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Investment Planning

Page history last edited by Matt Erskine 7 years, 5 months ago

Investment Planning

    Effective fiduciary investment requires five steps, Analysis, Allocation, Formalization, Implementation and Supervision.

 

 

 

Investment Planning 1

I. Summary Checklist for Investment Planning 12

A. Analysis Of Current Position 12

1. Required Documents 12

     a) Basic Information 12

     (1) The names and identities if the Trustees, successor trustees and other fiduciaries, as well as who can appoint a successor trustee and to whom the Trustee must account. 12

     (2) If there is an investment committee, is the committee appointed in writing? 12

     (3) If there is an investment committee, is the selection criteria, duties and responsibilities of the investment committee members laid out in writing in sufficient detail? 12

     (4) Does the trust or other documents allow the Trustee to prudently delegate investment management to others? 12

     (5) Are the actual cash flows, and the anticipated cash flows, to and from the portfolio detailed? 12

     (6) Are the Goals and Objectives of the underlying beneficiaires and investors described? 12

b) Defined Contribution Plan 13

(1) Plan Document, with amendment 13

(2) Custodial and brokerage statements 13

(3) Investment performance reports 13

(4) Service agreements with investment management vendors 13

(5) Minutes of investment committee meetings 13

(6) Most recent asset allocation study 13

(7) Due Diligence files on funds and managers 13

(8) Monitoring Procedures for funds and managers 13

(9) Participant Educational Materials 13

(10) Enrollment meeting minutes 13

(11) Records of any loan activity 13

(12) Most recent three IRS form 5500, including schedules 13

(13) Independent accountant audit report, if there are more than 100 employees, 13

(14) Summary of plan description 13

c) Defined Benefit Plan 13

(1) Plan Document, with amendment 13

(2) Custodial and brokerage statements 13

(3) Investment performance reports 13

(4) Service agreements with investment management vendors 14

(5) Minutes of investment committee meetings 14

(6) Most recent asset allocation study 14

(7) Due Diligence files on funds and managers 14

(8) Monitoring Procedures for funds and managers 14

(9) Enrollment meeting minutes 14

(10) Records of any loan activity 14

(11) Most recent three IRS form 5500, including schedules 14

(12) Independent accountant audit report, if there are more than 100 employees, 14

(13) Summary of plan description 14

(14) Actuarial report showing projected benefit obligation (PBO) and accumulated benefit obligation (ABO) and assumptions used for interest rates, return and benefit increases. 14

d) Foundations, Endowments and Charitable Trusts 14

(1) Applicable trust, endowment, gifting or other documents Document, with amendments and modifications 14

(2) Mission based or socially responsible investment strategy restrictions (if any) 14

(3) Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses) 14

(4) Funding Support Ratio (Grants divided by the operating budget of the Charity) note that for  non-operating Private Foundations, this must be at least 5% 15

(5) Smoothing rules (moving average over three year, inflation adjusted amount over previous year, subjective determination of need) 15

(6) Custodial and brokerage statements 15

(7) Investment performance reports 15

(8) Service agreements with investment management vendors 15

(9) Minutes of investment committee meetings (if any) 15

(10) Most recent asset allocation study 15

(11) Due Diligence files on funds and managers 15

(12) Monitoring Procedures for funds and managers 15

(13) Investment Committee Educational Materials 15

(14) Most recent three IRS form 900 and 990 PF, including schedules 15

(15) Summary of recent grants 15

e) Private Trusts 15

(1) Applicable trust and other documents, with amendments and modifications 15

(2) Socially responsible investment strategy restrictions (if any) 15

(3) Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses) 15

(4) Complete asset and liability study for Grantor, family 15

(5) Family Tree 16

(6) Estate and Philanthropic objectives 16

(7) Five year cash flow projections 16

(8) Major expenses anticipated in the next 5 years (college, house purchase etc.) 16

(9) Custodial and brokerage statements 16

(10) Investment performance reports 16

(11) Service agreements with investment management vendors 16

(12) Most recent asset allocation study 16

(13) Due Diligence files on funds and managers 16

(14) Monitoring Procedures for funds and managers 16

(15) Most recent three State and Federal income and gift tax returns for trusts, grantors and beneficiaries, including schedules 16

2. Interview with a Fiduciary 16

a) Are the Fiduciaries aware of their duties and responsibilities? 16

(1) Duty to Be Generally Prudent 16

(a) Investment Duties 16

(i) Prudent Man Rule 16

(ii) Prudent Investor Rule 16

(2) Duty to Carry Out Terms of the Trust 16

(3) Duty to Be Loyal to the Trust 17

(4) Duty to Give Personal Attention 17

(5) Duty to Account to the Beneficiary 17

(6) Specific Duties Arising from General Duties 17

(a) ERISA plan rules 17

(i) There is no self-dealing between the portfolio and the fiduciaries or other parties in interest. 17

(ii) ERISA prohibited transactions 17

(b) Private Foundation Rules 17

(i) Acts of self-dealing 17

(7) Additional Obligations of the Trustee 17

3. Investment operations 17

a) Written service agreements or contracts for asset management, custody 17

b) What is the timing of cash flows into and out if the portfolio, and the payment of liabilities? 17

c) Are assets custody so as to protect the portfolio from theft and embezzlement? 18

B. Diversification and Allocation of Portfolio 18

1. What risk level has been identified for this portfolio? 18

2. What is the expected model return required to meet the investment objectives of the Portfolio? 18

3. What is the investment time horizon? 18

4. What asset classes are consistent with the risk level, modeled return and time horizon for the portfolio? 18

5. Is the number of asset classes consistent with the Portfolio size? 18

C. The Investment Policy Drafting 18

1. Is there specific enough detail to implement a specific Investment Strategy? 18

2. Does the Investment Policy define the duties and responsibilities of all parties? 18

a) Investment Adviser/Consultant 18

b) Investment Manager 19

c) Custodian 19

d) The Investor 19

3. Does the Investment Policy define diversification and re-balancing guidelines? 19

4. Does the Investment policy define the due diligence criteria for selecting investment options? 19

5. Does the Investment Policy define the monitoring criteria for investment options and service vendors? 19

6. Does the Investment Policy define procedures for controlling and accounting for investment expenses? 19

7. If Applicable, the Investment Policy defines appropriately structured socially responsible investment strategies. 19

D. Investment Policy Implementation 19

1. Has the Investment Policy been implemented with the required level of Prudence? 19

2. If the Fiduciary Elects to use Safe Harbor provisions, have those applicable provisions been followed? 20

3. Is the investment approach appropriate for the portfolio size? 20

4. Has a due diligence process been used for selecting and monitoring custodian and other service providers? 20

E. Monitoring and Supervision of Investment Plan 20

1. Do the quarterly reports compare the investment performance against the required index, peer group and Investment policy objectives? 20

2. Have periodic reviews been made of qualitative and organizational changes at investment managers and advisors? 20

3. Are control procedures in place to periodically review policies for best execution, soft dollars and proxy voting? 20

4. Are the fees for investment management services consistent with the Investment Agreement and the law? 20

5. Are the finder’s fees, 12(b)-1 fee, and other forms of compensation for asset placement been appropriately applied, utilized and documented? 20

II. Analysis of the Current Position of the Fiduciary 21

A. Have all of the relevant documents been collected and reviewed? 21

1. Documents for a Defined Contribution Plan 21

2. Documents for Defined Benefit Plans 22

3. Foundations, endowments and other charitable trusts 22

4. Private Trusts and individual or family investment accounts 23

B. Are the Fiduciaries aware of their duties and responsibilities? 24

1. The Duties of the Trustee 24

a) . . . Duty to Be Generally Prudent 24

b) . . . Duty to Carry Out Terms of the Trust 24

c) . . . Duty to Be Loyal to the Trust 24

d) . . . Duty to Give Personal Attention 25

e) . . . Duty to Account to the Beneficiary 26

f) . . . Specific Duties Arising from General Duties 26

g) . . . Additional Obligations of the Trustee 27

h) Further References 28

2. Investments in Trusts 28

a) The Prudent Man Rule 28

b) Rules of Conduct 30

c) The Prudent Investor Act. 31

d) Further References. 32

3. ERISA Plans: Meeting Your Fiduciary Responsibilities 33

C. There is no self-dealing between the portfolio and the fiduciaries or other parties in interest. 33

1. ERISA: "Parties in Interest" 33

a) ERISA prohibited transactions 33

2. Private trusts 34

3. Private Foundations 34

a) Acts of Self Dealing 35

(1) Exemptions for self dealing 35

D. Are service agreements and contracts in writing, and do not conflict with Fiduciary Duty of Care? 35

E. What is the timing of cash flows into and out if the portfolio, and the payment of liabilities? 36

F. Are assets custody so as to protect the portfolio from theft and embezzlement? 36

III. Diversification and Allocation of the Portfolio. 37

A. What risk level has been identified for this portfolio? 37

B. What is the expected model return required to meet the investment objectives of the Portfolio? 38

C. What is the investment time horizon? 39

D. What asset classes are consistent with the risk level, modeled return and time horizon for the portfolio? 39

E. Is the number of asset classes consistent with the Portfolio size? 40

IV. Formalize the Investment Policy 41

A. Is there specific enough detail to Implement a specific Investment Strategy? 41

1. Does the Investment Policy define the duties and responsibilities of all parties? 41

a) Investment Adviser/Consultant 42

b) Investment Manager 42

c) Custodian 44

d) The Investor 44

2. Does the Investment Policy define diversification and re-balancing guidelines? 45

3. Does the Investment policy define the due diligence criteria for selecting investment options? 46

4. Does the Investment Policy define the monitoring criteria for investment options and service vendors? 47

5. Does the Investment Policy define procedures for controlling and accounting for investment expenses? 47

6. If Applicable, the Investment Policy defines appropriately structured socially responsible investment strategies. 48

V. Implement the Investment Policy 48

A. Has the Investment Policy been implemented with the required level of Prudence? 48

B. If the Fiduciary Elects to use Safe Harbor provisions, have those applicable provisions been followed? 49

1. ERISA plans where investment decisions are made by an investment committee 50

2. ERISA plans where the investment decisions are made by the participants 50

C. Is the investment approach appropriate for the portfolio size? 52

D. Has a due diligence process been used for selecting and monitoring custodian and other service providers? 53

VI. Monitor and Supervise the Investment Policy 54

A. Do the quarterly reports compare the investment performance against the required index, peer group and Investment policy objectives? 55

B. Have periodic reviews been made of qualitative and organizational changes at investment managers and advisors? 56

C. Are control procedures in place to periodically review policies for best execution, soft dollars and proxy voting? 57

D. Are the fees for investment management services consistent with the Investment Agreement and the law? 58

E. Are the finder’s fees, 12(b)-1 fee, and other forms of compensation for asset placement been appropriately applied, utilized and documented? 58

VII. Charitable Trusts 59

A. Private Foundations 59

1. Tax on excess Investment income 59

2. Disqualified persons 60

3. Substantial contributors 61

4. Excess business holdings 62

5. Jeopardizing Investments 63

6. Failure to distribute income 63

a) Exceptions to excise tax for failure to distribute income 64

7. Taxable Expenditures 65

B. Charitable Lead Trusts 66

1. Jeopardizing Investments: more than 60% of aggregate value 66

C. Charitable Remainder Trusts 67

1. Restrictions on investment that will produce a reasonable income 67

2. Jeopardizing investments 67

VIII. Appendices 67

A. Appendix A: Due Diligence on Asset Managers 67

1. Screen 1 68

2. Screen 2 68

3. Screen 3 69

B. Appendix B: Investment planning for individuals 71

1. Planning for individuals 72

2. Ten Commandments for Individual investors 73

3. Ten Friendly suggestions for investors 73

C. Appendix C: Request for Proposal for Investment Services 74

1. Basic Information 74

2. Investment Style 75

3. Technical Data: 75

D. Appendix D: Models and forms 76

1. Model Portfolios 76

2. Asset classes by portfolio size 78

3. Investment policy form 79

a) Re-balancing of strategic allocation 79

b) Summary 79

4. Risk Level Assessment 79

5. Questionnaire for Artists 83

6. Questionnaire for Collectors 91

E. Appendix F: M.G.L. - Ch. 203C - Prudent Investor Act - Table of Contents 99

1. Chapter 203C: Section 2. Trustees managing trust assets; duty to comply with prudent investor rule 99

2. Chapter 203C: Section 3. Investment and management decisions 100

a) Comments 101

3. Chapter 203C: Section 4. Diversification 105

a) Comment 105

4. Chapter 203C: Section 5. Review of assets 107

a) Comment 107

5. Chapter 203C: Section 6. Beneficiaries’ interests 108

a) Comment 108

6. Chapter 203C: Section 7. Two or more beneficiaries 109

a) Comment 109

7. Chapter 203C: Section 8. Costs incurred 110

a) Comment 110

8. Chapter 203C: Section 9. Determination of compliance with prudent investor rule 110

a) Comment 110

9. Chapter 203C: Section 10. Delegation of investment and management functions 111

a) Comment 111

10. Chapter 203C: Section 11. Trust provisions; terms 115

a) Comment 116

F. Appendix G: Investments in Art. 116

1. Long-term Investment 117

2. Short Term Investment 119

I.Summary Checklist for Investment Planning

A.Analysis Of Current Position

See also: Analysis of the Current Position of the Fiduciary

1.Required Documents

See also: Have all of the relevant documents been collected and reviewed?

a)Basic Information

See also: Investment Planning

(1)The names and identities if the Trustees, successor trustees and other fiduciaries, as well as who can appoint a successor trustee and to whom the Trustee must account.
(2)If there is an investment committee, is the committee appointed in writing?
(3)If there is an investment committee, is the selection criteria, duties and responsibilities of the investment committee members laid out in writing in sufficient detail?
(4)Does the trust or other documents allow the Trustee to prudently delegate investment management to others?
(5)Are the actual cash flows, and the anticipated cash flows, to and from the portfolio detailed?
(6)Are the Goals and Objectives of the underlying beneficiaires and investors described?

b)Defined Contribution Plan

See also: Documents for a Defined Contribution Plan

(1)Plan Document, with amendment
(2)Custodial and brokerage statements
(3)Investment performance reports
(4)Service agreements with investment management vendors
(5)Minutes of investment committee meetings
(6)Most recent asset allocation study
(7)Due Diligence files on funds and managers
(8)Monitoring Procedures for funds and managers
(9)Participant Educational Materials
(10)Enrollment meeting minutes
(11)Records of any loan activity
(12)Most recent three IRS form 5500, including schedules
(13)Independent accountant audit report, if there are more than 100 employees,
(14)Summary of plan description

c)Defined Benefit Plan

See also: Documents for Defined Benefit Plans

(1)Plan Document, with amendment
(2)Custodial and brokerage statements
(3)Investment performance reports
(4)Service agreements with investment management vendors
(5)Minutes of investment committee meetings
(6)Most recent asset allocation study
(7)Due Diligence files on funds and managers
(8)Monitoring Procedures for funds and managers
(9)Enrollment meeting minutes
(10)Records of any loan activity
(11)Most recent three IRS form 5500, including schedules
(12)Independent accountant audit report, if there are more than 100 employees,
(13)Summary of plan description
(14)Actuarial report showing projected benefit obligation (PBO) and accumulated benefit obligation (ABO) and assumptions used for interest rates, return and benefit increases.

d)Foundations, Endowments and Charitable Trusts

See also: Foundations, endowments and other charitable trusts

(1)Applicable trust, endowment, gifting or other documents Document, with amendments and modifications
(2)Mission based or socially responsible investment strategy restrictions (if any)
(3)Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses)
(4)Funding Support Ratio (Grants divided by the operating budget of the Charity) note that for  non-operating Private Foundations, this must be at least 5%
(5)Smoothing rules (moving average over three year, inflation adjusted amount over previous year, subjective determination of need)
(6)Custodial and brokerage statements
(7)Investment performance reports
(8)Service agreements with investment management vendors
(9)Minutes of investment committee meetings (if any)
(10)Most recent asset allocation study
(11)Due Diligence files on funds and managers
(12)Monitoring Procedures for funds and managers
(13)Investment Committee Educational Materials
(14)Most recent three IRS form 900 and 990 PF, including schedules
(15)Summary of recent grants

e)Private Trusts

See also: Private Trusts and individual or family investment accounts

(1)Applicable trust and other documents, with amendments and modifications
(2)Socially responsible investment strategy restrictions (if any)
(3)Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses)
(4)Complete asset and liability study for Grantor, family
(5)Family Tree
(6)Estate and Philanthropic objectives
(7)Five year cash flow projections
(8)Major expenses anticipated in the next 5 years (college, house purchase etc.)
(9)Custodial and brokerage statements
(10)Investment performance reports
(11)Service agreements with investment management vendors
(12)Most recent asset allocation study
(13)Due Diligence files on funds and managers
(14)Monitoring Procedures for funds and managers
(15)Most recent three State and Federal income and gift tax returns for trusts, grantors and beneficiaries, including schedules

2.Interview with a Fiduciary

a)Are the Fiduciaries aware of their duties and responsibilities?

See also: Are the Fiduciaries aware of their duties and responsibilities?

What is the Fiduciaries' understanding of the following duties as fiduciary?

(1)Duty to Be Generally Prudent
(a)Investment Duties

See also: Investments in Trusts

(i)Prudent Man Rule

(ii)Prudent Investor Rule

(2)Duty to Carry Out Terms of the Trust
(3)Duty to Be Loyal to the Trust
(4)Duty to Give Personal Attention
(5)Duty to Account to the Beneficiary
(6)Specific Duties Arising from General Duties
(a)ERISA plan rules

See also: ERISA Plans: Meeting Your Fiduciary Responsibilities

(i)There is no self-dealing between the portfolio and the fiduciaries or other parties in interest.

(ii)ERISA prohibited transactions

(b)Private Foundation Rules

See also: There is no self-dealing between the portfolio and the fiduciaries or other parties in interest.

(i)Acts of self-dealing

(7)Additional Obligations of the Trustee

3.Investment operations

See also: Investment Planning

a)Written service agreements or contracts for asset management, custody

See also: Are service agreements and contracts in writing, and do not conflict with Fiduciary Duty of Care?

b)What is the timing of cash flows into and out if the portfolio, and the payment of liabilities?

See also: What is the timing of cash flows into and out if the portfolio, and the payment of liabilities?

c)Are assets custody so as to protect the portfolio from theft and embezzlement?

See also: Are assets custody so as to protect the portfolio from theft and embezzlement?

B.Diversification and Allocation of Portfolio

See also: Diversification and Allocation of the Portfolio.

1.What risk level has been identified for this portfolio?

See also: What risk level has been identified for this portfolio?

2.What is the expected model return required to meet the investment objectives of the Portfolio?

See also: What is the expected model return required to meet the investment objectives of the Portfolio?

3.What is the investment time horizon?

See also: What is the investment time horizon?

4.What asset classes are consistent with the risk level, modeled return and time horizon for the portfolio?

See also: What asset classes are consistent with the risk level, modeled return and time horizon for the portfolio?

5.Is the number of asset classes consistent with the Portfolio size?

See also: Are the number of asset classes consistent with the Portfolio size?

C.The Investment Policy Drafting

See also: Formalize the Investment Policy

1.Is there specific enough detail to implement a specific Investment Strategy?

See also: Is there specific enough detail to implement a specific Investment Strategy?

2.Does the Investment Policy define the duties and responsibilities of all parties?

See also: Does the Investment Policy define the duties and responsibilities of all parties?

a)Investment Adviser/Consultant

See also: Investment Adviser/Consultant

b)Investment Manager

See also: Investment Manager

c)Custodian

See also: Custodian

d)The Investor

See also: The Investor

3.Does the Investment Policy define diversification and re-balancing guidelines?

See also: Does the Investment Policy define diversification and re-balancing guidelines?

4.Does the Investment policy define the due diligence criteria for selecting investment options?

See also: Does the Investment policy define the due diligence criteria for selecting investment options?

5.Does the Investment Policy define the monitoring criteria for investment options and service vendors?

See also: Does the Investment policy define the due diligence criteria for selecting investment options?

6.Does the Investment Policy define procedures for controlling and accounting for investment expenses?

See also: Does the Investment Policy define the monitoring criteria for investment options and service vendors?

7.If Applicable, the Investment Policy defines appropriately structured socially responsible investment strategies.

See also: If Applicable, the Investment Policy defines appropriately structured socially responsible investment strategies.

D.Investment Policy Implementation

See also: Implement the Investment Policy

1.Has the Investment Policy been implemented with the required level of Prudence?

See also: Has the Investment Policy been implemented with the required level of Prudence?

2.If the Fiduciary Elects to use Safe Harbor provisions, have those applicable provisions been followed?

See also: If the Fiduciary Elects to use Safe Harbor provisions, have those applicable provisions been followed?

3.Is the investment approach appropriate for the portfolio size?

See also: Are the investment approach appropriate for the portfolio size?

4.Has a due diligence process been used for selecting and monitoring custodian and other service providers?

See also: Has a due diligence process been used for selecting and monitoring custodian and other service providers?

E.Monitoring and Supervision of Investment Plan

See also: Monitor and Supervise the Investment Policy

1.Do the quarterly reports compare the investment performance against the required index, peer group and Investment policy objectives?

See also: Do the quarterly reports compare the investment performance against the required index, peer group and Investment policy objectives?

2.Have periodic reviews been made of qualitative and organizational changes at investment managers and advisors?

See also: Have periodic reviews been made of qualitative and organizational changes at investment managers and advisors?

3.Are control procedures in place to periodically review policies for best execution, soft dollars and proxy voting?

See also: Are control procedures in place to periodically review policies for best execution, soft dollars and proxy voting?

4.Are the fees for investment management services consistent with the Investment Agreement and the law?

See also: Are the fees for investment management services consistent with the Investment Agreement and the law?

5.Are the finder’s fees, 12(b)-1 fee, and other forms of compensation for asset placement been appropriately applied, utilized and documented?

See also: Are the finder’s fees, 12(b)-1 fee, and other forms of compensation for asset placement been appropriately applied, utilized and documented?

II.Analysis of the Current Position of the Fiduciary

A.Have all of the relevant documents been collected and reviewed?

Each portfolio should have the following documented:

  • The names and identities if the Trustees, successor trustees and other fiduciaries, as well as who can appoint a successor trustee and to whom the Trustee must account.

  • If there is an investment committee, is the committee appointed in writing?

  • If there is an investment committee, are the selection criteria, duties and responsibilities of the investment committee members laid out in writing in sufficient detail?

  • Does the trust or other documents allow the Trustee to prudently delegate investment management to others?

  • Are the actual cash flows, and the anticipated cash flows, to and from the portfolio detailed?

  • Are the Goals and Objectives of the underlying beneficiaries and investors described?

