We have analyzed the investment process required of trustees
under those state statutes regarding the investment responsibilities and
liabilities of trustees, which generally are known as "prudent
investor" statutes. The common theme of these statutes is their directive
that the trustee focus on the trust portfolio as a whole, revising the
traditional notion of trust law that assessed each asset in isolation. While
granting broad investment powers to trustees, these statutes impose
significant new duties on professional trustees which, if inadequately
performed, could result in liability to the trustee regardless of the
positive returns of trust portfolios.
The professional trustee is now required to conduct an ongoing investment
process that is, in substance and procedure, more complex and sophisticated
than was previously required by law. It is arguable that asset allocation is
the single most important task in this process. Furthermore, this emerging
investment process may well establish the foundation for a standard by which
not only professional trustees will be measured, but all financial
intermediaries who provide professional investment advice, including
Uniform Prudent Investor Act
Until recently, the investment authority of trustees in most states was
governed by a standard known as the "Prudent Man Rule." This
standard was originally formulated as a general statement of care, skill and
caution that would allow trustees the flexibility appropriate to particular
circumstances. However, its utility was gradually eroded by case law and
influential treatises such as the Restatement of Trusts (Second), which
developed a host of sub-rules deeming certain investments and techniques as
"speculative," and presumptively imprudent. Despite important
developments in financial markets and financial theory, a justifiable fear of
liability discouraged trustees from investment strategies that would maintain
or increase the purchasing power of trust portfolios. Many modern practices
as to optimal methods of investment management were not allowed by the
Prudent Man Rule as it was developed by the courts.
Thus, elements of the Prudent Man Rule gradually came to be viewed as
detrimental to the long-term interests of trust beneficiaries. The Employee
Retirement Icome Security Act (ERISA), enacted in
1974, had as one of its central purposes a public policy of ensuring the
adequate investment returns necessary for defined benefit plan participants.
While based in large part on traditional principles of trust law, ERISA recognized
the limitations of these principles in portfolio management and thus departed
somewhat from the Prudent Man Rule by setting a standard of prudence to
govern pension investments that is more attuned with economic reality and
important academic developments in financial theory. ERISA rejects a per se
rule as to imprudent investments and provides a safe harbor from liability if
the fiduciary has given "appropriate consideration" to the facts
and circumstances of the investment and its relationship to the needs of the
pension plan. It is process oriented rather than rule oriented.
A successful effort to revise trust investment law in the same way is nearing
completion. The American Law Institute’s 1992 Restatement (Third) of Trusts
restated the legal principles which should govern trust investments with the
purpose of reconciling trust investment law with changes in investment
practices. The Restatement (Third)’s revised standard of prudent investment
is known as the "Prudent Investor Rule" and follows the innovations
of ERISA. In 1994, the National Conference of Commissioners on State Laws
approved a model state statute incorporating the principles of the Uniform
Prudent Investor Act (UPIA) Restatement (Third) of Trusts.
At least 38 states have enacted some version of the Prudent Investor Rule,
and it is expected that most, if not all, of the other states will do so in
the near future. Some of these statutes preceded the UPIA and the
Restatement. However, most are based on the UPIA and, therefore, we will use
the UPIA for purposes of this analysis.
The UPIA fundamentally changes trust investment law.1 It emphasizes the
portfolio as a whole and the interplay between risk and reward. The UPIA has
no categoric restrictions. A trustee can choose any
investment, but there is no "safe" investment that protects a
trustee from liability. The UPIA disavows the emphasis in prior law on
avoiding "speculative" or "risky" investments. In
contrast, traditional trust law emphasizes the duty to "preserve
principal" at all costs and to avoid "speculation." Because
each investment was considered on its own merits without regard to the
portfolio as a whole, a trustee could become a guarantor of risky
investments, even if it picked many more winners than losers. Under the UPIA,
a trustee must determine the appropriate risk profile for a trust and then
develop and implement an investment strategy for the portfolio. It must be
able to justify the reasonableness of that strategy and the prudence of each
investment as it relates thereto.2
Points of the UPIA
1. The standard of prudence applies to the trust as a whole rather than to
individual investments, with a realization that particular investments that
would have been viewed as speculative and subject to surcharge under old law
may be sensible, risk-reducing additions to a portfolio viewed as a whole.
