might” be a candidate down the road. It may not be prudent to spend a great deal of time on someone who isn’t going to be a lifelong client or who can take advantage of the various services.
Wealth management is also very time-intensive and requires some investment. There is a lot of discovery (of client’s financial needs), a lot of front-end work. It’s very service-intensive and the advisor has to be willing to put in the time required.
Making the switch from a traditional financial-advisory business is no simple feat and can also be somewhat of a risk. Change is difficult. The wealth management mindset is different. It’s not about sales or products; it’s about the consulting process and what is best for the client. Some veteran advisors have a harder time with the transition, but many report bigger and better business after having done so.
Technology and training are also hurdles for some advisors and there are some risks associated with not having the proper tools to effectively structure a wealth management program for clients. Training is essential in helping advisors understand and implement the numerous aspects of a client’s wealth management strategy. Not having the proper training and education is risky, not only for the client (who deserves a skilled practitioner) but also for the advisor’s practice, in terms of fiduciary responsibility and compliance aspects.
V REGULATORY REQUIREMENTS
Wealth management strategies take into account various and numerous investment products and solutions, financial planning concepts, tax and legal concepts as well as specific techniques, risk management measures, estate and legacy planning specifically for high net worth individual investors and foundations and endowments. There is no single federal regulatory body of opinions or law controls on the practice of wealth management, or one that regulates wealth management with respect to individual accounts.
Since wealth management is unique and custom to the individual and/or foundation and endowment, these individual investment accounts, therefore, are governed by the Uniform Prudent Investor Act (UPIA), adopted as state law in all states. Foundations and endowments are governed by The Uniform Management of Institutional Funds Act (UMIFA), also a state law in most jurisdictions.
UNIFORM PRUDENT INVESTOR ACT (Summary)
Trustees of trusts have been subject to rules severely restricting the types of investment modalities in which they can invest the assets of the trusts that they administer and manage. Interest-bearing instruments — safe income — of limited kinds (no junk bonds) are the limit of risk permitted — or thought to be permitted — under the traditional rules. Protect the paper value of the principal at all costs is the mandate for trustees. In addition, a trustee’s performance is rated by the performance of each and every investment, singly, and not on the performance of the whole of the portfolio. The result for trusts is modest income production at best without regard for the erosion of a trust’s assets by inflation. Can it be that these rules miscalculate the real risk and actually jeopardize the assets of a trust rather than provide for their protection?
The answer is yes. A remedy is in the Uniform Prudent Investor Act (UPIA), promulgated by the Uniform Law Commissioners in 1994. The adoption of this act by the state legislatures will correct the rules, based on false and damaging premises, that now govern the actions of trustees.
By no means does UPIA turn trustees into unrestrained speculators. It provides rules governing investment that, in fact, result in greater protection for the trust’s assets while providing a prospect of better income. UPIA does not encourage irresponsible, speculative behavior, but requires careful assessment of investment goals, careful analysis of risk versus return and diversification of assets to protect them. It gives the trustee the tools to accomplish these ends. UPIA requires trustees to become devotees of “modern portfolio theory” and to invest as a prudent investor would invest “considering the purposes, terms, distribution requirements, and other circumstances of the trust” using “reasonable care, skill, and caution.”
The trustee has a list of factors which must be considered in making investment decisions, including “general economic conditions,” “possible effect of inflation or deflation,” “the expected total return from income and the appreciation of capital,” and, “other resources of the beneficiaries.” The trustee must take tax consequences of investment decisions into account. There is a positive obligation to diversify assets “unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.” The trustee’s obligations are significant, requiring sophisticated approaches to investment that really take into account the right risk to return ratio for the particular trust.
In addition, a trustee’s performance in UPIA is measured by the performance of all the assets together. A loss with respect to a single asset does not mean that the trustee has violated his or her fiduciary responsibilities. The act takes the truly holistic approach to investment practices.
In return for these obligations, UPIA removes any restrictions upon the types of investment modalities that may be chosen in a trust’s portfolio. It is quite possible, for example, to hold positions in high-interest bonds (junk bonds) or mutual funds investing in such bonds, in a diversified portfolio, if such an investment meets the needs of the particular trust in light of the risk/return analysis specific to that trust.
One of the boons to trustees of smaller trusts is the ability to invest in mutual funds. Mutual funds reduce investment risk by diversifying their portfolios. By using mutual funds, a trustee of a trust that does not have a large enough corpus to effectively diversify its assets can enhance diversification of the trust’s portfolio to limit the trust’s risk of loss.
UPIA also permits the trustee to delegate investment and management functions “that a prudent trustee of comparable skills could properly delegate under the circumstances.” Careful selection of the agent and careful, periodic review of the agent’s actions are part of the trustee’s responsibility when delegating authority. An agent has a responsibility of reasonable care in conducting the delegated business of the trust.