1.Documents for a Defined Contribution Plan

    Defined contribution plan, are so-called "profit sharing" plans, under sec. 401(k). They are more in favor with employers now than in the past.

    Controlling law: ERISA

    Oversight Bodies: Internal Revenue Service (Tax and Reporting), Department of Labor (Investment and management), and Pension Benefit Guaranty Corporation (Investments).

Required Documents:

  • Plan Document, with amendment

  • Custodial and brokerage statements

  • Investment performance reports

  • Service agreements with investment management vendors

  • Minutes of investment committee meetings

  • Most recent asset allocation study

  • Due Diligence files on funds and managers

  • Monitoring Procedures for funds and managers

  • Participant Educational Materials

  • Enrollment meeting minutes

  • Records of any loan activity

  • Most recent three IRS form 5500, including schedules

  • Independent accountant audit report, if there are more than 100 employees,

  • Summary of plan description

2.Documents for Defined Benefit Plans

Defined Benefit Plans (DCBP) is the traditional "pensions" of corporations. They are not as in favor now as in the past, as the contributions to the plan by the plan sponsor is fixed not by the profitability of the Corporation, but by the actuarial calculations of the needed funds now to pay an annuity at some point in the future. As the work force ages, these plans can be quite expensive, and there is great pressure not to use, or curtail contributions to, these plans.

Controlling law: ERISA

    Oversight Bodies: Internal Revenue Service (Tax and Reporting), Department of Labor (Investment and management), and Pension Benefit Guaranty Corporation (Investments).

Required Documents:

  • Plan Document, with amendment

  • Custodial and brokerage statements

  • Investment performance reports

  • Service agreements with investment management vendors

  • Minutes of investment committee meetings

  • Most recent asset allocation study

  • Due Diligence files on funds and managers

  • Monitoring Procedures for funds and managers

  • Enrollment meeting minutes

  • Records of any loan activity

  • Most recent three IRS form 5500, including schedules

  • Independent accountant audit report, if there are more than 100 employees,

  • Summary of plan description

  • Actuarial report showing projected benefit obligation (PBO) and accumulated benefit obligation (ABO) and assumptions used for interest rates return and benefit increases.

3.Foundations, endowments and other charitable trusts

    These can vary widely, but generally, they comply with the qualifications of the IRC to qualify as a tax exempt entity

 

Controlling law: Internal Revenue Code, Prudent Investor Act

Oversight Bodies: Internal Revenue Service, State Attorney General

 

Required Documents:

  • Applicable trust, endowment, gifting or other documents Document, with amendments and modifications

  • Mission based or socially responsible investment strategy restrictions (if any)

  • Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses)

  • Funding Support Ratio (Grants divided by the operating budget of the Charity) note that for non-operating Private Foundations, this must be at least 5%

  • Smoothing rules (moving average over three year, inflation adjusted amount over previous year, subjective determination of need)

  • Custodial and brokerage statements

  • Investment performance reports

  • Service agreements with investment management vendors

  • Minutes of investment committee meetings (if any)

  • Most recent asset allocation study

  • Due Diligence files on funds and managers

  • Monitoring Procedures for funds and managers

  • Investment Committee Educational Materials

  • Most recent three IRS form 900 and 990 PF, including schedules

  • Summary of recent grants

 

4.Private Trusts and individual or family investment accounts

Controlling Law: Internal Revenue Code, Prudent Investor Act

Oversight Bodies: Professional Organizations, civil law suits

Required Documents

  • Applicable trust, and other documents, with amendments and modifications

  • Socially responsible investment strategy restrictions (if any)

  • Equilibrium spending rate (Modeled return on portfolio less the sum of inflation and investment expenses)

  • Complete asset and liability study for Grantor, family

  • Family Tree

  • Estate and Philanthropic objectives

  • five year cash flow projections

  • Major expenses anticipated in the next 5 years (college, house purchase etc.)

  • Custodial and brokerage statements

  • Investment performance reports

  • Service agreements with investment management vendors

  • Most recent asset allocation study

  • Due Diligence files on funds and managers

  • Monitoring Procedures for funds and managers

  • Most recent three State and Federal income and gift tax returns for trusts, grantors and beneficiaries, including schedules

B.Are the Fiduciaries aware of their duties and responsibilities?

1.The Duties of the Trustee

The duties of the Trustee arise from the paramount obligation of the Trustee to carry out the Grantor's intention in establishing the Trust. From this obligation, the Common Law has created five general duties of the Trustee:

a). . . Duty to Be Generally Prudent

The Trustee must act reasonably and competently in allmatters of the Trust. This is a conduct, not a performance, standard when applied to investments.

b). . . Duty to Carry Out Terms of the Trust

The Trustee must carry out the intent of the Grantor as laid out in the Trust document. The Beneficiary's desires are subordinate to the Grantor's intent; in effect the Trustee is the Grantor's agent.

c). . . Duty to Be Loyal to the Trust

The Trustee must have an undivided loyalty to the Trust in all matters that directly or indirectly affect the Trust and it’s Beneficiary.

 

1.         Loyalty to the Trust must be diligently pursued by the Trustee.

 

2.         Because self benefiting acts by the Trustee are inherently fraudulent, the court can set aside such acts at the Beneficiary's option. The courts strictly enforce this very high standard when the Trustee acts in a manner that places the Trustee in conflict with the Trust. In effect, the Trustee is personally liable for any loss to the Trust, or gain to the Trustee, arising from transactions in which that Trustee received personal benefit, even if the transactions were otherwise reasonable.

 

3.         Trustee fees, a divided loyalty, are permitted but are limited to those that are “reasonable”.

 

4.         The Trustee may not:

           • Receive loans from the Trust.

           • Hold its own stock in the Trust, if this Trustee is a corporation.

                       •    Buy or sell assets or services to the Trust (either directly or otherwise) including legal, accounting, or consulting fees beyond the Trustee's usual fee.

 

5.         Although commercial transactions with the Beneficiary are permitted, there is a presumption that even outside the Trust; the Trustee has undue influence over the Beneficiary. This can be rebutted where the Beneficiary has been fully informed or has been receiving advice from a third party.

d). . . Duty to Give Personal Attention

The Trustee may not delegate the administration of the Trust.

 

1.         The Trustee may hire competent legal, financial, and accounting expertise but may not delegate the coordination of Trust administration or any matters of discretion.

 

2.         The Trustee may engage agents such as stockbrokers, custody agents, and real estate brokers and may vote stock by proxy.

 

3.         The Trustee may engage an asset manager or advisor, provided that the Trustee supervises that manager or advisor and sets an investment policy.

e). . . Duty to Account to the Beneficiary

The Trustee must account for his or her conduct in fulfilling the intent of the Grantor as expressed in the Trust. This includes:

 

                       1.   Providing timely and complete information in a comprehensible form of the Beneficiary's interest in the Trust.

      • Keeping records and preparing a written accounting of the Trust assets to the Beneficiary, showing the nature, amount, and handling of the Trust assets, along with a written summarization of the receipts of principal, payments from principal, remaining principal on hand, income received, payments of income, and income on hand. The beginning balance and tax cost basis of assets in the accounts are based on the terms of the trust, and if there is no definition of what method for determining the beginning balance, then the inventory in the Trust under a will or the estate tax returns in an inter vivos Trust. These accountings are made annually, unless otherwise specified for in the Trust.

 

                       3.   To pay, personally, for any errors or omissions in his or her actions while handling the assets in the Trust. The courts may discharge the Trustee from this liability with the appropriate accounting of his or her conduct as Trustee filed for the final term of the Trustee’s tenure.

f). . . Specific Duties Arising from General Duties

Within each of the general duties, the Trustee has specific duties to take certain actions in the Trust:

 

                       1.   To control, segregate, earmark, and protect Trust assets. Based on the duty of loyalty to the Trust, mingling Trust assets with other, non- trust, assets is wrong.

 

                       2.   To make Trust assets productive. This duty gives rise to the "Prudent Man Rule," which seeks a middle ground for the Trustee between the interests of the income Beneficiary and the Remainderman: to make the assets productive for the income Beneficiary while being prudent with them for the Remainderman. (See the Erskine & Erskine brochure entitled Investments in Trusts.)

 

                       3.   To hold to a code of confidentiality. The duty of loyalty requires that the Trustee tell third parties only what the law requires the Trustee to disclose. Even the child of the Beneficiary, the Remainderman, or anyone else, who has either an indirect or a contingent interest, cannot direct the Trustee to disclose information concerning the Trust.

 

                       4.   To separate income from principal and to determine the right to income. The Trustee must hold income separate from principal, particularly where the income Beneficiary is someone other than the Remainderman. The law of the jurisdiction controls the determination of what is income and what are principal, not other laws such as the Federal Tax Code, which can result in a receipt being income for tax purposes but principal for Trust purposes. In simple receipts and disbursements, allocation is straightforward, but as the nature of the assets grows in complexity, allocation problems grow with it.

 

                       5.   To be impartial. Unless the Trust requires otherwise, the Trustee must treat all Beneficiaries equally. Where there is an inequality in the Trust, the Trustee must further the Grantor's intention, not the Trustee's personal biases. Additionally, the Trustee must balance the conflicting, equitable interests between the income Beneficiaries and the Remainderman. This impartiality is particularly important, and difficult, in the areas of investments and disclosure of information.

g). . . Additional Obligations of the Trustee

Governmental regulation requires the Trustee to take additional steps outside of the duties imposed by the Trust. These steps include:

•    Tax filings, including income, estate, and gift taxes as well as sales and property taxes.

Security and Exchange Commission filings where necessary.

Banking regulations, when the Trustee is a national bank.

h)Further References

1.         Loring A Trustee's Handbook, 1999 ed. (Aspen Publishers, Inc.) excellent quick reference (and from which this summary is drawn)

 

2.         Newhall's Settlement of Estates and Fiduciary Law in Massachusetts5th ed. (The Lawyers Cooperative Publishing Company; 1958) a Massachusetts specific work with annual updates

 

3.         Scott on Trusts, William F. Fratcher, 4th ed. (Little, Brown and Company) 1988 Exhaustive detailed work of trust law nationwide, difficult to use unless you have a specific question, but invaluable when used in conjunction with Loring above.

2.Investments in Trusts

The duty to make trust assets productive rises from the general duties of a Trustee to be generally prudent and to carry out the terms of the Trust. (See the Erskine & Erskine brochure entitled "The Duties of a Trustee.") By common law, a Trustee must follow the "Prudent Man Rule" when considering investments by the trust. This rule holds a Trustee to a standard of conductrather than a standard of performance.

 

This general duty can be changed by the Trust if the Grantor specifies that a Trustee hold assets or take action that would not be prudent under common law. In investing the assets of the Trust, a Trustee must first consider the intent of the Grantor as expressed in the Trust. A Trustee uses this summary only if the grantor does not list specific variances from the common law in the Trust.

a)The Prudent Man Rule

takes its name from the landmark case Harvard College v. Amory26 Mass (9 Pick) 446 (1830). In this case, the Supreme Judicial Court held that in the area of investments, a Trustee must use the skill, care, and caution in investing the Trust assets as "men of prudence" would show in investing funds permanently (and not for speculation) considering both income and the safety of the principal. This Rule has undergone modification and been codified but has remained essentially the same due to its simplicity and flexibility.

 

1.         The core of this Rule is a reasonable balance between the interest of the beneficiary (income) and the interest of the Remainderman (Principal). It is not prudent to have the trust assets in income only assets, such as bonds or bank accounts, since the Principal is wasted by the effects of inflation. Likewise, it is not prudent to have the Trust assets invested in speculative equities, where the Beneficiary receives little or no income.

  • Some investments are to be avoided, including 1) mortgages (particularly junior mortgages), 2) wasting assets (e.g., leases, royalties, patents, oil and gas wells, mineral or timber lands), 3) family or closely held businesses, 4) speculative assets (such as venture capital), 5) any enterprise in which a Trustee has a personal interest.

 

Specific allowance in the Trustcan permit such investments either to be retained after being transferred to the Trust by the Grantor or invested in by a Trustee. Obviously, when a Trust is set up for a particular purpose that would otherwise be imprudent, such as holding stock in a family business, a Trustee should hold that asset until the purpose of the Trust is achieved.

 

3.         The Proper Investments for a Trustare assets which are liquid and marketable in an appropriate mix between fixed income assets (bonds, preferred stock, money funds, or certificates of deposits) and equities (common stock of publicly traded companies for which there is a national market). The whole portfolio must be considered to create sufficient diversity to eliminate, as far as possible, risks due to maturity dates, interest rates, price, and particular businesses. This lends itself to an equity/fixed income mix with a greater portion being in equities, but an investment policy should be created and referred to in creating this portfolio that embodies the intent of the Grantor.

 

4.         Once Purchased, Investments Should Be Heldand not changed except for good reason. This "buy and hold" investment strategy is deemed the most prudent since it is inherently a long-term strategy which meshes well with the long-term nature of Trusts. Other strategies, such as "market timing" are inherently speculative in nature, and so imprudent.

 

5.         Professional Investment Advisors Can Be Hiredby a Trustee to consult on assets invested in the Trust and to recommend investments. A Trustee cannot delegatesetting investment objections, investment policies, selection of assets, and the personal monitoring of the portfolio's performance on a regular basis. Mutual fundsare allowed but since there is a delegation of authority there are significant risks that should be considered before investing in such funds.

b)Rules of Conduct

 

of a Trustee in making investments can be summarized as follows: it is not a shield to liability, but can be used as evidence of prudence.

 

1.         Start with a Clean Slate. If, after careful review, there are inappropriate investments or breaches of duty, have them corrected before assuming Trusteeship or as soon as possible afterwards.

 

2.         Immediately Assume Control. As soon as possible, obtain personal control of the assets of the Trust; investigate all of the investments and dispose of inappropriate assets.

 

3.         Understand Grantor's Intent and Invest Appropriately. Always refer first to the Grantor's intent, as expressed in the trust, in setting policy and making investments. Each Grantor has individual beliefs, so too should their Trusts be individually invested, where practicable.

 

4.         Actively Monitor and Make Changes to Investments. The Investments cannot remain unsupervised by a Trustee and where changes are required; a Trustee is personally responsible to make those changes.

 

5.         Liquidityshould be sufficient to meet the cash flow of the Trust.

 

6.         Diversifyholdings to reduce risks.

 

7.         Choose Long-term Investmentsover short-term investments.

 

8.         Keep Assets Investedat all times, unless there is a compelling reason not to.

 

9.         Obtain Expert Advicewhen necessary. A written, overall investment policy is advisable.

 

10.       Keep Detailed Recordsof all investments, transactions, and discussions on investments.

c)The Prudent Investor Act.

 

    Since 1998, and Massachusetts trustee must invest trust assets in accordance with the Massachusetts Prudent Investor Act (the “Act”) MGL Ch. 203C. This was enacted to regularize the somewhat piecemeal approach to Trust Investments without decreasing any of the flexibility that Massachusetts ha maintained in handling trust investments, or the Trustee’s duties under the prior law.

 

    The Act goes into some detail on administration and duties of a Trustee that are relevant, but not directly on point, in this discussion. The general intent of the Act is described in section 2 of the Act, and in summary:

  • A Trustee shall use reasonable care in investing and managing trust assets, the same care that a prudent investor would consider the terms, circumstances and purpose of the trust.

  • In deciding on individual investments, the Trustee make the selection based on the overall investment strategy of the trust and not because individual investments as inappropriate per se as an asset of the trust.

  • The investment strategy should consider relevant circumstances including the economy, inflation, taxes; the role an individual investment plays in the overall portfolio, total return from income and realized gains, other resources (or lack thereof) available to the beneficiary, needs for liquidity and the subjective value of the asset to the beneficiaries.

  • Although a Trustee may reasonably diversify investments, the trustee is not required to do so in any particular manner. The Trustee must make reasonable efforts to verify the facts about investments and management and if the trustee has special skills, and those special skills are one of the reasons why the Trustee was appointed, then the Trustee has an obligation to use those skills in the investment of the trust assets.

  • The Trustee may delegate investment management to an agent, if it is prudent to so and the Trustee uses reasonable care in selecting the manager, establishes the terms of the delegation that are based on the terms and purpose of the Trust, and periodically reviews and monitor’s the manager’s performance.

  • The Act is as flexible as the prior law was, but in many ways it means more work for the Trustee. A Trustee cannot categorically rule out considering such investments as hedge funds, international stocks and venture capital but rather he or she must affirmatively rule these investments out as inappropriate to achieve the purposes of the endowment due to excessive risk or inefficient returns.

  • To understand how a Trustee should go about determining what would be a prudent delegation of the investment management of the endowment the Trustee has to have grounding on how the equity and fixed income market’s work, and how managers select investments before a prudent delegation can be made.

d)Further References.

 

                       1.   Loring's A Trustee's Handbook, 1999 ed. (Aspen Publishers, Inc., 1998) excellent quick reference (and from which this summary is drawn)

 

                       2.   Newhall's Settlement of Estate and Fiduciary Law in Massachusetts, 5th ed. (Lawyer's Cooperative Publishing Co.; 1958) a Massachusetts specific work with annual updates

 

                       3.   Scott on Trusts, William F. Fratcher, 4th ed. (Little, Brown & Co.) 1987 Exhaustive detailed work of trust law nationwide, difficult to use unless you have a specific question, but invaluable when used in conjunction with Loring's above.

3.ERISA Plans: Meeting Your Fiduciary Responsibilities

See document(s): fiduciaryresponsibility.html

See attachment(s): ERISA plans - fiduciary responsabilities.pdf

C.There is no self-dealing between the portfolio and the fiduciaries or other parties in interest.

1.ERISA: "Parties in Interest"

With respect to an ERSIA qualified plan, the following are considered "parties in interest" with whom any transaction between such a party and the portfolio is, de jure, void:

  • Any fiduciary, counsel or employee of the plan,

  • Any person providing services to the plan,

  • An employer, any of whose employees are covered by the plan, as well as anyone who owns 50% or more of that employer,

  • A relative (spouse, ancestor, descendant) of any person described above,

  • The spouse of any person described above,

  • An employee organization, whose members are covered by the plan,

  • Any corporation or any other entity of which at least 50% is owned by a person or organization described above,

  • Officer, directors, shareholders with 10% or more interest in any organization described above, and

  • a 10% or more partner of, or joint venture with, any person or organization above.

 

a)ERISA prohibited transactions

    Any party in interest, who enters into a transaction with the ERISA plan, is creating a prohibited transaction. Even if the transaction is otherwise to the advantage of the plan, it is pro se prohibited by the DOL.

    The exceptions to this rule are services that are 1) necessary, 2) the contract for the services is reasonable, and 3) the compensation for the services is reasonable.

    For example, a CPA who does the financial report for the plan can also provide audit or tax preparation services to the plan.

    Some specific examples of prohibited transactions are

  • A plan sponsor using the plan assets to purchase real estate for corporate use,

  • Using assets of a plan for collateral for a private loan to relatives of the plan trustee,

  • Selling plan property for below market value,

  • Buying artwork or collectable from plan assets for the sole purpose of putting the artwork on display (non-investment)

2.Private trusts

See Duties of Loyalty

3.Private Foundations

 

Section 4941 of the Internal Revenue Code imposes an excise tax on certain transactions (acts of self-dealing) between a private foundation and disqualified persons.

Initial tax. An excise tax of 5% of the involved inthe act of self-dealing is imposed on the disqualified person, other than a foundation manager acting only as a manager, for each year or part of a year in thetaxable.

An excise tax of 2-1/2% of the amount involved is imposed on a foundation manager who knowinglyparticipatesin an act of self-dealing, unless participation is notwillfuland is due to reasonable cause, for each year or part of a year in the taxable period.

Additional tax. An excise tax of 200% of the amount involved is imposed on the disqualified person, other than a foundation manager acting only as a manager, who participated in the act of self-dealing, if the act of self-dealing is not corrected within the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the act of self-dealing is corrected during the correction period.

If the additional tax described above is imposed on the disqualified person, an excise tax of 50% of the amount involved is imposed on any foundation manager who refuses to agree to part or all of the correction of the self-dealing act.

Limits on liability for management. The maximum initial tax imposed on the foundation manager is $10,000 and the maximum additional tax is $10,000 for any one act.

There is no maximum on the liability of the self-dealer, including one who is a foundation manager.

If more than one person is liable for the initial and additional taxes imposed for any act of self-dealing, all parties will be jointly and severally liable for those taxes.

a)Acts of Self Dealing

The following transactions are generally considered acts of self- dealing between a private foundation and a disqualified person:

In addition, the law prohibits indirectself-dealing. Thus, transactions between organizations controlledby a private foundation may also be taxable self-dealing.

(1)Exemptions for self dealing

Certain transactions between a private foundation and a disqualified person are not considered self-dealing.

D.Are service agreements and contracts in writing, and do not conflict with Fiduciary Duty of Care?

    Since Fiduciaries cannot be experts in everything, they have a duty to delegate those areas of service that they do not have the skills to do on their own to others who are experts. Hiring professional investment advisors, custodians, records keeper and other investment professionals is the most common way of doing this and maintain the fiduciaries duties for the trust or plan. Any such delegation, however, must be in writing and clearly stipulate the scope, compensation, and length of time the service engagement is for.

    It is especially important to determine who is paying fees for what. For example, mutual funds can be no-load, front-end load, back-end load, break point and many other compensation methods to brokers and advisors that are fees incurred by the service arrangement, but are not directly paid (or reported) to the fiduciary. It is important to find out if the advisor is being compensated solely by the client, or is the advisor getting gifts, commissions, finder’s fees, soft money or other benefits from the broker-dealer, money manager or mutual fund they are recommending.

    It is best to prepare a three column sheet listing 1) all parties involved in the management, custody and administration of the portfolio, 2) the services they will provide and 3) the specific costs of those services.

E.What is the timing of cash flows into and out if the portfolio, and the payment of liabilities?

    A report of the cash flow into, and cash flow out of, the portfolio is useful, and based on the prior cash flow, estimates of projected cash flow for the next five years should be detailed. Additionally, major liabilities that require withdrawals from the portfolio (such as a retirement, payment of college education, and purchase of a house) should also be described if it is likely that such expenses will occur within the next five years.

    This will help to determine the appropriate level of portfolio liquidity, and allow efficient tax planning on meeting that cash flow out, as well as efficient use of investments on cash flow in.

F.Are assets custody so as to protect the portfolio from theft and embezzlement?

    Safeguarding assets is much easier if the assets are held 1) within the jurisdiction of U.S. or similar court systems, and 2) the managing, reporting and auditing function is not being done by the custody agent.

    Separating Custody from reporting is like Churchill’s description of democracy, the worst system except for all others. By having a reputable custody agent (such as a trust company, an online broker, or a brokerage house) that has no conflict of interest in reporting errors in trading, fees and so forth allows a fiduciary to avoid having negligence or malfeasance to go undetected by falsified reporting by the asset manager.