2. The overall investment strategy should be based upon risk and reward
objectives suitable for the trust. These objectives will vary widely,
depending on the circumstances in each trust arrangement. A trust for an
elderly widow of modest means will have a lower risk profile than a trust for
a wealthy young person. However, both trusts will be concerned with
preserving the real purchasing power of the trust and the effects of
inflation on that power, a factor that was often ignored under prior law.
3. There is a duty to diversify unless the trustee reasonably determines that
it is in the interests of the beneficiaries not to diversify, taking into
account the purposes and terms of the governing instrument. The UPIA has so
enhanced the long-standing duty to diversify as to fundamentally change it.
While prior law also stressed diversification, it did so on
a more limited basis, stressing diversification within an asset class without
also stressing diversification across asset classes.
4. No particular investment is inherently prudent or imprudent. The premise
of the rule is that trust beneficiaries are better protected by increasing
the trustee’s responsibilities and powers than by per se restrictions or safe
5. A corporate fiduciary or paid professional advisor acting as fiduciary is
accountable under a special investment skills standard.
6. Delegation is permitted, encouraged and in some cases required. The UPIA
reverses the anti-delegation rule of prior law. This change recognizes that
prudent investing may require the use of outside expertise in some
circumstances by both professionals and non-professionals.
7. The trustee’s liability for improper conduct will be measured by reference
to the total return that should have been expected from an appropriate
investment program. Thus, a positive return will not necessarily protect a
trustee from liability.3
UPIA and Modern Portfolio Theory
One cannot read the UPIA, the Restatement (Third) and the commentary thereto,
as well as the various state legislative histories, without concluding that
modern portfolio theory is the intellectual underpinning of the UPIA.4 The
UPIA is clearly the result of a consensus about the significance of modern
portfolio theory and the realization that the law and the markets should have
similar views regarding prudent investment practices. While the UPIA is a
process-oriented rule, it is not merely procedural. Much of the investment process
required by the UPIA relates to substantive tasks that require a familiarity
with modern portfolio theory; a professional trustee is presumed to have this
knowledge. As the Restatement (Third) makes clear, a trustee who strays from
the basic tenets of modern portfolio theory must carry a burden of persuasion
as to the reasonableness of his or her actions.
There are no universally accepted and enduring theories of financial markets
or prescriptions for investment to provide clear, specific guidance to
trustees and courts. Varied approaches to the prudent investment of trust
funds are permitted by the law. This does not mean, however, that the legal
standard of prudence in trust law is without substantive content or that
there are no principles by which the fiduciary’s conduct may be guided or
judged. A trustee’s approach to investing must be reasonably supported in
concept and must be implemented with proper care, skill and caution.
Furthermore, although competing theories of investment provide some conflicting
signals, they also offer some consistent themes.5
Another prominent commentator has reached the same conclusion: "The
field is sufficiently well-developed and scientifically grounded that no
financial advisor should feel safe in ignoring its teachings."6
Modern portfolio theory refers to the process of reducing risk in a
portfolio through systematic diversification across asset classes and within
a particular asset class.7 It involves the relationship between risk and
reward. It assumes that all investors desire the highest possible returns
while bearing the lowest amount of risk and that public markets are generally
efficient. To increase the return, an investor must incur more risk.
A well-diversified portfolio minimizes the risk that a particular investment
will not perform well (firm-specific risk) and leaves a portfolio exposed
only to market risk. Investors without an efficiently diversified portfolio
are exposed to unnecessary risk, which will not be compensated by the
Thus, modern portfolio theory focuses on portfolio
selection rather than simply buying securities viewed as undervalued. Having
determined their risk tolerance, investors should then assemble an optimal
portfolio along what is called the "efficient frontier," which maximizes
potential returns at the desired level of risk.
While major advances have been made in understanding financial markets and
the investment process, there are many unsettled areas. For example, there is
disagreement about the degree of efficiency of public markets. Thus, modern
portfolio theory and the UPIA allow for many alternative strategies.
UPIA and the Investment Process
In a sense, the UPIA "deregulates" trust investments. The UPIA
rejects generalizations and labels as inappropriate to the complicated
process of trust investing. A trustee can choose any investment for a trust
and not be responsible for the performance of the investments if the trustee
has properly conducted the process required by the UPIA.