Why is it that the prudent man rule of prior law may, in fact, jeopardize the assets in a trust? Some of the instruments in which trustees have been able to invest have become more volatile in price. Treasury bonds, for example, long thought to be safe investments, now fluctuate considerably in value with the fluctuation of interest rates. The former so-called safe investment may not be so safe anymore. In contrast, common stocks have shown consistently better returns over the years than bonds — yet trustees have been prevented from investing in common stocks. Stocks have been historically safer investments, therefore, in diversified portfolios than bonds have been. Trusts have been deprived of return at some greater risk by the antiquated rules that govern investment of their assets.
By far the most insidious damage to trust assets comes from inflation. If trustees cannot invest in modalities that exceed the rate of inflation in return, the inevitable result is diminution of the corpus of the trusts they manage. The beneficiaries of trusts so restricted lose in all ways, both with respect to income and principal.
The UPIA provides rules that can be modified or waived in the trust agreement. Any person who wishes to put property in trust and who wants to provide different standards of conduct for the trustee is permitted to do so under UPIA.
UPIA provides a reasonable approach to the investment of trust assets that better meets the needs of beneficiaries while preserving trust assets. It should become the law in every state as soon as possible.
The Uniform Prudent Investor Act, and the newer Uniform Trust Code remove much of the
common law restriction upon the investment authority of trustees of trusts and like fiduciaries. The Act was
completed by the Uniform Law Commissioners in 1994 and allows fiduciaries to utilize
modern portfolio theory to guide investment decisions reducing portfolio volatility and
losses. A fiduciary’s performance is measured on the performance of the whole
portfolio, not upon the performance of each investment singly. The Act allows the
fiduciary to delegate investment decisions to qualified and supervised agents and
requires sophisticated risk-return analysis to guide investment decisions. Every state and
the District of Columbia has adopted the UPIA or the UTC or at least relative portions or a version there of.
UNIFORM MANAGEMENT OF INSTITUTIONAL FUNDS ACT
In 1972, the National Conference of Commissioners on Uniform State Laws approved the Uniform Management of Institutional Funds Act. At that time uncertainty existed as to the standards that governed directors of charitable corporations in managing and investing the funds of the charitable organizations. Directors of a charity organized as a nonprofit corporation had been held to the investment standards that applied to trustees of private trusts. (See Lynch v. John M. Redfield Foundation, 9 Cal. App. 3d 293 (1970) stating that directors of a charitable corporation are essentially trustees and as such are held to an investment duty similar to that of a trustee of a private trust). [See also Restatement (Second) of Trusts § 389 (1959)].
For directors of large institutions, the then-current restrictions on trust investing made the use of modern investment strategies problematic. UMIFA (1972) provided guidance and authority to the governing boards of those charitable organizations within its scope on several issues. The statute gave a governing board broad investment authority and indicated that a governing board was not restricted to investments authorized for trustees. The statute permitted a board to delegate authority to independent financial advisors. With respect to endowment funds, the statute authorized a governing board to expend unrealized appreciation, even if the endowment fund provided only for the distribution of “income.” This provision enabled fund managers to use modern investment techniques such as total-return investing and unitrust-style spending. UMIFA (1972) also permitted the governing board to release restrictions on the use or investment of institutional funds if the donor consented and to release restrictions that had become “obsolete, inappropriate, or impracticable” if a court approved.
The investment standards adopted by UMIFA (1972) foreshadowed changes to trust investment law in the Uniform Prudent Investor Act (1994). UPIA applies modern portfolio theory to trusts, including charitable trusts. The Uniform Principal and Income Act (1997) furthered the principles of UPIA, providing tools for the use of investment techniques authorized under UPIA. The Uniform Trust Code (2000) expanded the application of the doctrine of cy pres. These Uniform Acts have informed the work of the Drafting Committee of the Uniform Management of Institutional Funds Act.
UMIFA uses language from UPIA and the Revised Model Nonprofit Corporation Act reflecting the fact that standards for investing and managing institutional funds are and should be the same regardless of whether a charitable organization is organized as a trust, as a nonprofit corporation or in some other manner. The rules governing expenditures from endowment funds have been modified to give a governing board more flexibility in making expenditure decisions, so that the board can cope with fluctuations in the value of the endowment. As under UMIFA (1972), these rules are available to decision makers of charities organized as charitable trusts, as nonprofit corporations, or in some other manner, but the rules do not apply to a fund managed by a trustee that is not a charity. The Act does not apply to trusts managed by corporate or individual trustees, but the Act does apply to a trust managed by a charity. The provisions governing the release and modification of restrictions have been changed to permit more efficient management of institutional funds.
UMIFA addresses investment issues and issues relating to endowment funds but is not a comprehensive statute addressing all legal issues that apply to charitable organizations. For matters not governed by UMIFA a charitable organization will continue to be governed by rules applicable to charitable trusts, if it is organized as a trust, or rules applicable to nonprofit corporations, if it is organized as a nonprofit corporation.