    Additionally, even if the negligence or malfeasance is detected, the fiduciary has to enforce a judgment against the manager for damages. This requires careful consideration of the jurisdiction over disputes the courts may or may not have in each case. Many times a fiduciary can prove wrongdoing against a broker, but the mandatory arbitration clause of the contracts opening the account will bar the client's access to the courts for redress.

    This is particularly true when dealing with offshore accounts, as some of the "asset protection" countries have deliberately hostile laws and courts to suits brought by creditors of an account in their jurisdiction, which may be turned against the fiduciary if they are seeking a judgment against theft or embezzlement in their offshore account.

III.Diversification and Allocation of the Portfolio.

    The hierarchy of decisions for diversification and allocation as follows:

    Primary: What is the time horizon for the portfolio?

    Secondary: What asset classes will be considered?

    Tertiary: what sub-asset classes will be considered?

    Finally: What managers/funds will be considered?

    The following are the questions that need to be addressed when considering the asset allocation and diversification.

A.What risk level has been identified for this portfolio?

    Several factors will determine the appropriate level of risk required to achieve the goals of the portfolio. These goals, these target rates of return, is directly correlated to the fiduciary's need to take risk in investing the portfolio.

    An example is a portfolio of $1 Million, which has to pay out $40,000 annually, adjusted for inflation, and has costs and fees of 1.5%. If inflation is assumed to be 3%, then the targeted rate of return is 8.5% (income plus inflation plus fees and costs).

    Determining the optimal allocation of the portfolio to meet the targeted total return at the lowest risk can be done by portfolio optimization software based on the mathematical work done by Nobel laureate Harry Markowitz. The problem is that these calculations are not constrained by reality. For example, the portfolio optimization software may require a 0.64% allocation of the portfolio to Venture Capital, but the Fiduciary is constrained by the minimum investment in a VC fund of $1 million, the result being (using the above example) the fiduciary with the $1 million portfolio will have nothing in Venture Capital because the fiduciary cannot by just $6,400.00 in a VC fund.

    Additionally, very small or very large percents of a portfolio invested in an asset class will either have little impact or a large impact on the portfolio because the fiduciary is constrained by the denomination of the investments in dollars. So, a 0.3% allocation to Junk Bonds in a $100,000 portfolio is only $300, so even a 20% return is only $6.00.

    Another issue is expected returns. there are two ways return is estimated, the historical method and the risk premium method. The historical method is just the historical returns of asset classes projected into the future. The issue is that history never precisely repeats itself. The risk premium is an attempt to calculate the premium the investor will demand for taking the level of risk entailed in investing in a specific asset class. So, if the return on a no-risk investment (treasury bills) returns 1.5% and the market returns 8.5%, the risk premium the investors demand on investing in stocks is 7%, or 8.5% less the no risk return of 1.5%.

    Using preloaded assumptions on expected returns, standard deviations and correlations in optimization software can be mathematically prudent, but in reality these often lead to unrealistic return expectations. For example, the expected return on cash may be preloaded at 3.45% return, but in actually, cash is yielding 1.5% return.

    For determining an individual's level of risk tolerance, see Risk level assessment.

B.What is the expected model return required to meet the investment objectives of the Portfolio?

    A modeled return is simply the expected rate of return on the portfolio and the probable range of returns associated with that rate of return.  

    This rate of return is what allows the fiduciary to meet the goals and objectives of the portfolio. The rate may be set by outside considerations, such as the spending policy of an endowment, a required payment from a private foundation to avoid and excise tax, the actuarial report of a defined benefit plan, or the required payment on a unitrust or annuity trust. If it is not, then the fiduciary must follow the "prudent investor" rule based on the rate of return required and the level of risk acceptable for the portfolio.

    A fiduciary is not liable if a portfolio does not realize the expected rate of return (or even the market rate of return) provided that the client follows a prudent process for determining the portfolio's model return. The portfolio variation should, however, be clearly communicated to the clients both in person and in the investment policy. This way the client knows that the portfolio may have to endure rises and falls in value to achieve the sought for return. For example, the model portfolio is holding 80% in equities and 20% in fixed income; the investment policy should have some language like:

 

    ”The Return necessary to achieve the goals of the portfolio has been determined to be 6.9%, as along term average. In order to achieve this long term average return, the asset allocation will require that 80% of the portfolio be invested in Equities and 20% are invested in fixed income securities. It is also expected that, because of the long term nature of the investments, short term variations in value (even as low as -19.1 to a high of 46.2%) in any given year are not unexpected"

 

    See Model Portfolios for data on return and ranges of return.

C.What is the investment time horizon?

    The investment time horizon is determined by the need for cash flow. The time horizon for a portfolio is that period of time when the cash flowing out of the portfolio exceeds the contributions into the portfolio and/or the total return on the portfolio. There are basically four time horizons:

  • Secular time horizon: Monitored on a quarterly basis, review on an annual observation basis, a secular time horizon is used very long term portfolios (such as endowments, foundations and core family wealth) where the investment duration exceeds 10 years. This secular time horizon is used for analysis of countries and industries and usually comprises several 4 to 4.5 year cycles.

  • Long term time horizon: Monitored on a monthly basis, review on a quarterly basis. A long term time horizon is used by most investors in the market for less than 10 years, but more than 5, and expect cyclic bottoms every 4 to 4.5 years, bull markets extend for 28 months+/-, Bear 15 months +/-

  • Intermediate time horizon: Monitored on a weekly basis, reviewed on a monthly basis. This time horizon is used by most traders (as apposed to investors) in the market for less than 5 years but more than one year. there are approximately 20 week cycles, trough to trough, with three intermediate trend junctures each calendar year. a Bull market will skew the intermediate time horizon by 12 weeks +/-, and Bear markets by 8 weeks, +/-

  • Short term time horizon: Monitored on a daily basis, reviewed on a weekly basis. Although used as a time horizon by speculators in the markets only, when investors (long) and traders (intermediate) execute entry or exit of the market at intermediate and long term junctures, they will use a short term horizon to execute those entries and exits. the trough to trough trend cycles of short term time horizon is approximately 39 days apart (out of a 240 trading days annually) and there are 5 to 7 short term time horizon top and bottom junctures each calendar year.

    One client may have different investment time horizons for different portfolios, or parts of a portfolio. So, a client may have a portfolio intended to generate current usable cash flow (an intermediate time horizon, with short term time horizon for periodic withdrawals), a portfolio to buy a new house in 8 years (long term time horizon) and a portfolio for a private foundation (secular time horizon of 10+ years).

D.What asset classes are consistent with the risk level, modeled return and time horizon for the portfolio?

    There is no right or wrong answer for the question what are the correct asset classes that should be used for building an investment portfolio. A Fiduciary, after considering the restrictions imposed by the Trust Agreement or the relevant legislation, should select specific assets or asset classes for investment based on their being a part of the overall investment plan, rather than on the merits of the individual asset itself.

    Relevant factors for the fiduciary to consider (but not an exclusive list) are recited in the Uniform Prudent Investor Act, MGL CH. 203c se 3c as follows:

         (1) general economic conditions;

         (2) the possible effect of inflation or deflation;

         (3) the expected tax consequences of investment decisions or strategies;

         (4) the role that each investment or course of action plays within the overall trust portfolio;

         (5) the expected total return from income and the appreciation of capital;

         (6) other resources of the beneficiaries;

         (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and

         (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one of the beneficiaries.

    As a practical matter, the Fiduciary should also include reference to the modeled returnof the portfolio and the time horizonfor the endowment.

E.Is the number of asset classes consistent with the Portfolio size?

    There is no set correct number of assets, or asset classes for any portfolio. In general, a minimum of ten individual asset positions is required to begin to have the benefit of diversification, and more than 40 individual asset positions so dilutes the return (even on a very large portfolio) that there is no advantage and exceeding this number.

    In the case of an ERISA qualified plan, the plan must provide a minimum of three investment options to the participants, a stock fund, a bond fund and a cash account, that span the entire risk range of investments.

    Adding or removing an asset class has to be done solely in order to improve the portfolio's risk/return ratio afterfees and taxes. This means that in a taxable portfolio, the net tax effect of liquidating a highly appreciated position only to address a marginal increase or decrease of asset class numbers is imprudent.

    In considering the number of assets and asset classes, the following should be factored in

  • The size of the Portfolio,

  • The investment expertise of the fiduciary,

  • Whether the portfolio is taxable or non-taxable,

  • Investment expenses (some asset classes have higher investment expenses than others)

  • Legislative, beneficiary, social or trust restrictions on asset classes, and

  • The ability or the fiduciary to properly monitor the chosen asset classes.

 

 

IV.Formalize the Investment Policy

    By reducing the various factors considered in investments for a portfolio, you create a single reference document for all who are involved in the process, defining their respective duties, fees and responsibilities. This document, the Investment Policy, is not required by any statute, but is best practice in all types of portfolios and one of the documents oversight entities will require on an audit.

A.Is there specific enough detail to Implement a specific Investment Strategy?

    Too vague guidance is worse than no guidance at all, so the written Investment Policy must communicate the internal and external checks and balances to insure that all parties involved are clear as to what is necessary to live up to their respective obligations in the investment plan for the portfolio. It does not do to wait until the portfolio is stressed by a major market downturn to test the validity of the assumptions that lead to the creation of the Investment Policy in the first place.

    Assumptions should be spelled out, as much as possible, so that any third party (such as an auditor) can understand how the investment plan was arrived at and how it should be implemented. Conversely, the investment policy has to be flexible enough to allow implementation in a dynamic and complex financial market without the need for constant revision and updates.   The Investment Policy is, therefore, the Architectural Drawing of the portfolio from which the Asset Manager can build a portfolio based on the conditions that exist in reality.

    There are six elements that should be in every Investment Policy:

  • Purpose and Background,

  • Statement of Objectives for the Portfolio,

  • Identity of the parties,

  • Guidelines, including Risk Tolerance, Time Horizon, Chosen Asset Classes, and Expected Returns

  • Securities that are specifically included or excluded because of social or other non-market reasons should be noted,

  • The asset managers should be specifically selected, including fees, costs, scope and discretion.

  • Definitions of the Duties and Responsibilities of the parties, the reporting and monitoring requirements of the asset managers, the performance reporting and measurement criteria

  • The process for calculating and processing fees and expenses.

  •     Each of these is dealt with in more detail below.

1.Does the Investment Policy define the duties and responsibilities of all parties?

    There are a number of different roles any one particular portfolio may have, depending on the type of portfolio account it is. The following is the most important (but not exclusive) duties and responsibilities of the key parties in most portfolios.

a)Investment Adviser/Consultant

    Generally, an Investment Adviser who has more than 15 customers must file with the SEC as a Registered Investment Adviser, or RIA. The SEC defines an Investment Adviser as:

    "Investment adviser" means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities; but does not include (A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956 which is not an investment company; (B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession; (C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore; (D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation; (E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or (F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

The investment adviser is responsible for:

  • Preparing and maintaining the Investment Policy, based on the investment plan laid out by the Fiduciary,

  • Identify and provide sufficient asset classes with different risk/return profiles to maximize the portfolio's return for any given level of risk,

  • Prudently and objectively select the investment styles and options, based on the investment plan,

  • Control and monitor the investment management fees and expenses, and

  • Monitor and supervise all of the service vendors (actuaries, custodians, accountants, asset managers etc.) used by the Portfolio and review the available investment options.

b)Investment Manager

   As distinguished from an investment adviser, who is responsible for managing the investment process, an investment manager is responsible for the actual investment decisions, that is the actual selection of assets within the given asset class as well as the price at which assets are bought or sold. Investment management companies are regulated by the SEC, which defines them as follows:

    • When used in this title, "investment company" means any issuer which--

      • is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

      • is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

      • is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

    • As used in this section, "investment securities" includes all securities except (A) Government securities, (B) securities issued by employees' securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which (i) are not investment companies, and (ii) are not relying on the exception from the definition of investment company in paragraph (1) or (7) of subsection (c).

The responsibilities of the investment manager are as follows:

  • Manage the assets under agreement with them in accordance with the guidelines and restrictions in their service agreement, prospectus or the trust agreement,

  • Exercise full investment discretion in regards to buying, selling and managing the assets in the portfolio,

  • Seek the client's prior approval before purchasing or implementing the following securities or transactions:

    1) Unregulated stock, such as letter stocks, commodities or other commodities contracts,

    2) Short sales or margin transactions,

    3) Lending, pledging or hypothecating securities in the Portfolio

    4) Investing in securities of any fund or company with less than three years continuous operation, including the operation of a predecessor, and

    5) Investing with the intention of exercising control over the management of the target company.

  • Promptly vote all proxies or related actions consistent with the investment objectives of the portfolio as outlined in the Investment Policy, keeping such records of those votes as required,

  • Promptly communicate to the client all significant changes in the management of the portfolio, the personnel handing the portfolio management, or in the firm itself, such as ownership changes, organizational structure, financial condition, and staff changes that the client may be interested in.

  • Use "best price and execution" to effect all transactions for the portfolio and if the manager uses a brokerage for transactions to effect "soft dollar" transactions of these transactions will be communicated to the client

  • Comply with the Prudent Investor rule that they use the same care, skill, due diligence and prudence that the prevailing experienced investment professional uses in similar circumstances subject to similar laws, rules and regulations.

  • Sign and return a copy of the Investment Policy acknowledging these duties and responsibilities.

 

c)Custodian

    A Custodian is an organization, typically a commercial bank or broker/dealer that holds in custody and safekeeping someone else's assets. These assets may be cash, securities, or virtually anything of value.

The responsibilities and duties of a Custodian are generally to safeguard the assets, and more specifically as follows:

  • Maintenance of separate accounts by legal registration,

  • Provide the current value of the holdings,

  • Collect an account for all income, dividends, interest and realized gains on asset owned by the portfolio,

  • Settle all transactions of the Portfolio initiated by the Investment Manager,

  • Provide reports, at least monthly, that detail the transactions, cash flows, securities held, their current value, and changes in value of each security and in the overall portfolio since the next previous report.

d)The Investor

    The Investor is the fiduciary, investment committee or individual who legally owns the trust assets.

 

    For individuals and fiduciaries of private trusts, their responsibilities and duties are as follows:

  • Provide the investment Adviser with an up to date balance sheet highlighting all assets and liabilities, with sufficient details for the investment Adviser to be able to identify the asset classes (including non-investment assets) that the investor is currently invested in.

  • Provide income sources and outflows for the last five years, such as salary, social security, pensions, rents, and royalties. Examples or expectations of both the normal (monthly living expenses) and the extraordinary (new car, repairs to house, vacation) outflows or income should be detailed.

  • Determine the risk level the investor is comfortable with in order to determine the maximum equity exposure and liquidity needs in consideration of current and likely future circumstances.

  • Review regularly the investor's long and short term investment goals.

  • Notify the investment adviser of any material changes in any of the preceding that occurs prior to an annual review.

For ERISA plan sponsors and Investment Committees, their responsibilities and duties are as follows:

  • Determine the investment Goals and objectives of the portfolio or endowment.

  • Develop and articulate and asset allocation policy,

  • Establish, or approve if prepared by an investment adviser, the explicit, written investment policy that articulates the investment goals and objectives for the portfolio.

  • Approve the appropriate investment managers, funds and other investment experts for the implementation of the investment policy.

  • Avoid conflicts of interest and prohibited transactions

Note that under modern standards of prudent fiduciary investment, private fiduciaries, plan sponsors and investment committees are required to delegate their duties if they feel that they do not possess the knowledge and skill to perform those duties. Despite this requirement, the plan sponsors and investment committee members always retain the overall duty to prudently select and monitor the experts they hire. See Duties of the Fiduciary

2.Does the Investment Policy define diversification and re-balancing guidelines?

    the lower, target and upper limits on the percentage of the portfolio should be articulated in the Investment Policy. The difference between the Upper and Lower limits on the percentage in the portfolio represents the trading range within which the holdings in an asset class will be allowed to move without triggering a decision to either buy or sell assets in that class.

    In the case of tax deferred or tax exempt portfolios and endowments (such as ERISA plans and Private Foundations) regular re-balancing can be done to bring the asset allocations toward the target allocation on an almost automatic basis. In the case of private trusts and other taxable accounts, there are usually high transactional costs in the way of realized taxable gains, on the sale of assets, which makes re-balancing such taxable portfolio not an automatic process.

    When a taxable portfolio becomes unbalanced, you need to consider whether there are dividends, interest or new cash into the portfolio from the investor that can be used to purchase new assets in the under represented classes of assets. If not, then the net after tax gains should be considered rather than the mere benefit of re-balancing the portfolio for future growth.

    The primary purpose of re-balancing is to maintain the portfolio's desired level of risk, and the guidelines should be in place to create discipline and force the investor to make decisions based on the investment plan rather than on emotions. The classic mistake is to chase performance that is buying what is hot today at the expense of other asset classes. The result is that when the downturn in that asset class that was such a hot investment comes that returns the rate of return to its historic average, the portfolio was no in place either to neither avoid the loss on the downturn nor participate in the upswing in other asset classes.

    A fiduciary does not have to beat the market; just achieve the goals of the portfolio. if the assets are bought when they are on the upswing, rather than at the bottom of the market, and if they are sold when they still have room to grow, rather than at the top of the market, then the fiduciary has been prudent in investments.

    On setting the trading range, there is no fixed answer, but usually 25% above and below the target allocation is the norm.   See Re- balancing language for an example how this is articulated in an investment policy.

3.Does the Investment policy define the due diligence criteria for selecting investment options?

    Investment options must be defined so that they can be carried out independently an objectively. Some of the greatest scandals in the mutual funds are the Pay-to-Play schemes, where a mutual fund pays a (usually undisclosed) amount to a brokerage firm in return for the Firm recommending the purchase of the funds to the brokerage firm's clients.

    Investment options should be selected from an open architecture trading platform that is the investment manager has as wide an array as possible of possible trading options. This must be applied to both mutual funds and separately managed accounts, applied to any database and used in the searching and monitoring of investment options.

    Standardizing a due diligence for a portfolio is harder, since there are many different databases, such as Morningstar and Bloomberg. Since due diligence relies heavily on peer group and asset class comparisons, the fact that one database defined one mutual fund as a small cap. value fund, while another classifies it as a mid-cap value fund, means that the results of the due diligence can be changed dramatically merely by shifting the database or peer group that the portfolio or manager is being compared to. The result is that an investment option does not meet selection criteria, does not immediately make the investment option a bad option, or should not be considered for inclusion in the portfolio. It merely means that more investigation is required to determine why the investment option does not meet the selection criteria.

    For a more detailed description of the three level screening for due diligence on investment managers, see Due Diligence on Asset Managers.

 

4.Does the Investment Policy define the monitoring criteria for investment options and service vendors?

     Using the Due Diligence process for Investment Managersthe investment policy should specify at least quarterly reviews that the investment managers are performing adequately and adhering to the reliant prospectus (for mutual funds) or investment objectives (for individually managed accounts). If the due diligence shows that the investment manager or fund is significantly below the average, then the manager or fund should be flagged for the annual revision of the portfolio.

5.Does the Investment Policy define procedures for controlling and accounting for investment expenses?

    Many firms (especially mutual funds and hedge funds) use complex compensation structures that make it difficult for the fiduciary to determine if the investment costs are reasonable and appropriate. Investment costs have to be unbundled to determine what they are and whether they are reasonable an appropriate.

    Investment costs should be separated out into four categories:

  • Management fees for a specific account or mutual fund,

  • Trading and custodial costs (including commissions),

  • Broker, adviser and consulting fees and commissions, and

  • Administrative fees (for pension plans).

These fees should be broken down into a percentage of the portfolio value, or basis points, where 100 basis points are equal to 1% of the portfolio's value. For example for a pension fund you might have the following break down of the fees:

    Investment management fee          117 basis points

    Trading and custody fees               23 basis points

    Investment Adviser fee                   75 basis points

    Administrative fees                         29 basis points

    Total Fees                                   244 basis points (2.44%)

During the annual review, the fees and expenses actually charged to the portfolio should be checked against the fees and expense in the investment policy and any difference should be question.

6.If Applicable, the Investment Policy defines appropriately structured socially responsible investment strategies.

    If the portfolio requires social, ethical moral and/or religious criteria for the investment strategies, then that socially responsible investment strategy should be clearly articulated in the Investment Policy. In doing so, however, the fiduciary has to show that the socially responsible investment strategy does not compromise the portfolio's performance. A socially responsible investment option would be prudent if the investment option passed the due diligence screening, but if it does not, it cannot be prudent to use the socially responsible investment strategy except if:

  • the trust document specifically states that a Socially Responsible Investment Strategy is appropriate,

  • a Donor specifically directs the use of a Socially responsible Investment Strategy, or

  • A reasonable person would deduce from the mission statement of the foundation or endowment that such an investment strategy is appropriate. (for example a substance abuse center not buying alcohol or tobacco stocks).

    There are no exceptions to the qualitative screening in an ERISA plan.

V.Implement the Investment Policy

    Fiduciaries, particularly fiduciaries of ERISA plans, have to be sensitive to the "prudent expert" standard the laws hold them to on investment of the portfolio. Essentially, fiduciaries are required to use experts with proven track records when they feel that they lack the expertise, knowledge, skills or time to actually manage the investments. This does not mean that the fiduciary can avoid their primary overall duty to oversee the investment process, but it does mean that they can prudently and reasonably delegate the specific investment decisions required to implement that investment policy to experienced professionals who have lived up to a high professional standard in the past, and who provide the information to verify that they continue to adhere to that standard into the future.

    In order to insure that this delegation, formalized in the Investment Policy, is implemented properly, the following should be asked.  

A.Has the Investment Policy been implemented with the required level of Prudence?

    There are two basic approaches to investing, an active approach and a passive approach. The active approach is in disfavor now when investing in the broader investment markets, such as publicly traded securities, but is still a viable approach when dealing with closely held, illiquid or private equity investing.

    Active Investment Approach: Because the markets for illiquid, private and other unmarketable assets is fundamentally inefficient, specific asset selection and market timing to have a substantially greater return than buying and selling in the private deal making or public auction marketplace. There are, for knowledgeable investors, opportunities to identify specific assets that are selling above or below their intrinsic worth. Generally, unless you are dealing with a private investor or trust with a very specific mandate on the investment portfolio (such as preserving an equity position in a family business or legacy real estate) this active style of investment is not generally considered prudent for a fiduciary.

    Passive Investment Approach: Because public equity markets are heavily regulated to prevent insider trading, are liquid and require public disclosure of most relevant information, this markets are generally very efficient, and an individual stock will move in a random manner, as outlined in the Efficient Market Theory of Eugene Fama, now codified as the Modern Portfolio Theory. Rather than selecting specific assets to invest in, this approach treats the selection process as buying into specific asset classes and sectors. Although fundamental analysis of the specific investment buy and sell is done by the investment manager, the Modern Portfolio Theory approach relies on the overall investment plan to be passively invested in the selected asset classes so as to capture as much of the random growth in value as possible.