The UPIA assesses the trustee’s liability by the investment process, not the
outcome. Under prior law, the investment process was also an important
element in assessing trustee liability, but evidence of careful deliberation
was usually sufficient to protect a trustee, as long as the trustee had
avoided investments that could be deemed "speculative."
However, the process required by the UPIA includes important substantive
elements. Unlike other process rules, such as the business judgment rule, it
includes requirements as to how the business—investment management for
trusts—is to be conducted. A trustee must be familiar with modern portfolio
theory to conduct the process. A trustee who does not incorporate these
concepts into its investment process probably will not be saved by an otherwise
impressive paper trail.
UPIA Section 2(f) charges a trustee with special
skills or expertise to use those skills or expertise. This is familiar law
but the comment thereto implies that all professional trustees will be held
to a single high standard that will not vary by location or amount of assets
under management. The notion seems to be that the basic tools and knowledge
necessary to manage risk in a professional manner are available to any
professional, wherever located. Smaller organizations in rural locations will
probably be held to the same standards as their larger counterparts.
The UPIA’s protection from liability depends upon
the trustee’s ability to demonstrate that it has met this heightened
standard. A trustee is at risk, even with a positive return, if the trustee
cannot demonstrate that it conducted a thorough and ongoing process for each
trust, incorporating the current standards in the investment management
industry (including risk and return assessment and efficient portfolio selection).9
It is important to recognize that this process imposes considerable new
responsibilities on professional trustees, and is a significant departure
from prior law.10 A professional trustee should not remain in the business
unless it has the resources required by the UPIA process and that it can
prove its compliance.
The UPIA recognizes that the key task of the trustee is to manage risk in
order to realize the trust’s objectives.11 The UPIA Official Commentary
states that Section 2 is "the heart of the act" and that it is
intended to sound "the main theme of modern investment practice,
sensitivity to the risk/return curve." Prior law emphasized the
avoidance of risk but modern portfolio theory has established that, without
risk, there will be no rewards. The UPIA requires a trustee to take on the
level of risk appropriate to the trust and to manage the risk.
Under the UPIA, risk is managed through efficient diversification. Trust law
has long required it. However, prior law required little more than not
putting all your eggs in one basket. UPIA Section 3 greatly enhances the duty
of diversification. It is clear that the Restatement (Third) and the UPIA
require that diversification be systematic and that it eliminate
Prudence is not self-evident under the UPIA. Section 8 states that the
trustee’s liability will be assessed "in light of the facts and
circumstances existing at the time of a trustee’s decisions and not by
hindsight." Thus, the trustee must be prepared to carry a burden to
justify each investment in relation to a portfolio strategy that the trustee
has developed as suitable for the risk level appropriate to each particular
The trustee’s investment process under the UPIA can be viewed in three steps.
The trustee must first evaluate the needs and purposes of the trust and
determine the appropriate risk level. The trustee must then decide on an
appropriate long-term investment policy suitable for that level of risk.
Finally, the trustee must implement that policy through a strategy of
selecting individual investments.
Some trusts require income, while others are oriented toward total return. As
trusts differ considerably in their risk-bearing capacities and needs, a
trustee must determine the appropriate risk profile for each trust through a
detailed and systematic process. The plain language of the UPIA compels this
conclusion. Section 2 requires that the trustee consider the "purposes,
terms, distribution requirements and other circumstances of the trust"
and develop "an overall investment strategy having risk and return
objectives reasonably suitable to the trust." It provides a
non-exclusive list of the factors a trustee must consider: general economic
conditions, possible effects of inflation or deflation, expected tax
consequences of investments and distributions, the role of each investment in
the portfolio, the expected total return of the portfolio, and the liquidity
and income needs of the beneficiaries. While trustees have always been
charged with a familiarity with the purposes and needs of a trust, the UPIA
increases that duty.13
A trustee cannot simply label a trust as having a "conservative"
risk profile and proceed accordingly. It must conduct and document a process
to gather, record and analyze information about each
trust’s time horizons, cash flow needs, risk aversion, tax status, intentions
and other factors, not only at the trust’s inception, but on an ongoing
basis. A primary purpose of this exercise is to generate the information necessary
for a trustee to determine the "efficient frontier" for each trust.