    On issue with the passive investment approach, however, is that investors tend to rely too heavily on past performance results in investing for future investment returns, but are wiling to follow a passive approach once the investments are made. Generally, a fiduciary is an investor and has a long term investment time horizon. Most asset managers who follow a particular style will be unable to meet or exceed the market returns in two consecutive 5 year time periods. This means that it is likely that if you exclusively invest in a manager who has had an excellent track record for the last five years, it is likely that you are going have the portfolio under perform the market for the next five years.   Unless the fiduciary is able to take a secular investment time horizon, this will be considered imprudent.

    The due diligence process is essential in determining which approach should be used, and which investment managers selected, for the portfolio.

B.If the Fiduciary Elects to use Safe Harbor provisions, have those applicable provisions been followed?

    Some oversight bodies have created rules that provide a safe harbor for the fiduciary on managing and investing the portfolio. If the fiduciary behaves in strict accordance with these rules, there is an absolute bar to claims against the fiduciary for breach of their investment related duties.

    These safe harbor rules under ERISA come in to basic types, one that relate to decisions made by investment committees and investment advisers, and those   decisions made by the participants in ERISA plans, such as a 401(k) plan.

 

1.ERISA plans where investment decisions are made by an investment committee

    Where there is an investment committee (or investment adviser) making investment decisions for an ERISA plan, then there are five criteria that must be followed to fall under the safe harbor rules:

  • Use prudent experts to make investment decisions,

  • Demonstrate that the prudent expert was selected by a due diligence process,

  • Give the prudent expert discretion over the management of the portfolio assets,

  • Have the prudent expert acknowledge its fiduciary status in writing, and

  • Monitor the activities of the prudent expert to ensure that the prudent expert in performing the agreed upon tasks.

2.ERISA plans where the investment decisions are made by the participants

    The rules in ERISA section 404(c) are generally not well known to many plan fiduciaries. Even if the plan sponsor of a 401(k) plan does know, they are often under the (mistaken) impression that if the plan participants with investment ability to make their own investment decisions among at least three prudent investment options, there is no liability for losses incurred by the plan participants.

    Although these are required, they are only one of a number of requirements a plan fiduciary has to comply with to obtain section 404(c) protection. Section 404(c) provides protection if the participant can exercise control, which it defines, in part, the means of:

Opportunity to exercise control. (i) a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:

(A) Under the terms of the plan, the participant or beneficiary has a reasonable opportunity to give investment instructions (in writing or otherwise, with opportunity to obtain written confirmation of such instructions) to an identified plan fiduciary who is obligated to comply with such instructions except as otherwise provided in paragraph (b)(2)(ii)(B) and (d)(2)(ii) of this section; and

(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed decisions with regard to investment alternatives available under the plan, and incidents of ownership appurtenant to such investments. For purposes of this subparagraph, a participant or beneficiary will not be considered to have sufficient investment information unless- -   

(1) The participant or beneficiary is provided by an identified plan fiduciary (or a person or persons designated by the plan fiduciary to act on his behalf):

(i) An explanation that the plan is intended to constitute a plan described in section 404(c) of the Employee Retirement Income Security Act, and title 29 of the Code of Federal Regulations, Sec. 2550.440c-1, and that the fiduciaries of the plan may be relieved of liability for any losses which are the direct and necessary result of investment instructions given by such participant or beneficiary;  

(ii) A description of the investment alternatives available under the plan and, with respect to each designated investment alternative, a general description of the investment objectives and risk and return characteristics of each such alternative, including information relating to the type and diversification of assets comprising the portfolio of the designed investment alternative;

(iii) Identification of any designated investment managers;

(iv) An explanation of the circumstances under which participants and beneficiaries may give investment instructions and explanation of any specified limitations on such instructions under the terms of the plan, including any restrictions on transfer to or from a designated investment alternative, and any restrictions on the exercise of voting, tender and similar rights appurtenant to a participant's or beneficiary's investment in an investment alternative;

(v) A description of any transaction fees and expenses which affect the participant's or beneficiary's account balance in connection with purchases or sales of interests in investment alternatives (e.g., commissions, sales load, deferred sales charges, redemption or exchange fees);

(vi) The name, address, and phone number of the plan fiduciary (and, if applicable, the person or persons designated by the plan fiduciary to act on his behalf) responsible for providing the information described in paragraph (b)(2)(i)(B)(2) upon request of a participant or beneficiary and a description of the information described in paragraph (b)(2)(i)(B)(2) which may be obtained on request; (vii) In the case of plans which offer an investment alternative which is designed to permit a participant or beneficiary to directly or indirectly acquire or sell any employer security (employer security alternative), a description of the procedures established to provide for the confidentiality of information relating to the purchase, holding and sale of employer securities, and the exercise of voting, tender and similar rights, by participants and beneficiaries, and the name, address and phone number of the plan fiduciary responsible for monitoring compliance with the procedures (see paragraphs (d)(2)(ii)(E)(4)(vii), (viii) and (ix) of this section); and

(viii) In the case of an investment alternative which is subject to the Securities Act of 1933, and in which the participant or beneficiary has no assets invested, immediately following the participant's or beneficiary's initial investment, a copy of the most recent prospectus provided to the plan. This condition will be deemed satisfied if the participant or beneficiary has been provided with a copy of such most recent prospectus immediately prior to the participant's or beneficiary's initial investment in such alternative;

(ix) Subsequent to an investment in a investment alternative, any materials provided to the plan relating to the exercise of voting, tender or similar rights which are incidental to the holding in the account of the participant or beneficiary of an ownership interest in such alternative to the extent that such rights are passed through to participants and beneficiaries under the terms of the plan, as well as a description of or reference to plan provisions relating to the exercise of voting, tender or similar rights.

For the entire section text see ERISA section 404(c)

    On its face, section 404(c) seems so complicated that no one would dare have a self directed retirement plan, but most plan fiduciaries turn to brokerage firms, banks and other service providers who have a specialty in administering to these types of ERISA plans. When making such a delegation, however, the fiduciary should check that the service contract requires:

  • a menu of at least three investment options (usually mutual funds,

  • All fees or commissions offered by these mutual funds to the service providers is fully disclosed, and

  • Clearly denote if the service provider is to become the named or functional fiduciary on the plan with clear written specifics of the functions they will perform and that they accept liability under ERISA,

Also, the education and investment options should be tailored to the educational and sophistication of the plan participants.

C.Is the investment approach appropriate for the portfolio size?

    Investment approaches are not per se prudent or imprudent, but the fees and costs of some approaches may be unreasonable based on the portfolio size. For example, if a portfolio is significantly less than $500,000, it is unlikely that an individually managed portfolio can be obtained economically, whereas exclusive use of mutual funds, ETFs and the like for portfolio's in excess of $5,000,000. Between $500,000 and $5,000,000 some blend of funds and individually managed investments should be used.

    Fiduciaries must be aware, and cautioned about, the difference between a managed (or wrap) account and separately managed accounts.

    A managed or wrap account involves wrapping all of the fees for services of the firm into one fee, including asset management fee, trading costs, reporting, consulting, brokers commissions and custody. Although the selling point of the wrap account is that the investor has access to asset managers who usually only manage multi million dollar accounts for institutions, in reality the people managing the wrap accounts (and their performance) have nothing in common with the institutional money managers other than their names.

    When even considering a wrap account from a brokerage firm for a portfolio, the fiduciary must require the broker to provide performance results for existing wrap account clients, not the composite reports of performance of the asset managers. If they plead confidentiality, then ask that they omit all client information form the performance reports and compare the result with the composite. If they will not do this either, then they are not a serious consideration.

    Separately managed accounts are very easy to customize for the investment plan of the portfolio. They allow the asset manager to pursue specific investment objectives or approaches for each portfolio, such as excluding certain asset classes, unwinding a highly appreciated and concentrated stock position, and dealing with restricted stock positions can be best handled with a separately managed account. The disadvantage of the separately managed accounts is that the asset managers usually have a required minimum fee and costs that make it impracticable for accounts much below $500,000.

D.Has a due diligence process been used for selecting and monitoring custodian and other service providers?

    Fees for investment managers are only one of the costs which can seriously reduce the return on a portfolio. Other services provider fees and expenses also need to be monitored by a prudent fiduciary. These service providers usually will include:

  • An auditor for plans with 100 or more employees,

  • A trustee,

  • A custodian,

  • a record keeper (see note below),

  • A third party Administrator (especially for self-directed plans),

  • investment manager, and

  • An investment adviser/consultant.

Private trust are not required to have as many separate service providers, though the roles of those service providers should be clearly allocated to the vendors the private trust does engage.

    It is important that the fiduciary in both plans and private trusts to have the same outline of services and the type of portfolio to the vendors, and follow a selection and monitoring process. Following are twelve very good guidelines for selection and monitoring these vendors.

  • Consider what services the portfolio requires (legal, accounting, trustee, custody, record keeping, investment consulting, investment management, investment education and actuarial services)

  • Ask service providers about their services, their experience with this type of portfolio, their fees and expenses, customer references, and so forth to determine their customer satisfaction with their services,

  • Present each with identical information about the portfolio, so that you can compare apples to apples,

  • Consider whether the vendors are providing "bundled" services and see if they will unbundle them for comparison,

  • Have the bids be specific about what services are included in the quoted fee and which are not. It is not required that a fiduciary pick the lowest cost provider, but there should be full disclosure of any revenue sharing agreements with the vendor and other service providers,

  • If the service provider is handling assets, make sure the vendor has a fidelity bond (insurance against fraudulent and dishonest acts) adequate to cover the assets they handle.

  • If the service provider has to be licensed (lawyers, accountants, investment managers, and investment advisers) check with the state or federal licensing authority that the licensing is up to date and whether there are any complaints against the provider.

  • Closely review the service agreement. If there are terms that you do not understand, do not sign the agreement until it is explained to your satisfaction. In particular, note the obligations both the fiduciary of the portfolio and the service provider is agreeing to, the fees and expenses that will be incurred and whether those fees and expenses are reasonable in light of the portfolio's requirements.

  • Prepare a written record of the process the fiduciary followed in making the selection, and the reasons why that particular provider was selected, as a record of the process used in making the selection if there are inquiries later about the selection.

  • Have a commitment from the service provider, and follow up on this commitment, to regularly provide information on the services provided.

  • Periodically review the performance, fees and costs of the service provider against the services, fees and costs agreed to in the service agreement.

  • Review the comments or complaints the beneficiaries of the portfolio have with the service provided on a regular basis (not just when the beneficiaries are screaming at the fiduciary) and whether there are any changes in the beneficiaries needs for information or services, or changes in the services provided by the service provider.

    If you are using a third party record keeper for the portfolio, do not assume that the fiduciary, or the portfolio, owns those records. Make sure that the service agreement clearly states that the fiduciary owns those records. Without these records, terminating a record keeper can be very difficult, and a duplicate set of records, updated regularly, should be delivered to the fiduciary with the other information from service providers.

VI.Monitor and Supervise the Investment Policy

    This is the most laborious of the five steps. The other four steps can be reviewed on an annual basis, but the supervision and monitoring has to be done on a quarterly basis. The complexity of the monitoring process is where it is most likely that the investment planning process will fall apart. It is, however, there the meat of the process is, and it is the place where all of the participants in the investment planning and investment management process are examined to see if they are living up to their respective obligations.

A.Do the quarterly reports compare the investment performance against the required index, peer group and Investment policy objectives?

    Periodic reports, usually quarterly, from the investment managers and other service providers to the portfolio are critical. Although performance of the investment managers is usually the primary quarterly report, the quarterly reports should also provide the fiduciary with the following:

  • The returns on major asset classes for the past quarter as well as the performance for the year to date, one-, three- and five- year periods,

  • The performance of the portfolio for the quarter, the year to date and since inception to date,

  • A comparison of the portfolio performance to the appropriate benchmark portfolio for quarter, year to date, one-three- and five- year periods,

  • A comparison of the current asset allocation against the target asset allocation in the Investment Policy,

  • A comparison of the individual mangers (or mutual funds) to the performance of their peer group,

    The preceding information should then be used to answer the following questions:

  • Is the overall portfolio performance satisfactory based on the target allocation in the Investment Policy?

  • Does the Portfolio need to be re-balanced?

  • Are the Investment Policy objectives being met?

  • Is there a need for a change in the target allocation? ( this only occurs when there is a change in the risk tolerance of the portfolio or the investor. Mere changes in the financial markets should not dictate changes in the portfolio target asset allocation. Changes include needs for income, shortening time horizons, and similar circumstances.)

    Once the information is collected, a comparison should be made between what was the performance of the overall financial market and the actual results of the portfolio. Although reports are needlessly complicated, they can be refined into the bottom line rather than complex risk/return scattergrams and the like. What the client wants to know is whether the portfolio, and the investment manager, is performing within expectations and is meeting the target goals in the investment policy.

    Caution should be used in using the actual, non-risk-adjusted, performance to the benchmarks as the only comparison as to whether the portfolio is performing satisfactorily. Sometimes the performance of the portfolio should lag the performance of the benchmark where less risk is tolerated than the benchmark, such as having a longer duration of bond maturities as well as the net tax effect of long equity positions hare liquidated to reallocate positions.

    Other factors to be addressed in the performance review include whether the benchmark is appropriate, portfolio volatility, and the time period being measured. The quarterly reports are to monitor the performance, final conclusion can only be drawn on annual (or longer) reporting periods since in the short term a well balanced portfolio moving into the market will under perform the market because of the transaction costs and fees involved in entering the market.

    On re-balancing the portfolio, the need to re-balance need to factor in the trading range of the asset allocation as noted in the investment policy. Divergence from the trading range should illicit an inquiry and written explanation from the investment manager, and perhaps a recommendation on re-balancing, but it should not be an automatic adjustment. Usually a fund or investment asset will go onto a "watch" list, which the client should be aware of so that if and when the asset or fund is sold, the client already knows the reason.

    Finally, inflation has a corrosive effect on purchasing power of assets in a portfolio, so the fact that the target rate of inflation has been met for the period should also be noted.

B.Have periodic reviews been made of qualitative and organizational changes at investment managers and advisors?

    In doing the due diligence for any investment manager, the following qualitative criteria should be included in the analysis of their strictly quantitative results:

  • What staff turnover has occurred?

  • What changes have been made to the firm's organizational structure or ownership?

  • How has the investment philosophy changed?

  • Has the level of service, including the quality of responses to requests for information, changed?

  • Has the quality of the reports changed?

  • Has the investment process changed?

  • Have there been any legal, SEC or regulatory proceedings or actions against or involving the firm?

    Although there is no single sure key to the quality of than investment manager, staff turn over does give a sense of the "institutional memory" of the firm. The longer the time the staff has been at the firm, the more likely that the staff have an institutional memory of market boom and bust cycles, and the less likely they will be sucked into a fad investment.

    Ownership of the firm is also a key component. As with every corporation, the interest of the shareholders comes first in operation of the business. If the firm is held for a long term investment by employees or family, their operations will reflect that long term perspective on relationship building and seeking profits on the fees, while if the ownership is a publicly traded stock, then there is more pressure to modify the investment philosophy and process to accommodate the next quarter's numbers. This is particularly true where investment products are being promoted to accept the most recent fad in investments. The so-called Hedge Funds offered by large brokerage firms like Merrill Lynch are designed to be sold, not to be owned. The business purpose is to get a higher fee per value of assets under management than they would have gotten under a more conventional mutual fund structure.

    The investment philosophy of the investment manager is often what you seek out when you are originally looking at the firm, whether the investment style is active or passive?, value or growth?, large or small cap? Doe sit invest in international markets and how? do the hedge currency positions? what is the commitment to low fees and trading costs? All of there shed light on the firm's philosophy of investing, as will a study of the firm's past performance. For example, when a particular style of investment is out of favor (small cap. value stocks in the 1990's, small cap growth stocks in the 2000's) some firm cheated by buying stocks outside of their stated investment philosophy, ultimately hurting their performance when their style came back into favor. Such cheating indicates a weakness in the firm's commitment to maintaining an investment philosophy.

    Investment management firms should also be free with the information needed to educate the clients about their investment process, by conferences, newsletters, online information and printed research reports.

C.Are control procedures in place to periodically review policies for best execution, soft dollars and proxy voting?

    Best execution means the process of obtaining the best trading price for a given security that is available in any market trading that security. That being said, there is no uniform rule as to how such best execution is determined or defined.

    This is not just the highest price on sales and lowest price on purchases of the security, but also in includes speed, market impact costs, and conflicts of interests. Conflicts of interests are the most worrisome of these concerns, since brokers can route trades for execution to one exchange, market maker, or electronic communication network (ECN) as well as fill the order internally out of their own inventory (which allows them to make more money on the spread between the market price and the actual price to the client).

    Individually managed account managers must route their trades through a broker for execution, but these trades should be monitored to see if they are getting the right price to the assets. In many ways, however, this is almost impossible to determine, until the investment manager or mutual fund begins to lag behind its peer group.

    So-called soft dollars are services that are provided to the management firm by the broker in exchange for the order. These are paid on the excess profit incurred between the cost of the trade to the client and the costs of the transaction to the brokerage firm. These services include research, technology and other assistance that are supposed to ultimately benefit the client. Though not strictly illegal, this practice does raise issues of whether the investment management firm could have obtained the services from a third party at less cost, and so been about to save the client money on the trade.

    Investment research is often purchased with these soft dollars, which lends itself to abuse when the brokerage is making a market in a security that they are also providing soft dollar research on to the investment managers. Additionally, in the past, large gifts have been given to the investment managers by the brokerage houses under the guise of soft dollars, such as trips and such. The investment manager should have a written the amount and nature of the soft dollar benefits they have with any relationship.

    Proxy voting is often overlooked, but should be done to enhance the value of the security. A voting log should be maintained as to how the manager voted the proxy.

 

D.Are the fees for investment management services consistent with the Investment Agreement and the law?

    Fees need to be paid in a way that is reasonable and appropriate for the type of portfolio the manager is investing for. For example, fees paid from an ERISA qualified plan may be deemed a direct benefit to the plan's beneficiaries, and so be treated as if it where a distribution from the plan to the beneficiaries.

    The reasonableness of the fees is not clearly defined, even when compared to similar fees for similar investment managers, since the specific requirements in the investment policy may result in the investment manager doing more or less work than his or her peers. the four components of a fee, that is money management, trading, custody and adviser/consulting needs to be broken out of the overall fee and each considered separately. That way the fiduciary can understand who is getting paid what for which service. These include sub-transfer agent costs as well as 12(b)-1 costs in mutual funds.

E.Are the finder’s fees, 12(b)-1 fee, and other forms of compensation for asset placement been appropriately applied, utilized and documented?

    The complex compensation structures of the financial industry results in a system where secrecy is normal and transparency is unusual, even though for those who know where to look, who is paid what can be determined.

    Finders fees are commissions paid to an adviser or broker for placing assets (usually over $1 million) with an investment manager. Most often this commission (usually a percentage of the AUM paid annually) is not disclosed to the fiduciary but are reflected in the front end or back end loads on mutual funds. these loads basically are reimbursing the fund for the cost of the finder’s fee.

    ERISA plans are especially susceptible to the lack of transparency. Fiduciaries are often told that the many services the plan participants receive are free, but this is patently false, since every provider of services are being paid so-called sub-T.A. fees, a form of revenue sharing, when the mutual fund kicks back a percentage of the fees for record keeping and other services. These fees are often not disclosed, so there is no way that the plan administrator can possibly know if they could have gotten these record keeping and other services for less from a third party provider.

    Another controversial fee is the so-called 12(b)-1 fee, which is a fees allowed under section 12(b)-1 of the investment Company act of 1940 for the cost of marketing and distribution of a fund. Originally, this was justified that the fees promoted market growth of the funds, and the growth of the funds benefited the investors by economies of scale and increased marketability and liquidity of the funds. The problem is that historically, the higher expenses of a 12(b)-1 fee does not translate into the expected higher return, because of the increased drag on the performance of the fund as a net return on investments. Fiduciaries should know what the 12(b)-1 fees are, and if the broker or adviser receives such fees form the fund.

VII.Charitable Trusts

A.Private Foundations

There is anexcise tax on the net investment income of most domestic private foundations. This tax must be reported on Form 990-PF, Return of Private Foundation, and must be paid annually at the time for filing that return or in quarterly estimated tax payments if the total tax for the year is $500 or more.

In addition, the Internal Revenue Code contains five provisions that impose two-tier excise taxes on private foundations,Foundation managers, or other disqualified personsthat engage in certain prohibited acts. These are the taxes onself-dealing between private foundations and their substantial contributors or other disqualified persons; (2) requirements that the foundation annuallydistribute income for charitable purposes; (3) limits on theirholdings in private businesses; (4) provisions that investments may notjeopardize the carrying out of exempt purposes; and (5) provisions to help ensure that expenditures further exempt purposes. These penalty excise taxes are reported and paid on Form 4720.

Violation of these provisions gives rise to taxes and penalties against the private foundation and, in some cases, its managers, its substantial contributors, and certain related persons. The first tier (initial) tax is automatically imposed if the foundation engages in a prohibited act. With the exception of self-dealing acts under section 4941, the initial taxes may be abated (set aside) if it is established that (1) a taxable event was due to reasonable cause and not to willful neglect, and (2) the event was corrected within the correction period.

Additional information

Excise tax on Private Foundations

1.Tax on excess Investment income

Internal Revenue Code section 4940 imposes an excise tax of 2% on the net investment income of most domestic tax-exempt private foundations, including pri­vate operating foundations. Some exceptions apply. An exempt operating foundation is not subject to the tax. Further, the tax: is reduced to 1% in certain cases.

This tax must be reported on Form 990-PF, Return of Private Foundation. Payment of the tax is subject to estimated tax requirements. For more information concerning payment of esti­mated tax, see the Instructions for Form 990-PF. Nonexempt private foundations are also subject to this tax, but only to the extent that the sum of the 2% tax plus tax on unrelated busi­ness income, applied as if the foundation were tax-exempt, is greater than income tax liability for the year.

Example. A taxable private foundation had an income tax liability for 2002 of $10,000. If the foundation were tax exempt, it would have a $4,000 liability for tax on net investment income and a $7,000 liability for tax on unrelated busi­ness income. The foundation is liable under sec­tion 4940 for $1,000, the amount by which the sum of the tax on net investment income and the tax on unrelated business income ($11,000) ex­ceeds the amount of income tax liability ($10,000).

 

2.Disqualified persons

For the rules relating to private foundation excise taxes, the following persons are considered disqualified personswith respect to a private foundation:

    • All substantial contributors to the founda­tion,

    • All foundation managers of the foundation,

    • An owner of more than 20% of-- a. The total combined voting power of a corporation, b. The profits interest of a partnership, or c. The beneficial interest of a trust or unin­corporated enterprise, which is, during the ownership) a substantial contributor to the foundation,

    • A member of the family of any of the individuals described in (1), (2), or (3),

    • A corporation of which more than 35% of the total combined voting power is owned by persons described in (1), (2), (3), or (4),

    • A partnership of which more than 35% of the profits interest is owned by persons described in( 1), (2), (3), or (4),

    • A trust, estate, or unincorporated enter­prise of which more than 35% of the bene­ficial interest is owned by persons described in (1), (2), (3), or (4),

    • For purposes of the tax on excess business holdings only, another private foundation that either-- a. is effectively controlled, directly or indi­rectly, by the same person or persons who control the private foundation in question, or b. receives substantially all of its contribu­tions, directly or indirectly, from the same persons described in (1), (2), or (3), or members of their families, who made, directly or indirectly, substantially all the contributions to the private foun­dation in question, and

    • For purposes of the tax on self-dealing only, a government offi­cial.

Indirect owner­ship of stock in a corporation, profits interest in a partnership, or beneficial interest in a trust, es­tate, or unincorporated enterprise is taken into account for determining whether:

    • The stockholdings, or profits or beneficial interest, amount to more than 20% of the total combined voting power of the corpo­ration or more than 20% of the profits or beneficial interests, or

    • More than 35% of the total combined vot­ing power of the corporation or more than 35% of the profits or beneficial interests are owned by persons described in cate­gories (1), (2), (3), or (4).

3.Substantial contributors

A substantial contributorincludes any per­son who contributed or bequeathed a total amount of more than $5,000 to the private foun­dation if the amount is more than 2% of the total contributions and bequests received by the foundation from its creation up through the close of the tax year of the foundation in which the contribution or bequest is received from that person. For a trust, a substantial contributor includes the creator of the trust. However, in no case does the term include a governmental unit.

In determining whether the total contribu­tions and bequests from a person are more than 2% of the total contributions and bequests re­ceived by a private foundation, both the total of the amounts received by the foundation, and the total of the amounts contributed and be­queathed by the person, are determined as of the last day of each tax year. Although the deter­mination is made on the last day of the foundation’s tax year, a donor is a substantial contributor as of the first day the foundation receives a gift large enough to make the donor a substantial contributor. Each contribution or be­quest is valued at its fair market value on the date it is received by the foundation. Gifts by an individual include all contributions and bequests made by that individual and his or her spouse.

A determination is to be made as to whether a person is a substantial contributor as of the end of each of the foundation’s tax years, based on the respective totals of all contributions re­ceived and the total amount received from a particular person by that date. Status as a sub­stantial contributor will date from the time the donor first met the $5,000–2% test. Once a person is a substantial contributor to a private foundation, generally that person remains a sub­stantial contributor even though the individual might not be so classified if a determination were first made at some later date. For instance, even though the total contributions and bequests of a person become less than 2% of the total re­ceived by a private foundation, generally the person remains a substantial contributor to the foundation.

However, a person ceases to be a substan­tial contributor as of the end of a private foundation’s tax year if:

    • That person (and all related persons) have not made any contributions to the founda­tion during the 10-year period ending with that tax year, and

    • That person (or any related person) was not a foundation manager of the founda­tion at any time during that 10-year period, and

    • The total contributions made by that per­son (and related persons) are determined by the IRS to be insignificant compared to the total contributions to the foundation by one other person. For the purpose of this comparison, appreciation on contributions while held by the foundation is taken into account.

A person is related to a substantial contribu­tor, for this rule, if that person’s relationship to the contributor would make that other person a disqualified person with respect to the contribu­tor, as discussed in this chapter. If the contribu­tor is a corporation, the term related personalso includes any officer or director of the corpo­ration.

Special rules. A substantial contributor does not include an entity that is described in section 509(a)(1), (2), or (3) or any organization wholly owned by such an entity. In addition, only for purposes of section 4941 excise taxes on self-dealing,a substantial contributor does not in­clude any other organization described in sec­tion 501 (c)(3) (other than an organization with section 509(a)(4) status).

The term contributionincludes gifts, and grants to the foundation, as well as bequests, devises, legacies, or transfers as outlined in the rules relating to estate and gift tax.

Entities excluded from the definition of sub­stantial contributor are also excluded from the definition of disqualified per­son.

4.Excess business holdings

Generally, under section 4943 of the Internal Revenue Code, the combined holdings of a private foundation and all of its disqualified persons are limited to 20% of the voting stock in a business enterprisethat is a corporation. The 20% limitation also applies to holdings in business enterprises that are partnerships, joint ventures, or other unincorporated enterprises. For a partnership or joint venture, profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. A private foundation that has excess business holdingsin a business enterprise may become liable for an excise tax based on the amount of the excess holdings.

Initial tax. An excise tax of 5% of the value of the excess holdings is imposed on the foundation. The tax is imposed on the last day of each tax year that ends during the taxable period.

The amount of the excess holdings is determined as of the day during the tax year when the foundation's excess holdings in the business were the greatest.

The initial tax may be abated if the foundation can show that the excess holdings were due to reasonable cause and not to willful neglect, and that the excess holdings were disposed of within the correction period.

Additional tax. After the initial tax has been imposed, an excise tax of 200% of the excess holdings is imposed on the foundation if it has not disposed of the remaining excess business holdings by the end of the taxable period. The additional tax will not be assessed, or if assessed will be abated, if the excess business holdings are reduced to zero during the correction period.

5.Jeopardizing Investments

a private foundation makes any investments that would financially jeopardize the carrying out of its exempt purposes, both the foundation and the individual foundation managers may become liable for taxes on these jeopardizing investmentsunder section 4944.

Initial tax. An excise tax of 5% of the amount involved (the jeopardizing investment) is imposed on the foundation for each tax year, or part of a year, in the taxable period. The foundation will not be liable for the tax if it can show that the jeopardizing investment was due to reasonable causeand not willful neglect, and that the jeopardizing investment was corrected within the correction period.

An excise tax of 5% of the amount involved is also imposed on any foundation manager who knowingly, willfully, and without reasonable causeparticipatedin making the jeopardizing investment.

This tax applies to investments of either income or principal.

Additional tax. If a private foundation is liable for the initial tax and has not removed the investment from jeopardy within the taxable period, an additional excise tax of 25% of the amount involved will be imposed on the foundation. The additional tax will not be assessed, or if assessed will be abated, if the investment is removed from jeopardy within the correction period.

In each case where this additional tax is imposed on the foundation, an additional excise tax of 5% of the amount involved is imposed on any foundation manager who refuses to agree to all or part of the removal from jeopardy within the correction period.

If more than one individual manager is liable for the excise tax on jeopardizing investments, all parties will be jointly and severally liable.

Limits on liability for management. For any one jeopardizing investment, the maximum initial tax that may be imposed is $5,000, and the maximum additional tax is $10,000

6.Failure to distribute income

Private foundations are required to spend annually a certain amount of money or property for charitable purposes, including grants to other charitable organizations. The amount that must be distributed annually is ascertained by computing the foundation’s distributable amount. The distributable amount is equal to the foundation’s minimum investment return with certain adjustments.

The distributable amount must be distributed as qualifying distributions. However, a foundation may set asidefunds for up to 60 months for certain major projects. Excess qualifying distributions may be carried forward for a period of 5 tax years immediately following the tax year in which the excess was created. Special transitional rules apply to foundations created before May 27, 1969.

A foundation that fails to pay out the distributable amount in a timely manner is subject to a 30 percent excise tax under section 4942 on the undistributed income. The tax is charged for each year or partial year that the deficiency remains uncorrected. An additional 100 percent tax is triggered if the foundation fails to make up the deficient distribution within 90 days of receiving notification from the IRS of its failure to make minimum distributions.

Limitedexceptionsto the tax may apply.

a)Exceptions to excise tax for failure to distribute income

The tax does not apply to the undistributed income of a private operating foundationor of an exempt operating foundation.

Certain long-established private foundations that have provided long-term care facilities continuously since May 26, 1969, are treated as private operating foundations and, therefore, are not subject to the excise tax on failure to distribute income.

To qualify for this treatment, the foundation must, on May 26, 1969, and continuously thereafter to the end of the tax year, operate and keep up facilities for the long-term care, comfort, maintenance or education of the permanently and totally disabled, elderly, needy widows, or children as its principal functional purpose. In addition, the foundation must meet the requirements of the endowment testthat applies to private operating foundations.

An organization will meet the principal function purpose requirement if it is organized for the principal purpose of operating and maintaining these residential facilities and at least 50% of the qualifying distributions normally made by the organization are spent for the operation and upkeep of these facilities.

These foundations are treated as private operating foundations only for the purposes of the distribution requirements of section 4942 of the Code. All other rules governing non-operating private foundations, including rules governing deductibility of contributions, apply.

Incorrect valuation of assets. The tax also does not apply to the undistributed income of a private foundation that failed to distribute only because of an incorrect valuation of assets, if:

    • The incorrect valuation was not willful and was due to reasonable cause,

    • The undistributed income is distributed as qualifying distributions during the allowable distribution period,

    • The foundation notifies the Service that the income has been distributed to correct its earlier failure to distribute, and

    • The distribution is treated as a correction of deficient distributions for earlier tax years that would otherwise be subject to this tax.

The foundation must be able to show it has made all reasonable efforts in good faith to value its assets according to applicable rules.

If a foundation, after full disclosure of the facts, obtains a good faith appraisal of an asset's fair market value by a qualified appraiser (whether or not that appraiser is a disqualified person with respect to the foundation), and the foundation relies on that appraisal, then failure to properly value an asset will ordinarily be regarded as not willful and due to reasonable cause. However, if a foundation does not obtain a good faith appraisal, the lack of such an appraisal will not, by itself, imply that the foundation's failure to properly value an asset was willful and not due to reasonable cause.

Example. In 1998 the Martin Foundation, which was established in 1997, incorrectly valued its assets in a manner that was not willful and was due to reasonable cause. As a result of the incorrect valuation, $20,000, which should have been distributed by the end of 1999, is still undistributed as of January 1, 2000. On September 29, 2000, a notice of tax deficiency is mailed to the foundation.

On November 5, 2000, (within the allowable distribution period) the foundation makes a qualifying distribution of $20,000 which is treated as made out of the foundation's undistributed income for 1998. The foundation notifies the Service of its action. Under these circumstances the foundation would have been liable for an initial tax of $3,000 (15% of $20,000). However, because the foundation meets the exception for failure to distribute because of an incorrect valuation of assets, it is not liable for the taxes.

7.Taxable Expenditures

If a private foundation makes any taxable expenditures, it is liable for taxes on these expenditures under section 4945 of the Internal Revenue Code. The taxes are imposed on both the foundation and on any foundation manager who knowinglyand willfullyagreesto the expenditures.

Initial tax.The initial tax on the foundation is 20 percent of the amount expended. The foundation is not liable for the tax if it can show the expenditure was due to reasonable causeand not to willful neglect, and the expenditure was correctedwithin the correction period. If a foundation manager knowingly, willfully, and without reasonable cause agrees to the taxable expenditure, the initial tax on the management is 5 percent of the amount expended, up to a maximum tax of $10,000 for any expenditure. A foundation manager who acts on advice of counsel, given in a reasoned legal opinion in writing, is not liable for the tax.

Additional tax. If the expenditure is not corrected within the taxable period, an additional tax of 100% of the amount expended is imposed on the foundation. The tax will not be assessed, or if assessed will be abated, if the expenditure is correctedwithin the correction period. Any foundation manager who refuses to agree to any part of the correction must pay an additional tax of 50% of the expenditure, up to a maximum tax of $20,000.

If more than one foundation manager is liable for either the initial or additional tax, all are jointly and severally liable.

B.Charitable Lead Trusts

1.Jeopardizing Investments: more than 60% of aggregate value

If the present value, on the date of the transfer, of all the income interests for a charitable purpose is more than 60% of the aggregate fair market value of all amounts in the trust (after payment of liabilities), the interest is not a guaranteed annuity interest (see ¶41,602 ) unless the trust instrument prohibits both the acquisition and retention of assets that would give rise to a tax under Code Sec. 4944 (which imposes an excise tax on a private foundation that makes investments that jeopardize the carrying out of the foundation's charitable purpose et seq.) if the trustee had acquired those assets.

RIA observation:

Reg § 1.170A-6(c)(2)(i)(D) (footnote 2) effectively coordinates the Code Sec. 508(e) governing instrument requirements for private foundations with the Code Sec. 4947 rules on how the private foundation rules apply to split-interest trusts. Code Sec. 508(e)(1)(B) requires a private foundation to include, in its governing instrument, a provision prohibiting the foundation from making any investments that would subject the foundation to the Code Sec. 4944 tax. Under Code Sec. 4947(a)(2) , split-interest trusts are subject to many of the same rules that apply to private foundations, including the Code Sec. 4944 tax. However, Code Sec. 4947(b)(3)(A) provides that the Code Sec. 4944 tax doesn'tapply to a split-interest trust if all the income interest and none of the remainder interest is devoted solely to charitable purposes, and all amounts in trust for which an income, estate, or gift tax deduction was allowed have an aggregate value of 60% or less of the aggregate fair market value of all amounts in the trust.

Reg § 1.170A-6(c)(2)(i)(D) (footnote 2) pulls all of these rules together by (i) requiring that the governing instrument of a charitable lead annuity trust (CLAT) (see ¶41,598 ) must prohibit the acquisition and retention of investments that would subject the CLAT to the Code Sec. 4944 tax, and (ii) providing an exception to this governing instrument requirement in situations where the present value of the charitable lead interests doesn't exceed 60% of the aggregate value of the net assets of the CLAT on the applicable valuation date.

 

C.Charitable Remainder Trusts

1.Restrictions on investment that will produce a reasonable income

A trust which includes a provision that restricts the trustee from investing the trust assets in a manner that will produce a reasonable amount of annual income or gain from the sale of trust assets doesn'tqualify as a charitable remainder trust. 31

Illustration:

An individual (A) owned a 70% joint venture partnership interest. The partnership's sole asset was an apartment complex which was subject to a nonrecourse mortgage. A transferred a portion of his partnership interest to a charitable remainder unitrust (CRUT, see¶41,502et seq.), and A was trustee of the CRUT. A, as trustee, wasn't restricted from investing the CRUT's assets in a manner which could result in the annual realization of a reasonable amount of income or gain. Therefore, the transfer of the partnership interest by A to the CRUT didn't violate the above rule relating to the restrictions on investments. 31.1

However, a taxpayer may establish a CRUT with publicly- trade stock that is subject to Securities and Exchange Commission (SEC) restrictions. Taxpayer was an officer and director of a corporation. As such, he was an “insider” or “affiliate” of the corporation for securities law purposes, so the timing and method of selling his stock was restricted. He established a CRUT, funded it with all of his stock in the corporation, and acted as initial trustee. Because of the restrictions placed on stock, the shares held by the trust didn't have a readily–ascertainable fair market value. Under the trust agreement, however, an independent special trustee was the sole party responsible for making the annual determination of the value of the assets. The SEC restrictions on the stock transferred to the trust didn't disqualify it as a CRUT if the trust otherwise qualified as a CRUT.

 

2.Jeopardizing investments

Charitable Remainder Trusts are subject to the samejeopardizing investment rules private foundations are subject to except for initial contributions made to the CRT by the Donor. seeReg. Sec. 53.4944-1 (2)(ii)(a)

VIII.Appendices

A.Appendix A: Due Diligence on Asset Managers

See attachment(s): Due Diligence on Asset Manager Selection.doc

1.Screen 1

    • Does the product/portfolio return since inception or 10 years, whichever is less, averages more than 66% of the average annual compound rate (AACR) of the manager’s style group?

    • Product/portfolio return was not in the bottom quartile of the style adjusted peer group during the last five years.

    • Product R2 of at least 85% (will vary by asset class) to the style adjusted benchmark?

    • Product downside returns since inception or 10 years, whichever is less, is not more than 110% of the style-adjusted benchmark.

    • Product upside returns since inception or 10 years, whichever is less, is not less than 100% of the style-adjusted benchmark.

    • Product Sharpe Ratio is in the top 50% since inception or the last 10 years, whichever is less.

Note:

    R2is the Coefficient of Determination, which is the square of the portfolio or product’s correlation coefficient with the market.

    Sharpe ratiois a measure of the amount of return in a portfolio per unit of risk. It is calculated by dividing the result of subtracting the risk-free return over a specific period from the portfolio’s return over the same specific period by the standard deviation of the portfolio over the same period. The higher the ration, the greater return for unit of risk on the portfolio.

 

2.Screen 2

    • Provide a summary of firm’s history, ownership and recent changes.

    • Brief description of the product/management style being offered

    • Description of Manager’s investment approach and philosophy, including any tax-aware characteristics.

    • Background of relevant investment professionals.

    • Firm Assets under management, specifying institutional versus private client assets.

    • Review of products key characteristics, including sector weights, PE ratio, PB, yield, number of holdings, median market cap. Duration and credit quality relative to the appropriate benchmark.

    • Total number of investment professionals firm wide, and the number of losses/additions over the past 5 years.

    • Number of investment professionals dedicated to the product being recommended and the number of losses/additions over the last 5 years,

    • Summary of applicable investment vehicles (separate account, mutual fund, comingled trust etc.) and the applicable minimum account sizes, and whether the investment are open or closed to new investments.

    • Summary of applicable fees and expenses

    • Provide firms SEC ADV Parts I & II

    • Provide after tax return, if possible.

 

3.Screen 3

This is a qualitative, rather than quantitative stage of examination, based on a visit to the firm, and an interview at my office, of the manager. Included in the interview are questions on:

    • Investment philosophy: Can the manager articulate (rather than just read from a script)

      • A well defined investment philosophy,

      • Why the manager’s approach worked and why it will continue to do so in the future?

      • What is the manager’s discernable competitive advantage?

      • What changes to the model or process have been made in the past, and what changes are contemplated?

      • What is the product/firm’s capacity for assets under management?

      • What the product/portfolio specifically designed for taxable investors? And if not what changes would have to be made to accommodate tax considerations and how would those changes affect the fundamental investment process?

      • Does the manager employ performance- based fees and if not why not?

    • Decision making process: How does the manager consider:

      • The selection universe,

      • The investment style,

      • The valuation criteria (quantitative, fundamental, top-down, technical, etc.)

      • Portfolio construction

        • How many issues are normally held and how are they weighed?

        • Are all industries and sectors represented in the portfolio, and how are they weighed?

        • What limits are placed on holding one security?

        • What is the policy for holding cash?

        • What triggers a buy/sell decision?

        • Description of how tax sensitivity is incorporated into the portfolio construction process

      • Benchmark Issues

        • What are the appropriate benchmarks for the portfolio or product?

        • To outperform the benchmark, what is the manager doing differently (market timing, sector or industry bets, bets on volatility, country, currency, etc.)?

        • How much does the manager expect to outperform the appropriate benchmark both net of fees and taxes?

        • What does the manager consider an appropriate measurement period and what is the expected annual variability around the targeted outperformance?

    • Implementation

      • Who is responsible for this product/portfolio? Are these the same people who are responsible for the firm’s long-term record?

      • Is there a team or a star approach?

      • Who makes the final buy/sell decision?

      • How tax considerations of possible trades are explicitly addressed?

      • How are decisions implemented?

      • Description of the transaction process and costs. What are the average commissions? Best Execution? Describe by whom and for what are soft dollars allocated (research, capital commitment, IPO allocations, sales and trading coverage)? How is cost of the market impact of trades measured?

      • How are securities allocated among accounts?

      • Performance dispersions: What degree of uniformity exists among accounts in the product or firm? How important an issue does the manager consider performance dispersion to be?

    • Culture and stability of the firm

      • Is asset management the sole or primary line of business?

      • Are there any changes in the ownership structure anticipated, and are there plans for generational transfer of ownership?

      • Are there strong personal, financial and psychological incentives for the managers, staff?

      • What are the compensation packages available for the firm’s staff, including incentive plans, and how and why are they awarded?

      • What specific incentives are employed to ensure key professionals do not leave the firm, either individually or collectively?

      • Is the firm investment driven or sales driven (Alpha factory or asset gatherer)?

      • What are the firm’s business objectives with respect to future growth?

      • What institutions have hired, or fired, the firm in the last two years? What are the reasons given for both?

    • Reporting and Communications

      • Describe the firm’s ability to provide timely information (portfolio and performance reports, written analysis, conference calls, meetings, etc.)

      • Do the asset managers meet with the clients?

    • Risk Control

      • Does the firm have a written risk control policy?

      • Do external auditors test the firm’s controls?

      • Does the firm have a disaster recovery/business continuation plan? Has the plan been stress-tested?

      • How is the investment performance of the client accounts monitored?

      • Do persons independent of the trade execution and recording function settle trades?

      • How often are accounts reconciled with custodian information?

      • Does the firm have a written policy on the use and monitoring of derivatives?

 

B.Appendix B: Investment planning for individuals

See attachment(s): Investment Policy for Individual Investors.pdf

Too often money managers for large institutions are promoted as the best for individual investors. When considering any investment program, whether directly with a manager or indirectly through a mutual fund, consider the distinctions between institutional and individual investors:

    • Individuals are mortal, life (and earning ability) is finite, and of unknown duration. This is the dominating reality in individual investing.

    • Individuals only have a finite time to save and invest before they stop earning.

    • Once Individuals stop earning, they will have a finite amount of resources to depend upon for an indefinite duration of their lives.

    • Assets take on a great symbolic value, and so emotions are involved in making any decisions. Individuals also make a great deal of impact on others, both emotionally and financially, by gifts made or not made. Investments therefore have far more than mere economic power, but also emotional and symbolic power as well.

    • All investors have to deal with inflation, but for individuals, it is the problem. Inflation corrodes purchasing power, even at low levels. Inflation at 5 percent in 15 years (less than the usual life expectancy of most at retirement age) will cut purchasing power in half.

    • Individuals have a set of responsibilities, such as education cost, retirement security, health care costs, benefiting their community, and passing assets to children, which often may be in conflict. These financial responsibilities are unknown, unlimited, and very personal.

1.Planning for individuals

  • Create a “balance sheet” of your responsibilities to yourself; your family and your community consider timing of predictable costs (such as purchase of a new car) and impact of foreseeable (like helping a child financially through a major illness) but unpredictable costs.

  • Plan for gifts and support of those for whom you feel responsible, but do so without jeopardizing your financial wellbeing.

  • Have an estate plan (wills, Trusts, health care proxy and durable powers of attorney), and integrate it with your financial plans Both Estate and Financial plans should be updated it annually, as the laws and your situation changes.

  • Begin with savings, then go to investments, first build a defensive reserve and use it freely, rather than go into debt. Further savings can then be invested for the long term.