Asset allocation is the long-term structuring of a portfolio to achieve
particular objectives over an extended period of time.14 It is the investment
policy that precedes investment selection.15 Every investment can be
classified within a certain asset class. Whether explicit or implicit, every
investment is part of an asset allocation. Every investment is the result of
a determination that the asset class is itself appropriate for the portfolio.
The trustee makes long-term policy decisions in the asset allocation process
about the types of investments appropriate for the purposes and risk profile
of each trust. As asset classes have quantifiable risk characteristics, just
as individual investments do, it is a distinct process from the selection of
There are various views about asset classes but they would seem to include
Large-cap, medium-cap and small-cap equities
Foreign equities with the same subdivisions but further subdivided by region
and market development
U.S. government and agency obligations (all debt instruments would be further
subdivided by maturity)
Tax-free municipal debt
Foreign sovereign debt
U.S. corporate debt (investment grade and high-yield)
Foreign corporate debt
UPIA Section 2’s requirement that the trustee develop an "overall
investment strategy" to "incorporate risk and return objectives reasonably
suitable to the trust" and UPIA Section 3’s enhanced diversification
requirement underscore the importance of the asset allocation process under
the UPIA. The starting point of diversification is the consideration and
selection of asset classes appropriate to the risk profile of each trust.
There is significant economic research concluding that most of the return of
investments in a particular asset class is a result of the basic decision to
invest in that asset class.16 The added value by the selection of a
particular asset within the class is minimal.
While delegation of the investment function may sometimes be appropriate, it
seems unlikely that a professional trustee could delegate evaluation and
asset allocation in ordinary circumstances, given UPIA Section 2(f)’s professional trustee standard and UPIA Section 7’s
requirement that the trustee minimize costs. Thus, "asset
allocation" is one of the trustee’s principal responsibilities under the
UPIA. A prominent law professor who acted as reporter to the UPIA project is
of the same view:
Increasingly, the main work of the fiduciary investor will be what has come
to be called asset allocation. The trustee will form a view of the needs,
resources, and risk tolerances of the beneficiaries of the particular trust.
The trustee will then decide what proportion of the portfolio to invest in
what classes of assets. These choices will take the form of allocating the
trust assets among large, diversified portfolios, primarily mutual funds and
bank common trust funds.17
No particular asset class is mandatory, nor are there a minimum number of
asset classes that must be considered.18 However, the trustee’s process
should at least reflect consideration of alternative asset classes.19 While a
trustee could invest in a single asset class, the trustee must be prepared to
justify that decision.20 Informed diversification and risk management means
more than just multiple baskets. The trustee must also determine the right
amount to put in each basket.21
Asset allocation is not just a pie chart illustrating the categories of a
portfolio. It should be a formal, ongoing recorded process which, based on
the trustee’s considered evaluation of each trust and the principles of
modern portfolio theory, guides the selection of investments for the trust’s
portfolio to its "efficient frontier."22 Intuition, unsupported
conclusions and mere labels will not meet the standards of the UPIA.23
Prior law looked at each investment in isolation while the UPIA looks at the
entire portfolio.24 While the trustee can invest in "any kind of
property or type of investment consistent with the standards" of the
UPIA, each investment must have a role in a well-diversified, efficient
portfolio. Thus a trustee cannot simply buy securities it believes to be
undervalued unless it has considered (and recorded in some meaningful way)
how those securities fit into the portfolio plan based on an evaluation of
the needs and purposes of the trust. Thus, under the UPIA, investing is part
of a process rather than an independent function.
Since optimal diversification may require participation in large portfolios,
a professional trustee may be required to use pooled investments in certain
Significant diversification advantages can be achieved with a small number of
well-selected securities representing different industries and having other
differences in their qualities. Broader diversification, however, is usually
to be preferred in trust investing. Broadened diversification may lead to
additional transaction costs, at least initially, but the constraining effect
of these costs can generally be dealt with quite effectively through pooled
investing.…Hence, thorough diversification is practical for nearly all
There is, as of yet, little case law regarding the UPIA. Because of its
significant changes from prior law, it is possible that it may take some time
for the case law to develop. However, the Restatement (Third), comments to
the UPIA, ERISA case law and other formative materials provide a wealth of
background as to its intended purposes.