  • Invest to accumulate at a compound rate tax-free, remember the rule of 7, assets compounding at 7 percent double in value every ten years.

  • Money available for long-term investments does best when invested, and kept, in stocks for the long term, whether individual stocks or stock mutual funds. Remember that even though the investor may not live for a long time, the investments (passing down to the family) may well remain for generations.

  • Avoid emotional investing, it is better to buy when stocks go down and stay down rather than when stocks go up and stay up. Know yourself and your personal financial goals, and invest accordingly. Do not follow the daily price of assets. Take frequent “cool downs” in following your assets.

  • Use individual money managers bound by a written investment policy, if possible. Otherwise use mutual funds which either is 1) an index fund (low cost and does no worse than market) or 2) closed-end funds selling at a discount which are obligated to become open-end funds within a reasonable period of time (such as five years). Avoid having multiple exotic funds, they are designed to sell the fund, not invest your money.

  • Take an annual, formal, objective review of investment goals, your financial resources against your financial responsibilities, and recent investment results compared with prior realistic expectations and your expectations from the beginning of the year.

  • Avoid speculation to “win big” but at the same time don’t be too cautious, a shift to “conservative” assets can open up risks for corrosion of assets by inflation.

2.Ten Commandments for Individual investors

  • Thou shall NOT speculate. Do your gambling in Foxwoods not in the market.

  • Thou shall NOT buy on tips. The only good tips are based on insider information; trading on insider information is illegal. Buy based on solid information.

  • Thou shall NOT invest for “Tax Reasons”. Tax shelters are intended to create brokers’ commissions, not wealth. An exception is charitable split interest gifts when selling low basis stock.

  • Thou shall NOT think of your home as an investment. Over the last 20 years real estate has returned less than Treasury bills. You don’t have to heat and re-shingle Treasuries.

  • Thou shall NOT buy commodities. Commodities are intended to smooth out industry costs of materials, not to be an investment vehicle.

  • Thou shall NOT be confused by salespersons. A salesman’s job, as good as he or she may be, is to earn money for their firm through commissions, not to make money for you. Never take their advice in an investment except when it agrees with your policy.

  • Thou shall NOT buy new or “interesting” investments. They are designed to make money by being sold to investors; they are not designed to make money by being owned by investors.

  • Thou shall NOT believe what other investors tell you. It is always polite to listen, but back it up with your own investigations.

  • Thou shall NOT let money dominate you. Look at investments three or four times a year and no more. More frequent “adding up” will risk your being caught up in the crowd.

  • Thou shall NOT trust your emotions. The secret of long-term investing is benign neglect.

 

3.Ten Friendly suggestions for investors

  • Get a pro. Investing is no place for amateurs, your job is to earn money; hire someone else whose job earns them money by achieving your investment goals. This can be done either directly or indirectly through a mutual fund.

    • Put your long term goals and plans in writing and stay with them. “Plan the work and work the plan!”

    • If your long-term investments drop then double up on your investments. If you spend considerable time and effort on your policy, then it is probably right in the long run.

    • Be a student of investing and investors, most errors are emotional, not computational.

    • Save.

    • Money is a powerful symbol; respect the meaning you and others bring to it.

    • Resist asking, “What stock should I buy?” If you do ask, don’t listen to the answer. If you do listen, promise not to act on the answer.

    • You are the most important investor in the market. It’s your money and you are the client, so the most important goal is achieving your long-term success.

    • Read the Annual Reports of Berkshire Hathaway.

    • Prices may rise and fall, but inflation is the real problem for individual investors. Markets come and go, but inflation persists and is unrelenting in its damage.

C.Appendix C: Request for Proposal for Investment Services

See attachment(s): Request for Proposal for asset management services.doc

The following are basic information, technical data and investment style questions needed to evaluate an asset manager for selection or review on the due diligence review.

1.Basic Information

    • Please provide your firm’s name, address, and contact information that should be used for this proposal.

    • Is your firm registered with the Securities and Exchange Commission?

      • Please provide the firms SEC ADV Parts I & II

    • Please provide a summary of your firm’s history, ownership and recent changes.

    • Has your firm, affiliates or key personnel been the subject of any legal proceedings that relate to investment services or operations?

    • How much is the face amount of any insurance you or your firm carries in respect to errors and omissions, fiduciary liability and fidelity bonding?

    • Is your firm related, by ownership or formal business agreement, to any provider of brokerage services? If yes, please explain the relationship.

    • Are there any potential conflicts of interest created by awarding this investment management contract to your firm?

2.Investment Style

 

1.   Please provide a brief description of the product/management style being offered.

    • Please provide a description of your investment approach and philosophy, including any tax-aware characteristics.

    • Please provide a brief background of relevant investment professionals considered for this account.

    • Please provide the Firm’s current Assets Under Management, specifying institutional versus private client assets.

    • Please provide a review of your model portfolios key characteristics, including sector weights, PE ratio, PB, yield, number of holdings, median market cap. Duration and credit quality relative to the appropriate benchmark.

    • Please provide the total number of investment professionals firm wide, and the number of losses/additions over the past 5 years.

    • Please provide number of relevant investment professionals dedicated to the product being recommended and the number of losses/additions over the last 5 years.

    • Please provide a summary of applicable investment vehicles (separate account, mutual fund, comingled trust etc.) and the applicable minimum account sizes, and whether the investments are open or closed to new investments.

    • Please provide a summary of applicable fees and expenses.

    • Please provide the after tax return on the model portfolios, if possible.

3.Technical Data:

    • What is the model portfolio return since inception or for the last 10 years, which ever is less?

    • What is your peer group for this portfolio?

      • What percentile of your style adjusted peer group has the model portfolio been for each of the last 5 years?

    • What is the style adjusted benchmark for the model portfolio?

    • What is the downside return since inception or for the last 10 years, which ever is less, as a percentage of the style adjusted benchmark?

      1. What is the upside return since inception or for the last 10 years, which ever is less, as a percentage of the style adjusted benchmark?

    • What is the Sharpe Ratio for your style adjusted peer group for the last 10 years?

      1. What is the Sharpe Ratio for the model portfolio since inception or for the last 10 years, which ever is less?

D.Appendix D: Models and forms

1.Model Portfolios

Model Portfolio (equity/fixed)

Expected Model Return

1 year return range

3 year avg. return range percent

5 year avg. return range percent

20/80

4.5%

-4.8 to 15.8

-0.6 to 10.8

0.6 to 8.7

30/70

4.9%

-6.8 to 20.3

-1.5 to 12.7

-0.6 to 10.2

40/60

5.3%

-9.2 to 25.2

-2.7 to 15.5

-1.8 to 11.8

50/50

5.7%

-11.6 to 30.9

-3.9 to 18.1

-2.9 to 13.7

60/40

6.1%

-14.1 to 36.2

-6.6 to 24.3

-3.8 to 15.7

70/30

6.5%

-16.6 to 41.3

-6.1 to 22.2

-4.8 to 17.6

80/20

6.9%

-19.1 to 46.2

-7.2 to 24.7

-6.1 to 19.4

100/0

7.6%

-24.1 to 55.8

-10.4 to 29.4

-8.5 to 22.8

 

Note: the range of returns reflects two standard deviations.

 

Model Portfolios:

Asset class

Index

Expected returns net fees

Portfolio A (20%Equity 80% Fixed)

Portfolio B (30%Equity, 709%fixed)

Portfolio C (40%Equity, 60% Fixed)

Portfolio D (50%Equity, 50% Fixed)

Portfolio E (60%Equity, 40% Fixed)

Portfolio F (70%Equity, 30%Fixed)

Portfolio G (80%Equity, 20%Fixed)

Portfolio H (100% Equity)

Short Term Bonds

Lehman 1 to 3 yr Gov’t

 

3%

 

40%

 

35%

 

30%

 

25%

 

20%

 

15%

 

10%

 

0%

Intermediate Bond

Lehman Interim. Credit

 

4.5%

 

40%

 

35%

 

30%

 

25%

 

20%

 

15%

 

10%

 

0%

Large Cap. Stocks

S&P 500

 

7%

 

6%

 

9%

 

12%

 

15%

 

18%

 

21%

 

24%

 

30%

Small Cap. Stocks

Russell 2000

 

9%

 

6%

 

9%

 

12%

 

15%

 

18%

 

21%

 

24%

 

30%

International Stocks

MSCI EAFE (net)

 

7%

 

6%

 

9%

 

12%

 

15%

 

18%

 

21%

 

24%

 

30%

Real Estate

Wilshire REIT

 

7.75%

 

2%

 

3%

 

4%

 

5%

 

6%

 

7%

 

8%

 

10%

Annualized return 1973- 2003

 

 

 

8.7%

 

9.1%

 

9.5%

 

9.9%

 

10.3%

 

10.6%

 

11.0%

 

11.5%

Annualized standard deviation

 

 

 

3.9

 

5.1

 

6.5

 

7.9

 

9.3

 

10.8

 

12.3

 

15.2

 

    Standard deviation is a means of measuring volatility of a security or asset class, and is a short hand way of defining risk. Basically, it is the extreme range of negative or positive returns on a security or an asset class over a specific period of time. One standard deviation is 68% of those variations in value, two standard deviations is 95% of that value.

 

    For example, the S&P 500 from the period 1926 to 2003 had an average return of 10% for the entire period, 68% of the time the actual annual return for the S&P 500 during that time period was from a low of –10% to a high of +30%, so the average standard deviation over the time period from 1926 to 2003 for the S&P 500 is 20% (20% low, and 20% high on average of 10%).

 

    Two standard deviations is 95% of the annual outcomes, so for the same 1926 to 20903 period, the average annual return is till 10%, but the range of annual returns for the S&P 500 is from a low of –43.3% in 1931 to a high of 53.9%, so an average two standard deviation of approximately 50% (or 100 points!)

 

2.Asset classes by portfolio size

 

Portfolio

Size

Large cap.Blend

Multisector Fixed

Cash

Int’l Equity

Small Cap. Blend

Intermed. Fixed

Mid-cap blend

Large value/large growth

Emerging Markets

Real Estate

High Yield bonds

Alternative investments

<$100,000

Yes

Yes

Yes

No

No

No

No

No

No

No

No

No

$100,00 to $500,000

Yes

No

Yes

Yes

Yes

Yes

No

No

No

No

No

No

$500,000 to $1,000,000

No

No

Yes

Yes

Yes

Yes

Yes

Yes/Yes

No

No

No

No

$1,000,000 to $5,000,000

No

No

Yes

Yes

Yes

Yes

Yes

Yes/Yes

Yes

Yes

No

No

$5,000,000>

No

No

Yes

Yes

Yes

Yes

Yes

Yes/Yes

Yes

Yes

Yes

Yes

 

Note: by the time an investor reached $500,000, use of mutual funds becomes less efficient to diversify the portfolio. This is due both by the inability of the fiduciary to discount the fees and costs due to the size the investment, and because the funds are not tax-sensitive nor can they be managed with the specific requirements of the portfolio in mind.

 

Note also: Although a specific class (such as Real Estate) should be considered as part of the portfolio, the fact that Real Estate is not included in the portfolio is not per se imprudent. It only means that the fiduciary considered and reasonably rejected the inclusion of that class of assets from the universe the manager can consider as an investment option, or that the manager has rejected the asset class based on their expertise and judgment within the terms of the investment policy. On the other hand, inclusion of an asset class which is not appropriate for the size of the Portfolio may indeed be imprudent.

3.Investment policy form

a)Re-balancing of strategic allocation

    The manager will consider re-balancing the portfolio back to the target allocation when the overall allocation or sub-asset classes deviate by plus or minus 25%. For example, if the target allocation is 10% of the portfolio, re- balancing will be considered when that asset class falls to 7.5% or below, or rises to 12.5% or above.

    Re-balancing is not automatic if the asset class reaches the upper or lower limit, but rather the manager shall deploy cash inflows and cash outflows in such a way as to bring the portfolio back to the target allocation, and only in the absence of such cash flows and after consideration of the transaction costs and tax effects on the portfolio and its beneficiaries will transactions be made to re-balance the portfolio.

b)Summary

Type of Portfolio:

         Defined Contribution Plan

 

4.Risk Level Assessment

See attachment(s): Risk Level Assessment.doc

    • What is the approximate value of this investment portfolio?  $_______________

      • What percentage of your total net worth does this portfolio represent? _____%

    • What is the need for income from the portfolio over the next 5 years?  $___________

      • When will this income be needed?   Beginning Year______________

    • Will there be significant cash withdrawals from, or contributions to, the portfolio over the next five years?

      • Year 1               $_________

      • Year 2               $_________

      • Year 3               $ _________

      • Year 4               $_________

      • Year 5               $_________

 

    • Is this portfolio taxable, or partially taxable? Yes ___        No ____

      • What is your expected tax rate for this portfolio? 15% ___ 28% ____ 33% ____

    • What is your investment time horizon? (The number of years you expect the portfolio to be invested before your must dip into principal or other substantial modification to your goals for the portfolio)

      • 1 to 4 years       _____

      • 5 to 10 years               _____

      • More than 10 years (please specify)

    • In my mind, a reasonable expectations for this portfolio over the investment period for each of the below are:

      • Total inflation-adjusted net annual return on the portfolio     ____%

      • Inflation                                    ____ %

      • Fees and costs                                ____ %

 

    • Which most accurately reflects your level of concern in the following areas (with 6 being the highest level of concern, and 1 the lowest) note: you may use a number more than once:

      • Preserve my capital                  1   2   3   4   5    6

      • Growth of the Portfolio             1   2   3   4   5    6   

      • Low volatility in the value of the portfolio  1    2   3   4   5   6

      • Protect against inflation            1   2   3   4   5    6   

      • Meet current cash flow needs       1   2   3   4    5   6   

      • Beating the market.                   1   2   3   4   5    6

    • What percentage of your portfolio would you always like to have available for emergencies?      

 

     1% to 5% ___    5% to 10% ____  10% to 15% ____     More then 20% ____

    • OPTIONAL: What are the maximum and minimum ranges of investments you are comfortable having in the portfolio?

 

      • T-Bills, CDs and Money Market        Min ____        Max ____

      • 2 to 5 year U.S. Treasury notes          Min ____        Max ____

      • 2 to 5 year corporate bonds              Min ____        Max ____

      • 2 to 5 year Municipal Bonds        Min ____        Max ____

      • 5+ year Treasury notes            Min ____     Max ____

      • 5+ year corporate bonds             Min ____        Max ____

      • 5+ year Municipal Bonds            Min ____        Max ____

      • Non-US Bonds                Min ____    Max ____

      • Domestic Large cap Equities         Min ____        Max ____

      • Domestic Mid Cap Equities               Min ____        Max ____    

      • Domestic Small Cap Equities        Min ____        Max ____

      • Foreign Equities (EFTs)              Min ____     Max ____

      • Real Estate (REITs)                Min ____    Max ____

      • Hedge funds                         Min ____    Max ____

      • Private Equities                Min ____    Max ____

      • Direct investments                    Min ____     Max ____

    • What is the percentage of this portfolio you are comfortable investing for 5 or more years?

    • Please rank the statements below from 1(this states my greatest worry) to 4 (this is my least worry).

      • I don’t reach my expected target return for the portfolio.     1   2   3   4

      • My buying power is eroded by inflation           1   2   3   4

      • The value of my portfolio drops substantially in value    1   2   3   4

In the short term, but comes back in the long term     

      • The value of my portfolio does not drop substantially     1   2   3   4

In the short term, but is worth less in 5 to 10 years

    • Except for the Great Depression, the longest time investors have had to wait after a market crash or significant decline More than 20% of the value of the portfolio) for their portfolio to return to the pre- decline value, if they remained invested in the market, is 4 years for stock and 2 years for bonds. Knowing this, and knowing that it is impossible to protect yourself from all declines in value due to inflation, are you prepared to live through a decline and a recovery period of:

      • Less than one year                    Yes ____     No ____

      • One to two years                 Yes ____     No ____

      • Two to three years                    Yes ____     No ____

      • Three to four years                    Yes ____     No ____

      • Four or more years                   Yes ____     No ____

 

Note: if you select the first or second option above, you will need to substantially reduce your goals

    • Please check the statement that reflects your preference

      • I would rather be out of the stock market when it is going down, than to be in the stock market when it is going up. ____

      • I would rather be in the stock market when it is going down rather than being out of the market when it is going up.    ____

    • Assuming inflation is 3.5%, please check which portfolio most nearly reflects your ideal portfolio

 

Overall risk

Expected return (inflation at 3.5%)

Lowest annual return

Highest average return

Worst case decline

Your preference (pick one)

Low/low

6.5%

-2.0%

13%

-4.0%

 

Mod/Low

7.5%

-3.0%

16%

-9.0%

 

Mod/Low

7.7%

-4.0%

19%

-10.0%

 

Mod/Low

8.0%

-4.5%

20%

-11.0%

 

Mod/Mod

8.3%

-5.0%

21%

-13.0%

 

High/Mod

8.5%

-6.0%

22%

-14.0%

 

High/Mod

9.0%

-7.0%

24%

-20.0%

 

High/Mod

9.5%

-8.0%

25%

-24%

 

    • Assume this is a test, please check either (a) or (b) below.

      • Which of these do you choose:

        • You win $80,000              a ___ b ___

        • You have an 80% chance

   of winning $100,000       a ___ b ___

  (or 20% of winning nothing)

      • Which of these do you choose:

        • You lose $80,000              a ___ b ___

        • You have an 80% chance          a ___   b ___

Of losing $10,000 (or a 20%

Of losing nothing)

    • Historical Returns:                 Compounded Standard Deviation

                            Return (%)

      • U. S. Treasury Bills               3.7% 3.3%

      • Intermediate Gov’t bonds        5.1%  5.7%

      • Common Stocks             10.2%    20.3%     

      • Small Company Stocks       12.2%     34.6%    

      • Inflation                 3.1%                4.6%

5.Questionnaire for Artists

 

 

ESTATE PLANNING QUESTIONS FOR THE COLLECTOR

    • INVENTORY/VALUATION OF YOUR ARTWORK

 

Do you have a current written inventory of all the work you own? yes_____no_____

 

Do you have a current written inventory of all work you have sold, gifted or bartered? yes_____no_____

 

 

Do you have a current written inventory of all original works in your collection by artist? yes_____no_____

 

Because artists often work in many different media, it is often difficult to determine who created what artworks in the collection.  Therefore, artists and collectors should maintain current written inventories of the works they have created as well as the works in their collections. Inventories should include:

        1. List of works created by client and/or in possession of client, authors (including joint authors and collaborations and contact information), date of creation

        2. Contracts associated with any works such as licenses, assignments, etc.  

        3. Where are the works located? Galleries, purchasers names and contact information

        4. There are both software programs and old-fashioned card catalogs systems for tracking inventory.

 

 

II.     SIGNIFICANT BUSINESS RELATIONSHIPS

 

Does a curator, dealer, agent or manager represent you for purchases or sales?

yes ________ no __________

If yes, who and what is your agreement with this individual?

Have you defined this relationship in a written contract? Do you have a copy of this contract?

 

Do you currently have a relationship with a gallery/dealer/publisher/record company/record publisher/film company/film producer, etc. who shows/distributes/produces/publishes or sells your artwork? yes_____no_____   

 

If yes, what works have you licensed/consigned/assigned/sold, and to whom and under what conditions?  Do you have those agreements in writing?

 

 

 

Do you keep a list of the works that are on loan or on consignment? yes_____no_____   

If yes, could an executor easily locate it? yes_____no_____   

 

 

Are there other gallery/dealer/publisher/record company/record publisher/film company/film producer who have shown/distributed/produced/published or sold you your artwork in the past? yes_____no_____   

 

If yes, to whom and what work?  What has subsequently happened to that artwork?

 

 

Have you ever had any of your artwork appraised by a professional?

yes_____no_____  By whom?  Do you still have copies of any such appraisals?

 

 

Has any of your work ever been sold at auction? yes_____no_____   

What auction house did you use and who purchased the work?  

Was it a charitable auction?

 

 

Do you have in your possession contracts such as location releases, image releases, synchronization licenses, image licenses, collaboration agreements, gallery consignment contracts, etc?  

For which project(s) and with whom?

 

 

II. COPYRIGHT ISSUES

 

Do you control the copyrights of works in your collection (whether produced by you or by other artists)? yes_____no_____  If no, who has control of such copyrights?

 

Do you control the copyright for works (produced by you) that are now owned/controlled by third parties? yes_____no_____ If no, who has control of such copyrights?

 

Do you have a current listing of the copyrights that you have registered? yes_____no_____

 

Did you create any projects or works with a collaborator?  Do you have an agreement governing the collaboration?

 

Copyright lasts for the life of the author plus an additional 70 years.  In the case of anonymous works (or works made for hire), the copyright lasts for 95 years from publication or 120 years from the date of first creation.

 

If the client is a joint author or collaborator in a joint work, the client will need to determine how the work will be managed and how the copyright in the work will be administered in the event one or both authors have died.  

 

Each author controls 100% of the work, but need all signatories for an exclusive license.  Was there a collaboration agreement defining how the work would be treated should either author die or become incapacitated?

 

 

 

 

 

 

 

 

 

 

III.     DISPOSITION OF YOUR ARTWORK

 

A. Executor

 

Have you appointed an executor to manage your estate? yes_____no_____

 

 

Would your executor readily know how to maintain and ultimately dispose of any artwork in your estate that is not specifically left to any person or organization in your Will? yes_____no_____

 

Cultural Executor:  In some circumstances a cultural executor such as a gallery or expert in the field may be better equipped to manage the disposition of artwork than family members.  Additional funds should be allocated for administrative costs.  

 

Insurance policies or funds from the estate can help alleviate the burden of these additional costs.  

 

 

Do you keep your purchase & sale inventory records (including the names of galleries/dealers/auction houses or other persons who might be interested in buying/selling your work and any prior appraisals) in a place where your agents or executor could readily find them in the event something happens to you? yes_____no_____

 

 

 

    B. Disposition & Copyright Controls

 

Have you specifically addressed the disposition of any copyrights you own in your Will?  yes_____no______  

 

Could your executor find records of the copyrights you own? yes______no______

 

Are you giving more than one person the copyright interest in individual works?  yes_____no______  

 

 

Have you addressed how unfinished works are to be treated? Can a third party finish your work?  

 

 

Do you have specific instructions or restrictions on how your works may be used or licensed: e.g., cannot be sold, commissioned books in the same series, music performed at certain venues, etc?

 

Copyright transfers by law must be in writing signed by the copyright owner.  In addition to a signed writing, the transfer may need to be recorded with the US Copyright Office.  To determine whether your client’s transfer should be recorded, review the Copyright Circular 12.

 

 

    C. Storage & Maintenance

 

Have you made arrangements for the maintenance and storage of your work pending its distribution? yes_____no_____

 

 

Have you made arrangements for the maintenance, storage and distribution of your art-making equipment and supplies? yes_____no_____

 

 

Have you estimated the total cost of your planned disposition of your art, equipment and supplies at your death (storage, distribution, conservation)? yes_____no_____

 

 

 

Do you have an insurance policy or other specially designated funds in your Will to pay for any such artwork-related estate administration costs? yes_____no_____

 

 

Visual art will need to be stored properly, as will photographs, film and digital files.  Additionally, equipment will also need to be properly stored and maintained if not sold off.  

 

Designated funds and/or an insurance policy can be helpful in alleviating these costs.

 

    D. Gifts & Bequests

 

Have you made specific bequests of your artwork to certain individuals in your Will? yes_____no_____ If yes, to whom?

 

If you are not leaving your artwork to family and/or friends, have you considered other means of ultimately distributing your artwork on your death, such as through a charitable organization?  

yes_____no_____

 

If yes, to which charitable organizations do you plan to donate any work?

 

In respect to charitable donations, collectors and estates can deduct the full market value of the art work.  Living artists may only deduct the cost of the materials.

IRS has separate art panel to verify valuations:

          1. http://www.irs.gov/individuals/article/0,,id=96804,00.html

 

Depending upon the number of pieces and overall value of the donation, there are different appraisal requirements:  

          1. http://www.irs.gov/publications/p561/ar02.html#d0e617

 

The recipient must accept the donation.  

 

Have you notified and received approval from the donee organization regarding your planned bequest(s)? yes_____no______

 

 

V. TRUSTS & FOUNDATIONS

 

Have you considered a trust to manage your collection?  yes _______  no ________

 

Trusts and charitable foundations are helpful vehicles in which to manage art

Because the trust or foundation can retain the copyright in its entirety, manage licensing and administer royalty payment to number beneficiaries.  For an example, see

www.warholfoundation.org

6.Questionnaire for Collectors

 

 

ESTATE PLANNING QUESTIONS FOR THE COLLECTOR

    • INVENTORY/VALUATION OF YOUR ARTWORK

 

Do you have a current written inventory of all the work you own? yes_____no_____

 

Do you have a current written inventory of all work you have sold, gifted or bartered? yes_____no_____

 

 

Do you have a current written inventory of all original works in your collection by name of the artist? yes_____no_____

 

Because artists often work in many different media, it is often difficult to determine who created what artworks in the collection.  Therefore, artists and collectors should maintain current written inventories of the works they have created as well as the works in their collections. Inventories should include:

        1. List of works created by artist and/or in you possession, authors (including joint authors and collaborations and contact information), date of creation

        2. Contracts associated with any works such as licenses, assignments, etc.  

        3. Where are the works located? Galleries, purchasers names and contact information

        4. There are both software programs and old-fashioned card catalogs systems for tracking inventory.

 

 

II.     SIGNIFICANT BUSINESS RELATIONSHIPS

 

Does a curator, dealer, agent or manager represent you for purchases or sales?

yes ________ no __________

If yes, who and what is your agreement with this individual?

Have you defined this relationship in a written contract? Do you have a copy of this contract?

 

Do you currently have a relationship with a gallery/dealer/publisher/record company/record publisher/film company/film producer, etc. who shows/distributes/produces/publishes or sells your artwork? yes_____no_____   

 

If yes, what works have you licensed/consigned/assigned/sold, and to whom and under what conditions?  Do you have those agreements in writing?

 

 

 

Do you keep a list of the works that are on loan or on consignment? yes_____no_____   

If yes, could an executor easily locate it? yes_____no_____   

 

 

Are there other gallery/dealer/publisher/record company/record publisher/film company/film producer who have shown/distributed/produced/published or sold you your artwork in the past? yes_____no_____   

 

If yes, to whom and what work?  What has subsequently happened to that artwork?

 

 

Have you ever had any of your artwork appraised by a professional?

yes_____no_____  By whom?  Do you still have copies of any such appraisals?

 

 

Has any of the artwork you owned ever been sold at auction? yes_____no_____   

What auction house did you use and who purchased the work?  

Was it a charitable auction?

 

 

Do you have in your possession contracts such as loan agreements, location releases, image releases, synchronization licenses, image licenses, collaboration agreements, gallery consignment contracts, etc?  

For which object(s) and with whom?

 

 

II. COPYRIGHT ISSUES

 

Do you control the copyrights of works in your collection?

yes_____no_____  If no, who has control of such copyrights?

 

Do you control the copyright for works that are now owned by third parties?

yes_____no_____  If yes, who has ownership of those object(s)?

 

Do you have a current listing of the copyrights that you have registered? yes_____no_____

 

Did you commission any art projects or works as a collaborator with the artist?  Do you have an agreement governing the collaboration?

 

Copyright(which includes the right to reproduce a replica or image of artwork) lasts for the life of the author plus an additional 70 years.  In the case of anonymous works (or works made for hire), the copyright lasts for 95 years from publication or 120 years from the date of first creation.

 

If the collector is a joint author (on such as a catalogue of their collection) or collaborator in a joint work (such as a custom piece of furniture or a commission painting), the collector will need to determine how the work will be managed and how the copyright in the work will be administered in the event one or both “creators” have died.  

 

Each “creator” controls 100% of the work, but need all signatories for an exclusive license.  Was there a collaboration agreement defining how the work would be treated should either author die or become incapacitated?

 

 

 

 

 

 

 

 

 

 

III.     DISPOSITION OF YOUR ARTWORK

 

A. Executor

 

Have you appointed an executor to manage your estate? yes_____no_____

 

 

Would your executor readily know how to maintain and ultimately dispose of any artwork in your estate that is not specifically left to any person or organization in your Will? yes_____no_____

 

Cultural Executor:  In some circumstances a cultural executor such as a gallery or expert in the field may be better equipped to manage the disposition of artwork than family members.  Additional funds should be allocated for administrative costs.  

 

Insurance policies or funds from the estate can help alleviate the burden of these additional costs.  

 

Insurance should be held in a specified Irrevocable Life Insurance Trust intended to provide liquidity to a collection, and should be drafted specifically to allow investments in, and loans collateralized by, artwork and collectables.

 

Do you keep your purchase & sale inventory records (including the names of galleries/dealers/auction houses or other persons who might be interested in buying/selling your work and any prior appraisals) in a place where your agents or executor could readily find them in the event something happens to you? yes_____no_____

 

Provenance has become critically important in the art world in the last decade, especially art coming out of Europe before and after WWII, and art coming out of countries in economic and political turmoil such as Russia in the 1990’s. All ephemera associated with the artwork, such as auction catalogues, notes etc., should be retained and catalogued for future reference.

 

    B. Disposition & Copyright Controls

 

Have you specifically addressed the disposition of any copyrights you own in your Will?  yes_____no______  

 

Unless the collector is also an artist, it is unlikely that they will have copyrights over artwork made by others, but where there was collaboration with the collector, such rights may exist.  Be aware that copyrights can be created of an image of an object (such as a piece of furniture), which might otherwise be in the public domain.  Also, consider that in drafting a specific gift to charity of an object, that gift does not carry the copyrights to the object unless specifically mentioned in the specific gift, but a gift to a non-charitable beneficiary of the same object will carry such rights.

 

Could your executor find records of the copyrights you own? yes______no______

 

Are you giving more than one person the copyright interest in individual works?  yes_____no______  

 

 

Have you addressed how unfinished works are to be treated? Can a third party finish your work?  

 

 

Do you have specific instructions or restrictions on how your works may be used or licensed: e.g., cannot be sold, commissioned books in the same series, music performed at certain venues, etc?

 

Copyright transfers by law must be in writing signed by the copyright owner.  In addition to a signed writing, the transfer may need to be recorded with the US Copyright Office.  To determine whether your client’s transfer should be recorded, review the Copyright Circular 12.

 

 

    C. Storage & Maintenance

 

Have you made arrangements for the maintenance and storage of your work pending its distribution? yes_____no_____

 

 

Have you made arrangements for the maintenance, storage and distribution of your art-making equipment and supplies? yes_____no_____

 

 

Have you estimated the total cost of your planned disposition of your art, equipment and supplies at your death (storage, distribution, conservation)? yes_____no_____

 

 

 

Do you have an insurance policy or other specially designated funds in your Will to pay for any such artwork-related estate administration costs? yes_____no_____

 

 

Visual art will need to be stored properly, as will photographs, film and digital files.  Additionally, equipment will also need to be properly stored and maintained if not sold off.  

 

Designated funds and/or an insurance policy can be helpful in alleviating these costs.

 

    D. Gifts & Bequests

 

Have you made specific bequests of your artwork to certain individuals in your Will? yes_____no_____ If yes, to whom?

 

Note issues re Copyrights above.

 

If you are not leaving your artwork to family and/or friends, have you considered other means of ultimately distributing your artwork on your death, such as through a charitable organization?  

yes_____no_____

 

If yes, to which charitable organizations do you plan to donate any work?

 

In respect to charitable donations, collectors and estates can deduct the full market value of the art work.  Living artists may only deduct the cost of the materials.

IRS has separate art panel to verify valuations:

          1. http://www.irs.gov/individuals/article/0,,id=96804,00.html

 

Depending upon the number of pieces and overall value of the donation, there are different appraisal requirements:  

          1. http://www.irs.gov/publications/p561/ar02.html#d0e617

 

The recipient must accept the donation.  

 

Have you notified and received approval from the donee organization regarding your planned bequest(s)? yes_____no______

 

 

V. TRUSTS & FOUNDATIONS

 

Have you considered a trust to manage your collection?  yes _______  no ________

 

Trusts and charitable foundations are helpful vehicles in which to manage art

Because the trust or foundation can retain the copyright in its entirety, manage licensing and administer royalty payment to number beneficiaries.  

 

In addition to a management trust or foundation, you should also consider the use of split interest trusts such as CRT, CLT, GRIT, GRAT, and so forth for transferring collections between generations.

E.Appendix F: M.G.L. - Ch. 203C - Prudent Investor Act - Table of Contents

See document(s): gl-203c-toc.htm

Link to the Massachusetts version of the Uniform Prudent Investor Act.

Comments are from the UPIA as published in 1994. Note that the reverence to sections in the comments are one section lower than the MPIA, as the first section was added by the Legislature.

For the entire UPIA see Uniform Prudent Investor Act.

1.Chapter 203C: Section 2. Trustees managing trust assets; duty to comply with prudent investor rule

Section 2. (a) Except as provided in subsection (b), a trustee who invests and manages trust assets shall owe a duty to the beneficiaries of a trust to comply with the prudent investor rule set forth in this chapter.

(b) The prudent investor rule may be expanded, restricted, eliminated or otherwise altered by the provisions of a trust. A trustee shall not be liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust.

2.Chapter 203C: Section 3. Investment and management decisions

Chapter 203C: Section 3. Investment and management decisions

Section 3.

    (a) A trustee shall invest and manage trust assets as a prudent investor would, considering the purposes, terms, and other circumstances of the trust, including those set forth in subsection (c). In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.

    (b) A trustee’s investment and management decisions respecting individual assets shall be considered in the context of the trust portfolio as a part of an overall investment strategy reasonably suited to the trust.

    (c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:

         (1) general economic conditions;

         (2) the possible effect of inflation or deflation;

         (3) the expected tax consequences of investment decisions or strategies;

         (4) the role that each investment or course of action plays within the overall trust portfolio;

         (5) the expected total return from income and the appreciation of capital;

         (6) other resources of the beneficiaries;

         (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and

         (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one of the beneficiaries.

    (d) A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.

    (e) A trustee may invest in any kind of property or type of investment consistent with the standards of this chapter.

    (f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee’s representation that the trustee has such special skills or expertise, shall have a duty to use such special skills or expertise.

a)Comments

Section 2 is the heart of the Act. Subsections (a), (b), and (c) are patterned loosely on the language of the Restatement of Trusts 3d: Prudent Investor Rule § 227 (1992), and on the 1991 Illinois statute, 760 § ILCS 5/5a (1992). Subsection (f) is derived from Uniform Probate Code § 7- 302 (1969).

 

Objective standard.Subsection (a) of this Act carries forward the relational and objective standard made familiar in the Amorycase, in earlier prudent investor legislation, and in the Restatements. Early formulations of the prudent person rule were sometimes troubled by the effort to distinguish between the standard of a prudent person investing for another and investing on his or her own account. The language of subsection (a), by relating the trustee's duty to "the purposes, terms, distribution requirements, and other circumstances of the trust," should put such questions to rest. The standard is the standard of the prudent investor similarly situated.

 

Portfolio standard.Subsection (b) emphasizes the consolidated portfolio standard for evaluating investment decisions. An investment that might be imprudent standing alone can become prudent if undertaken in sensible relation to other trust assets, or to other nontrust assets. In the trust setting the term "portfolio" embraces the entire trust estate.

 

Risk and return. Subsection (b) also sounds the main theme of modern investment practice, sensitivity to the risk/return curve. See generally the works cited in the Prefatory Note to this Act, under "Literature." Returns correlate strongly with risk, but tolerance for risk varies greatly with the financial and other circumstances of the investor, or in the case of a trust, with the purposes of the trust and the relevant circumstances of the beneficiaries. A trust whose main purpose is to support an elderly widow of modest means will have a lower risk tolerance than a trust to accumulate for a young scion of great wealth.

 

Subsection (b) of this Act follows Restatement of Trusts 3d: Prudent Investor Rule § 227(a), which provides that the standard of prudent investing "requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust."

 

Factors affecting investment.Subsection (c) points to certain of the factors that commonly bear on risk/return preferences in fiduciary investing. This listing is nonexclusive. Tax considerations, such as preserving the stepped up basis on death under Internal Revenue Code § 1014 for low-basis assets, have traditionally been exceptionally important in estate planning for affluent persons. Under the present recognition rules of the federal income tax, taxable investors, including trust beneficiaries, are in general best served by an investment strategy that minimizes the taxation incident to portfolio turnover. See generally Robert H. Jeffrey & Robert D. Arnott, Is Your Alpha Big Enough to Cover Its Taxes?, Journal of Portfolio Management 15 (Spring 1993).

 

Another familiar example of how tax considerations bear upon trust investing: In a regime of pass-through taxation, it may be prudent for the trust to buy lower yielding tax-exempt securities for high-bracket taxpayers, whereas it would ordinarily be imprudent for the trustees of a charitable trust, whose income is tax exempt, to accept the lowered yields associated with tax-exempt securities.

 

When tax considerations affect beneficiaries differently, the trustee's duty of impartiality requires attention to the competing interests of each of them.

 

Subsection (c)(8), allowing the trustee to take into account any preferences of the beneficiaries respecting heirlooms or other prized assets, derives from the Illinois act, 760 ILCS § 5/5(a)(4) (1992).

 

Duty to monitor.Subsections (a) through (d) apply both to investing and managing trust assets. "Managing" embraces monitoring, that is, the trustee's continuing responsibility for oversight of the suitability of investments already made as well as the trustee's decisions respecting new investments.

 

Duty to investigate. Subsection (d) carries forward the traditional responsibility of the fiduciary investor to examine information likely to bear importantly on the value or the security of an investment - for example, audit reports or records of title. E.g., Estate of Collins, 72 Cal. App. 3d 663, 139 Cal. Rptr. 644 (1977) (trustees lent on a junior mortgage on unimproved real estate, failed to have land appraised, and accepted an unaudited financial statement; held liable for losses).

 

Abrogating categoric restrictions. Subsection 2(e) clarifies that no particular kind of property or type of investment is inherently imprudent. Traditional trust law was encumbered with a variety of categoric exclusions, such as prohibitions on junior mortgages or new ventures. In some states legislation created so-called "legal lists" of approved trust investments. The universe of investment products changes incessantly. Investments that were at one time thought too risky, such as equities, or more recently, futures, are now used in fiduciary portfolios. By contrast, the investment that was at one time thought ideal for trusts, the long-term bond, has been discovered to import a level of risk and volatility - in this case, inflation risk - that had not been anticipated. Accordingly, section 2(e) of this Act follows Restatement of Trusts 3d: Prudent Investor Rule in abrogating categoric restrictions. The Restatement says: "Specific investments or techniques are not per se prudent or imprudent. The riskiness of a specific property, and thus the propriety of its inclusion in the trust estate, is not judged in the abstract but in terms of its anticipated effect on the particular trust's portfolio." Restatement of Trusts 3d: Prudent Investor Rule § 227, Comment f, at 24 (1992). The premise of subsection 2(e) is that trust beneficiaries are better protected by the Act's emphasis on close attention to risk/return objectives as prescribed in subsection 2(b) than in attempts to identify categories of investment that are per se prudent or imprudent.

 

The Act impliedly disavows the emphasis in older law on avoiding "speculative" or "risky" investments. Low levels of risk may be appropriate in some trust settings but inappropriate in others. It is the trustee's task to invest at a risk level that is suitable to the purposes of the trust.

 

The abolition of categoric restrictions against types of investment in no way alters the trustee's conventional duty of loyalty, which is reiterated for the purposes of this Act in Section 5. For example, were the trustee to invest in a second mortgage on a piece of real property owned by the trustee, the investment would be wrongful on account of the trustee's breach of the duty to abstain from self-dealing, even though the investment would no longer automatically offend the former categoric restriction against fiduciary investments in junior mortgages.

 

Professional fiduciaries.The distinction taken in subsection (f) between amateur and professional trustees is familiar law. The prudent investor standard applies to a range of fiduciaries, from the most sophisticated professional investment management firms and corporate fiduciaries, to family members of minimal experience. Because the standard of prudence is relational, it follows that the standard for professional trustees is the standard of prudent professionals; for amateurs, it is the standard of prudent amateurs. Restatement of Trusts 2d § 174 (1959) provides: "The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill." Case law strongly supports the concept of the higher standard of care for the trustee representing itself to be expert or professional. See Annot., Standard of Care Required of Trustee Representing Itself to Have Expert Knowledge or Skill, 91 A.L.R. 3d 904 (1979) & 1992 Supp. at 48-49.

 

The Drafting Committee declined the suggestion that the Act should create an exception to the prudent investor rule (or to the diversification requirement of Section 3) in the case of smaller trusts. The Committee believes that subsections (b) and (c) of the Act emphasize factors that are sensitive to the traits of small trusts; and that subsection (f) adjusts helpfully for the distinction between professional and amateur trusteeship. Furthermore, it is always open to the settlor of a trust under Section 1(b) of the Act to reduce the trustee's standard of care if the settlor deems such a step appropriate. The official comments to the 1992 Restatement observe that pooled investments, such as mutual funds and bank common trust funds, are especially suitable for small trusts. Restatement of Trusts 3d: Prudent Investor Rule § 227, Comments h, m, at 28, 51; reporter's note to Comment g, id. at 83.

 

Matters of proof. Although virtually all express trusts are created by written instrument, oral trusts are known, and accordingly, this Act presupposes no formal requirement that trust terms be in writing. When there is a written trust instrument, modern authority strongly favors allowing evidence extrinsic to the instrument to be consulted for the purpose of ascertaining the settlor's intent. See Uniform Probate Code § 2-601 (1990), Comment; Restatement (Third) of Property: Donative Transfers (Preliminary Draft No. 2, ch. 11, Sept. 11, 1992).

 

3.Chapter 203C: Section 4. Diversification

Section 4. A trustee shall reasonably diversify the investments of the trust unless, under the circumstances, it is prudent not to do so.

a)Comment

The language of this section derives from Restatement of Trusts 2d § 228 (1959). ERISA insists upon a comparable rule for pension trusts. ERISA § 404(a)(1)(C), 29 U.S.C. § 1104(a)(1)(C). Case law overwhelmingly supports the duty to diversify. See Annot., Duty of Trustee to Diversify Investments, and Liability for Failure to Do So, 24 A.L.R. 3d 730 (1969) & 1992 Supp. at 78-79.

 

The 1992 Restatement of Trusts takes the significant step of integrating the diversification requirement into the concept of prudent investing. Section 227(b) of the 1992 Restatement treats diversification as one of the fundamental elements of prudent investing, replacing the separate section 228 of the Restatement of Trusts 2d. The message of the 1992 Restatement, carried forward in Section 3 of this Act, is that prudent investing ordinarily requires diversification.

 

Circumstances can, however, overcome the duty to diversify. For example, if a tax- sensitive trust owns an underdiversified block of low-basis securities, the tax costs of recognizing the gain may outweigh the advantages of diversifying the holding. The wish to retain a family business is another situation in which the purposes of the trust sometimes override the conventional duty to diversify.

 

Rationale for diversification."Diversification reduces risk . . . [because] stock price movements are not uniform. They are imperfectly correlated. This means that if one holds a well diversified portfolio, the gains in one investment will cancel out the losses in another." Jonathan R. Macey, An Introduction to Modern Financial Theory 20 (American College of Trust and Estate Counsel Foundation, 1991). For example, during the Arab oil embargo of 1973, international oil stocks suffered declines, but the shares of domestic oil producers and coal companies benefitted. Holding a broad enough portfolio allowed the investor to set off, to some extent, the losses associated with the embargo.

 

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. The investor requires a higher expected return to induce the investor to bear the greater risk of disappointment associated with the start-up firm. This is compensated risk - the firm pays the investor for bearing the risk. By contrast, nobody pays the investor for owning too few stocks. The investor who owned only international oils in 1973 was running a risk that could have been reduced by having configured the portfolio differently - to include investments in different industries. This is uncompensated risk - nobody pays the investor for owning shares in too few industries and too few companies. Risk that can be eliminated by adding different stocks (or bonds) is uncompensated risk. The object of diversification is to minimize this uncompensated risk of having too few investments. "As long as stock prices do not move exactly together, the risk of a diversified portfolio will be less than the average risk of the separate holdings." R.A. Brealey, An Introduction to Risk and Return from Common Stocks 103 (2d ed. 1983).

 

There is no automatic rule for identifying how much diversification is enough. The 1992 Restatement says: "Significant diversification advantages can be achieved with a small number of well-selected securities representing different industries . . . . Broader diversification is usually to be preferred in trust investing," and pooled investment vehicles "make thorough diversification practical for most trustees." Restatement of Trusts 3d: Prudent Investor Rule § 227, General Note on Comments e- h, at 77 (1992). See also Macey, supra, at 23-24; Brealey, supra, at 111-13.

 

Diversifying by pooling.It is difficult for a small trust fund to diversify thoroughly by constructing its own portfolio of individually selected investments. Transaction costs such as the round-lot (100 share) trading economies make it relatively expensive for a small investor to assemble a broad enough portfolio to minimize uncompensated risk. For this reason, pooled investment vehicles have become the main mechanism for facilitating diversification for the investment needs of smaller trusts.