The UPIA sets a more demanding process-direct standard for professional
trustees than that of prior law. While the trust investment process has
always been important, the UPIA adds substantive elements. A paper trail will
be of little value unless it reflects an understanding and consideration of
risk in accordance with the basic tenets of modern portfolio theory. The UPIA
should protect a trustee who observes this process but puts at risk a trustee
who does not, regardless of the success of the portfolio.
A substantial percentage of the American workforce are
either direct or indirect participants in the securities markets. This has
come about in a period when the domestic equity markets in particular have
risen dramatically. It would be a fool’s errand to expect that this growth
will continue indefinitely. At such time as the inevitable correction occurs,
it is not unreasonable to assume that the methods used by financial
intermediaries—be they investment advisors, trustees, financial planners or
brokers who dispense investment advice in return for compensation—will be
examined retrospectively. In all likelihood, the standard to which their
conduct will be held will be the UPIA. At such time as this examination takes
place, one can expect an outcome transparent to a determination made by an
appellate court in New York:
It was not shown in any instance that the losses resulted from imprudence or
negligence. There was evidence of attention and consideration with reference
to each decision made. Obviously, it is not sufficient that hindsight might
suggest that another course might have been more beneficial; nor does a mere
error of investment judgment mandate a surcharge. Our courts do not demand
infallibility, nor hold a fiduciary to prescience in investment decisions.26
1. "[C]omplex notions of this new standard
are, in part, counterintutitive to traditional
notions of prudence," W. Brantley Phillips, Jr., Note, "Chasing
Down the Devil: Standards of Prudent Investment Under the Restate-ment (Third) of Trusts," 54 Wash. & Lee Law
Review 335, 384 (1997).
2. It should be noted that the UPIA is a default standard. It applies only in
the absence of another standard articulated in the trust instrument for the
3. The UPIA does not itself address remedies, but the Restatement (Third) of
Trusts (1992) does at Sections 205 and 208-211, and suggests a "total
return" measure of damages to reflect the gains or losses that
reasonably should have been expected from an appropriate investment program.
See Edward C. Halbach, Jr., "Trust Investment
Law in the Third Restatement," 27 Real Prop., Prob
8 Tr. J 407, 459 (1992). It seems likely that states that have enacted the
UPIA will adopt this standard of damages as the UPIA would seem to be
toothless without it.
4. See Prefatory Note to UPIA and Introduction to Restatement (Third) of
5. Restatement (Third) of Trusts, Section 227, comment
6. Jonathan R. Macey, An Introduc-tion
to Modern Financial Theory, (American College of Trust &
Estate Counsel Foundation), 1991, p. 94. See also Katherine L. Babson, Jr., "Trustee Investment Decision-Making In
Accordance With the Uniform Prudent Investor Rule," ALI-ABA Course of
Study—Representing Trust and Estate Beneficiaries and Fiduciaries, 1998, p.
7. A leading introductory text on modern portfolio theory is R. A. Brealey, An Introduction to _Risk and Return from Common
Stocks, (2d ed. 1983). See also Restatement Third of Trusts: Prudent Investor
Rule Sec. 227 (1992), comments e through h, and General Note on comments e
8. See comment to UPIA Section 3. "Modern portfolio theory divides risk
into the categories of ‘compensated’ and ‘uncompensated’ risk. The risk of
owning shares in a mature and well-managed company in a settled industry is
less than the risk of owning shares in a start-up high-technology
venture." In the case of compensated risk, "the firm pays the investor
for bearing the risk. By contrast, nobody pays the investor for owning too
few stocks…. Risk that can be eliminated by adding different stocks (or
bonds) is uncompensated risk."
9. A Washington appellate court has
held that under the Washington prudent investor
statute a trustee could be liable notwithstanding an acceptable investment
return if the trustee’s investment process did not meet the standards of the
statute. Matter of Estate of Cooper, Wash. App. Div. 3, 1996, 913 P.2d, 393,
review denied 928 P.2d, 414.
10. ". . . [T]he new rule increases the oversight and administrative
burdens of fiduciaries," Rozlyn L. Anderson,
"The Prudent Investor Rule: Planning Implications For the
Millennium," PLI 29th Annual Estate Planning Institute Course Handbook,
September 1998, p.552.
11. See Restatement (Third) of Trusts, Section 227 comment e: "Therefore
the duty of caution does not call for the avoidance of risk by trustees but
for their prudent management of risk."
12. See Restatement (Third) of Trusts, Section 227 comment e, "Failure
to diversify on a reasonable basis in order to reduce uncompensated risk is
ordinarily a violation of both the duty of caution and the duties of care and
skill." See comment to UPIA Section 3: "The object of diversification
is to minimize this uncompensated risk of having too few investments."
13. The New York statute lists other factors such as the size of the
portfolio, the nature and estimated duration of the fiduciary relationship,
related trusts, beneficiaries’ other income and resources. McKinney’s Consolidated Laws
of New York, E.P.T.L. 11-2.3.
14. James McDonald, "Consideration of Asset Allocation in Trust,"
Trusts and Estates, April 1991, pp. 51–52.
15. "An investment policy…is a decision with an indefinite (though not
infinite) horizon, taken with regard to the ability to assume investment
risk. The investment policy task is to determine how much risk to take as a
matter of principle, independent of the current outlook, over a horizon far
longer than the expected ‘half-life’ of any strategy," Douglas A. Love,
"Investment Policy vs. Investment Strategy," Financial Analysts
Journal, March–April 1977, p. 22.
16. Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower,
"Determinants of Portfolio Performance," Financial Analysts
Journal, July–August 1986, p. 39. The study statistically demonstrated that
over an extended period of time, almost 94 percent of the difference in
portfolio management results was attributable to asset allocation, rather
than market timing and individual asset selection. See also Gary P. Brinson,
Brian D. Singer and Gilbert L. Beebower,
"Determinants of Portfolio Performance II: An Update," Financial
Analysts Journal, May–June 1991, pp. 40–48 (updating the original study with
additional data and arriving at the same conclusion).
17. John H. Langbein, "The Uniform Prudent
Investor Act and the Future of Trust Investing," 81 Iowa Law Review 641, 655
(March 1996). The commentary to the Restatement (Third) supports this view;
see also Section 227, comment f.
18. See Restatement (Third) of Trusts, Section 227, comment f. "There is no defined set of asset categories to
be considered by fiduciary investors. Nor does a trustee’s general duty to
diversify investments assume that all basic categories are to be represented
in a trust’s portfolio."
19. "Limiting asset allocation to high quality U.S. equities and U.S. bonds has meant
missing out on many categories of assets which have historically provided
higher returns," McDonald, supra, note 14, p.
52. See also Langbein, supra, note 17 at pp.
659–660 on foreign securities as appropriate investments. See also Babson,
supra note 6, p. 88.
20. "To the extent that an investment strategy involves…a departure from
an efficiently diversified portfolio, that strategy should be justifiable in
terms of special circumstances or opportunities or in terms of a
realistically evaluated prospect of enhanced return," Halbach, supra, note 3, p. 434.
21. Roger C. Babson, Asset Allocation (Business One
Irwin), 1990, p. 125.
22. "To allocate assets with skill, the fiduciary or his advisor must
understand risk, time horizons and the correlation of asset classes," Anderson, supra, note 10, p. 557.
23. "The trust investment manager is ill advised to rely simply upon
comfortable, accepted guidelines or historically accepted asset
classifications; the investment world is now much more complicated…,"
McDonald, supra, note 14, p. 55.
24. One observer put it succinctly: "Remember this prudent investor
axiom: no investment is considered in isolation but as part of the totality.
In this regard, individual investments are like watch parts: in concert, they
drive the operation of the whole," Anderson, supra, note 10, p. 552.
25. Restatement (Third) comment f. See also Langbein, supra, note 17, p. 655.
26. In re OnBank and Trust Co., 90 N.Y.2d 725, 665 n.y.s.2d 389, 688 N.E.2d 245, 1997.
Eugene F. Maloney is director,
executive vice president and corporate counsel of Federated Investors, Inc.,
in Pittsburgh, Pennsylvania.