 

Most states have legislation authorizing common trust funds; see 3 Austin W. Scott & William F. Fratcher, The Law of Trusts § 227.9, at 463-65 n.26 (4th ed. 1988) (collecting citations to state statutes). As of 1992, 35 states and the District of Columbia had enacted the Uniform Common Trust Fund Act (UCTFA) (1938), overcoming the rule against commingling trust assets and expressly enabling banks and trust companies to establish common trust funds. 7 Uniform Laws Ann. 1992 Supp. at 130 (schedule of adopting states). The Prefatory Note to the UCTFA explains: "The purposes of such a common or joint investment fund are to diversify the investment of the several trusts and thus spread the risk of loss, and to make it easy to invest any amount of trust funds quickly and with a small amount of trouble." 7 Uniform Laws Ann. 402 (1985).

 

Fiduciary investing in mutual funds.Trusts can also achieve diversification by investing in mutual funds. See Restatement of Trusts 3d: Prudent Investor Rule, § 227, Comment m, at 99-100 (1992) (endorsing trust investment in mutual funds). ERISA § 401(b)(1), 29 U.S.C. § 1101(b)(1), expressly authorizes pension trusts to invest in mutual funds, identified as securities "issued by an investment company registered under the Investment Company Act of 1940 . . . ."

 

4.Chapter 203C: Section 5. Review of assets

Section 5. 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, and the other circumstances of the trust, and with the requirements of this chapter.

a)Comment

Section 4, requiring the trustee to dispose of unsuitable assets within a reasonable time, is old law, codified in Restatement of Trusts 3d: Prudent Investor Rule § 229 (1992), lightly revising Restatement of Trusts 2d § 230 (1959). The duty extends as well to investments that were proper when purchased but subsequently become improper. Restatement of Trusts 2d § 231 (1959). The same standards apply to successor trustees, see Restatement of Trusts 2d § 196 (1959).

 

The question of what period of time is reasonable turns on the totality of factors affecting the asset and the trust. The 1959 Restatement took the view that "[o]rdinarily any time within a year is reasonable, but under some circumstances a year may be too long a time and under other circumstances a trustee is not liable although he fails to effect the conversion for more than a year." Restatement of Trusts 2d § 230, comment b(1959). The 1992 Restatement retreated from this rule of thumb, saying, "No positive rule can be stated with respect to what constitutes a reasonable time for the sale or exchange of securities." Restatement of Trusts 3d: Prudent Investor Rule § 229, comment b(1992).

 

The criteria and circumstances identified in Section 2 of this Act as bearing upon the prudence of decisions to invest and manage trust assets also pertain to the prudence of decisions to retain or dispose of inception assets under this section.

 

5.Chapter 203C: Section 6. Beneficiaries’ interests

Section 6. A trustee shall invest and manage the trust assets solely in the interest of the beneficiaries

a)Comment

duty of loyalty is perhaps the most characteristic rule of trust law, requiring the trustee to act exclusively for the beneficiaries, as opposed to acting for the trustee's own interest or that of third parties. The language of Section 4 of this Act derives from Restatement of Trusts 3d: Prudent Investor Rule § 170 (1992), which makes minute changes in Restatement of Trusts 2d § 170 (1959).

 

The concept that the duty of prudence in trust administration, especially in investing and managing trust assets, entails adherence to the duty of loyalty is familiar. ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a)(1)(B), extracted in the Comment to Section 1 of this Act, effectively merges the requirements of prudence and loyalty. A fiduciary cannot be prudent in the conduct of investment functions if the fiduciary is sacrificing the interests of the beneficiaries.

 

The duty of loyalty is not limited to settings entailing self-dealing or conflict of interest in which the trustee would benefit personally from the trust. "The trustee is under a duty to the beneficiary in administering the trust not to be guided by the interest of any third person. Thus, it is improper for the trustee to sell trust property to a third person for the purpose of benefitting the third person rather than the trust." Restatement of Trusts 2d § 170, comment q, at 371 (1959).

 

No form of so-called "social investing" is consistent with the duty of loyalty if the investment activity entails sacrificing the interests of trust beneficiaries - for example, by accepting below-market returns - in favor of the interests of the persons supposedly benefitted by pursuing the particular social cause. See, e.g., John H. Langbein & Richard Posner, Social Investing and the Law of Trusts, 79 Michigan L. Rev. 72, 96-97 (1980) (collecting authority). For pension trust assets, see generally Ian D. Lanoff, The Social Investment of Private Pension Plan Assets: May it Be Done Lawfully under ERISA?, 31 Labor L.J. 387 (1980). Commentators supporting social investing tend to concede the overriding force of the duty of loyalty. They argue instead that particular schemes of social investing may not result in below-market returns. See, e.g., Marcia O'Brien Hylton, "Socially Responsible" Investing: Doing Good Versus Doing Well in an Inefficient Market, 42 American U.L. Rev. 1 (1992). In 1994 the Department of Labor issued an Interpretive Bulletin reviewing its prior analysis of social investing questions and reiterating that pension trust fiduciaries may invest only in conformity with the prudence and loyalty standards of ERISA §§ 403-404. Interpretive Bulletin 94-1, 59 Fed. Regis. 32606 (Jun. 22, 1994), to be codified as 29 CFR § 2509.94-1. The Bulletin reminds fiduciary investors that they are prohibited from "subordinat[ing] the interests of participants and beneficiaries in their retirement income to unrelated objectives."

 

6.Chapter 203C: Section 7. Two or more beneficiaries

Section 7. If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries.

a)Comment

The duty of impartiality derives from the duty of loyalty. When the trustee owes duties to more than one beneficiary, loyalty requires the trustee to respect the interests of all the beneficiaries. Prudence in investing and administration requires the trustee to take account of the interests of all the beneficiaries for whom the trustee is acting, especially the conflicts between the interests of beneficiaries interested in income and those interested in principal.

 

The language of Section 6 derives from Restatement of Trusts 2d § 183 (1959); see also id., § 232. Multiple beneficiaries may be beneficiaries in succession (such as life and remainder interests) or beneficiaries with simultaneous interests (as when the income interest in a trust is being divided among several beneficiaries).

 

The trustee's duty of impartiality commonly affects the conduct of investment and management functions in the sphere of principal and income allocations. This Act prescribes no regime for allocating receipts and expenses. The details of such allocations are commonly handled under specialized legislation, such as the Revised Uniform Principal and Income Act (1962) (which is presently under study by the Uniform Law Commission with a view toward further revision).

7.Chapter 203C: Section 8. Costs incurred

Section 8. In investing and managing trust assets, a trustee shall incur only costs that are appropriate and reasonable in relation to the assets, the purpose of the trust, and the skills of the trustee.

a)Comment

Wasting beneficiaries' money is imprudent. In devising and implementing strategies for the investment and management of trust assets, trustees are obliged to minimize costs.

 

The language of Section 7 derives from Restatement of Trusts 2d § 188 (1959). The Restatement of Trusts 3d says: "Concerns over compensation and other charges are not an obstacle to a reasonable course of action using mutual funds and other pooling arrangements, but they do require special attention by a trustee. . . . [I]t is important for trustees to make careful cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio." Restatement of Trusts 3d: Prudent Investor Rule § 227, comment m, at 58 (1992).

8.Chapter 203C: Section 9. Determination of compliance with prudent investor rule

Section 9. Compliance with the prudent investor rule shall be determined in light of the facts and circumstances existing at the time of a trustee’s decision or action.

a)Comment

This section derives from the 1991 Illinois act, 760 ILCS 5/5(a)(2) (1992), which draws upon Restatement of Trusts 3d: Prudent Investor Rule § 227, comment b, at 11 (1992). Trustees are not insurers. Not every investment or management decision will turn out in the light of hindsight to have been successful. Hindsight is not the relevant standard. In the language of law and economics, the standard is ex ante, not ex post.

 

9.Chapter 203C: Section 10. Delegation of investment and management functions

Section 10.

    (a) A trustee may delegate investment and management functions if it is prudent to do so. A trustee shall exercise reasonable care, skill and caution in:

         (1) selecting an agent;

         (2) establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust; and

         (3) periodically reviewing the agent’s actions in order to monitor the agent’s performance and compliance with the terms of the delegation.

    (b) In performing a delegated function, an agent shall owe a duty to the trust to exercise reasonable care to comply with the terms of the delegation.

    (c) A trustee who complies with the requirements of subsection (a) shall not be liable to the beneficiaries or to the trust for the decisions or actions of the agent to whom the function was delegated.

    (d) By accepting the delegation of trust functions from the trustee of a trust that is subject to the laws of the commonwealth, an agent submits to the jurisdiction of the courts of the commonwealth.

a)Comment

This section of the Act reverses the much- criticized rule that forbad trustees to delegate investment and management functions. The language of this section is derived from Restatement of Trusts 3d: Prudent Investor Rule § 171 (1992), discussed infra, and from the 1991 Illinois act, 760 ILCS § 5/5.1(b), (c) (1992).

 

Former law.The former nondelegation rule survived into the 1959 Restatement: "The trustee is under a duty to the beneficiary not to delegate to others the doing of acts which the trustee can reasonably be required personally to perform." The rule put a premium on the frequently arbitrary task of distinguishing discretionary functions that were thought to be nondelegable from supposedly ministerial functions that the trustee was allowed to delegate. Restatement of Trusts 2d § 171 (1959).

 

The Restatement of Trusts 2d admitted in a comment that "There is not a clear-cut line dividing the acts which a trustee can properly delegate from those which he cannot properly delegate." Instead, the comment directed attention to a list of factors that "may be of importance: (1) the amount of discretion involved; (2) the value and character of the property involved; (3) whether the property is principal or income; (4) the proximity or remoteness of the subject matter of the trust; (5) the character of the act as one involving professional skill or facilities possessed or not possessed by the trustee himself." Restatement of Trusts 2d § 171, comment d(1959). The 1959 Restatement further said: "A trustee cannot properly delegate to another power to select investments." Restatement of Trusts 2d § 171, comment h(1959).

 

For discussion and criticism of the former rule see William L. Cary & Craig B. Bright, The Delegation of Investment Responsibility for Endowment Funds, 74 Columbia L. Rev. 207 (1974); John H. Langbein & Richard A. Posner, Market Funds and Trust-Investment Law, 1976 American Bar Foundation Research J. 1, 18-24.

 

The modern trend to favor delegation.The trend of subsequent legislation, culminating in the Restatement of Trusts 3d: Prudent Investor Rule, has been strongly hostile to the nondelegation rule. See John H. Langbein, Reversing the Nondelegation Rule of Trust-Investment Law, 59 Missouri L. Rev. 105 (1994).

 

The delegation rule of the Uniform Trustee Powers Act.The Uniform Trustee Powers Act (1964) effectively abrogates the nondelegation rule. It authorizes trustees "to employ persons, including attorneys, auditors, investment advisors, or agents, even if they are associated with the trustee, to advise or assist the trustee in the performance of his administrative duties; to act without independent investigation upon their recommendations; and instead of acting personally, to employ one or more agents to perform any act of administration, whether or not discretionary . . . ." Uniform Trustee Powers Act § 3(24), 7B Uniform Laws Ann. 743 (1985). The Act has been enacted in 16 states, see "Record of Passage of Uniform and Model Acts as of September 30, 1993," 1993-94 Reference Book of Uniform Law Commissioners (unpaginated, following page 111) (1993).

 

UMIFA's delegation rule.The Uniform Management of Institutional Funds Act (1972) (UMIFA), authorizes the governing boards of eleemosynary institutions, who are trustee-like fiduciaries, to delegate investment matters either to a committee of the board or to outside investment advisors, investment counsel, managers, banks, or trust companies. UMIFA § 5, 7A Uniform Laws Ann. 705 (1985). UMIFA has been enacted in 38 states, see "Record of Passage of Uniform and Model Acts as of September 30, 1993," 1993-94 Reference Book of Uniform Law Commissioners (unpaginated, following page 111) (1993).

 

ERISA's delegation rule.The Employee Retirement Income Security Act of 1974, the federal statute that prescribes fiduciary standards for investing the assets of pension and employee benefit plans, allows a pension or employee benefit plan to provide that "authority to manage, acquire or dispose of assets of the plan is delegated to one or more investment managers . . . ." ERISA § 403(a)(2), 29 U.S.C. § 1103(a)(2). Commentators have explained the rationale for ERISA's encouragement of delegation:

 

ERISA . . . invites the dissolution of unitary trusteeship. . . . ERISA's fractionation of traditional trusteeship reflects the complexity of the modern pension trust. Because millions, even billions of dollars can be involved, great care is required in investing and safekeeping plan assets. Administering such plans-computing and honoring benefit entitlements across decades of employment and retirement-is also a complex business. . . . Since, however, neither the sponsor nor any other single entity has a comparative advantage in performing all these functions, the tendency has been for pension plans to use a variety of specialized providers. A consulting actuary, a plan administration firm, or an insurance company may oversee the design of a plan and arrange for processing benefit claims. Investment industry professionals manage the portfolio (the largest plans spread their pension investments among dozens of money management firms).

 

John H. Langbein & Bruce A. Wolk, Pension and Employee Benefit Law 496 (1990).

 

The delegation rule of the 1992 Restatement.The Restatement of Trusts 3d: Prudent Investor Rule (1992) repeals the nondelegation rule of Restatement of Trusts 2d § 171 (1959), extracted supra, and replaces it with substitute text that reads:

 

§ 171. Duty with Respect to Delegation. A trustee has a duty personally to perform the responsibilities of trusteeship except as a prudent person might delegate those responsibilities to others. In deciding whether, to whom, and in what manner to delegate fiduciary authority in the administration of a trust, and thereafter in supervising agents, the trustee is under a duty to the beneficiaries to exercise fiduciary discretion and to act as a prudent person would act in similar circumstances.

 

Restatement of Trusts 3d: Prudent Investor Rule § 171 (1992). The 1992 Restatement integrates this delegation standard into the prudent investor rule of section 227, providing that "the trustee must . . . act with prudence in deciding whether and how to delegate to others . . . ." Restatement of Trusts 3d: Prudent Investor Rule § 227(c) (1992).

 

Protecting the beneficiary against unreasonable delegation.There is an intrinsic tension in trust law between granting trustees broad powers that facilitate flexible and efficient trust administration, on the one hand, and protecting trust beneficiaries from the misuse of such powers on the other hand. A broad set of trustees' powers, such as those found in most lawyer-drafted instruments and exemplified in the Uniform Trustees' Powers Act, permits the trustee to act vigorously and expeditiously to maximize the interests of the beneficiaries in a variety of transactions and administrative settings. Trust law relies upon the duties of loyalty and prudent administration, and upon procedural safeguards such as periodic accounting and the availability of judicial oversight, to prevent the misuse of these powers. Delegation, which is a species of trustee power, raises the same tension. If the trustee delegates effectively, the beneficiaries obtain the advantage of the agent's specialized investment skills or whatever other attributes induced the trustee to delegate. But if the trustee delegates to a knave or an incompetent, the delegation can work harm upon the beneficiaries.

 

Section 9 of the Uniform Prudent Investor Act is designed to strike the appropriate balance between the advantages and the hazards of delegation. Section 9 authorizes delegation under the limitations of subsections (a) and (b). Section 9(a) imposes duties of care, skill, and caution on the trustee in selecting the agent, in establishing the terms of the delegation, and in reviewing the agent's compliance.

 

The trustee's duties of care, skill, and caution in framing the terms of the delegation should protect the beneficiary against overbroad delegation. For example, a trustee could not prudently agree to an investment management agreement containing an exculpation clause that leaves the trust without recourse against reckless mismanagement. Leaving one's beneficiaries remediless against willful wrongdoing is inconsistent with the duty to use care and caution in formulating the terms of the delegation. This sense that it is imprudent to expose beneficiaries to broad exculpation clauses underlies both federal and state legislation restricting exculpation clauses, e.g., ERISA §§ 404(a)(1)(D), 410(a), 29 U.S.C. §§ 1104(a)(1)(D), 1110(a); New York Est. Powers Trusts Law § 11-1.7 (McKinney 1967).

 

Although subsection (c) of the Act exonerates the trustee from personal responsibility for the agent's conduct when the delegation satisfies the standards of subsection 9(a), subsection 9(b) makes the agent responsible to the trust. The beneficiaries of the trust can, therefore, rely upon the trustee to enforce the terms of the delegation.

 

Costs.The duty to minimize costs that is articulated in Section 7 of this Act applies to delegation as well as to other aspects of fiduciary investing. In deciding whether to delegate, the trustee must balance the projected benefits against the likely costs. Similarly, in deciding how to delegate, the trustee must take costs into account. The trustee must be alert to protect the beneficiary from "double dipping." If, for example, the trustee's regular compensation schedule presupposes that the trustee will conduct the investment management function, it should ordinarily follow that the trustee will lower its fee when delegating the investment function to an outside manager.

10.Chapter 203C: Section 11. Trust provisions; terms

Section 11.

    The following terms or comparable language in the provisions of a trust, unless otherwise limited or modified, authorize any investment or strategy permitted under this chapter and shall not be interpreted to be a restriction, elimination, or other alteration of the prudent investor rule for purposes of subsection (b) of section 2: “investments permissible by law for investment of trust funds”, “legal investments”, “authorized investments”, “using the judgment and care under the circumstances then prevailing that persons of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of their capital”, “prudent man rule”, “prudent trustee rule”, “prudent person rule”, and “prudent investor rule”.

a)Comment

This provision is taken from the Illinois act, 760 ILCS § 5/5(d) (1992), and is meant to facilitate incorporation of the Act by means of the formulaic language commonly used in trust instruments.

 

F.Appendix G: Investments in Art.

See attachment(s): Investing in Artowrk and Collectables.pdf

Portfolio Diversification to Artwork and Collectibles

 

Tangible assets are not the complete solution to a troubled portfolio, but they do offer a reasonable addition--and give dividends in the pleasure of holding them.

Background: Flows of investment monies are global.

To explain: Saudis receive oil payments in dollars. These Saudis buy dollar-denominated assets only if they believe the value of those US assets will rise. If they see the US returning to an economic slump, they will avoid all assets related to the US. So, upon receipt of payment in dollars, they--along most other foreign investors--will sell those dollars and buy a currency and related assets in an economy they believe to be on the rise. The result here in the USA is annoying: the dollar drops in value, stocks drop in value and, with the need to finance our looming deficit, even bonds may drop in value (albeit a bit less precipitously than stocks.)

Why are tangibles considered an asset diversification?

The reason is three-fold:

    • Tangible assets are not currency specific.Named works of transportable art, antiques and fine objects enjoy a global marketplace: EXAMPLE:  Since it can be sold in an established marketplace in nearly any G8 country, a quality painting by a known artist with an auction track record doesn't fall victim to a declining dollar.

    • Inflationary expectations raise the price of tangibles.The fall in the currency means that imported goods cost more; this is inflationary. What increases with inflation? Hard assets such as metals. So art objects and jewelry made with silver, gold and platinum tend to go up as inflationary fears increase, even in a foundering economy:  EXAMPLE:  If you don't wish to transport your tangibles abroad to sell them, you can sell (trade) your Verdura gold jewelry or Zuni inlay silver here at home for more dollars because their intrinsic materials value will have appreciated.

    • Long term profit potential of tangibles persists.Fine collectible objects retain the potential to increase in value as they become more recognized and valued by a broader audience:  EXAMPLE:  If an artist of modest renown receives a museum retrospective or other major exhibition, the value of the artwork usually enjoys and often sustains a sharp increase in value.

 

When structuring an investment portfolio, received wisdom declares it prudent to diversify. In a diversified portfolio, by definition, the various categories will out-perform or under- perform depending on the market environment. So, a diversified portfolio never truly maximizes on any given market; its structure is designed to perform modestly well in nearly all circumstances. Keeping 10-15% of total holdings in hard, transportable assets seems like a reasonable hedge against the deeping stock market correction or--in a different reality--an overheating inflationary boom. Short of having been positioned entirely in shorter maturity US government fixed-income securities, there was little to be done on the long side to compensate for this recent bursting of the stock market bubble. But at least I am enjoying what I perceive to be a modest appreciation in my 18th century Austrian writing desk and my walls of contemporary paintings as I watch the continued erosion of my increasingly modest equity portfolio.

1.Long-term Investment

# 1 Buy the Best You Can Afford The best work by artists--great and not-so-great--appreciates in value more than mediocre work by the same artist. The same is true for antiques and collectibles, too. Even in a down market, prices hold-up better for the top examples of any type of object. #2 Buy Items with a Paper Trail

A good provenance hikes the value and adds to the resale allure of an object. Two reasons: it testifies that the piece is authentic & it tells a story. People love a story. #3 Buy Signed Objects The signature doesn't show when you exhibit the item? Nobody sees the signature on a Cartierbrooch or on the back of an abstract painting. For resale value, it must be there. #4 Buy Items in Perfect Condition Everybody knows stories about the huge price spreadbetween mint-in-boxtoys versus ones that kids actually used. Sure, you can have a piece restored, but it will never be as desirable as something that was never damaged. #5 Keep Items in Perfect Condition Simple attrition is one of the basic reasons antiques have value. Over time, fewer items survive and those that have survived usually deteriorate. Your investment goes up because you take care of it. #6 Buy Small Scale Objects On a dollars/square inch basis, small items trade higher than big ones. This has to do with display logistics: People prefer Amish crib quilts versus full size ones, because you get the idea, and it takes half the space to show it. #7 Buy Typical Items Sure, you could buy a Jackson Pollock drawing showing a representational depiction of a reclining nude. When friends walk in the door, they say: "nice nude". For resale, buy a Pollock dripped painting. Friends' response: "awesome Pollock!"(Resale market: nice nude=$X0,000; awesome Pollock=$X0,000,000) #8 Do NOTBuy at the Top Tempting it may be, but whatever is terminally fashionable and on everyone's tongue this week is probably not a viable long- term investment. (That's not to say you can't flip it.) If an object, period or artist you own is all over the mass media, it's time to think about unloading. #9 Sensitize Yourself to Major Trends Global political and economic shifts are a great clue in trend spotting: In the early 80's as OPEC's oil-pricing power declined, prices of oriental rugs took a hit. In the late 80's the price of Korean antiques skyrocketed as that Tiger economy grew. In the 90's, the fracturing of the USSR generated good interest in Stalinist memorabilia & other tchotchkassince they marked the Cold War--an era now relegated to the history books. Pick your political or economic scenario and build a portfolio of tangible investments around it.

2.Short Term Investment

    Short-term investing in tangibles--like short-term trading in stocks or commodities--requires knowledge, nerve and intense focus. While not for everyone, trading fine art and antiques offers profit potential for those with an eye for beauty and a nose for value.

Buyers' Tip #1 Specialize

Select an area of interest and immerse yourself in itthrough viewing items, handling them (when possible), turning over tags, talking with dealers, and reading. Go to museums and galleries to learn the attributes of the finest examples of the items in your narrow field. Familiarize yourself with the wholesale and retail markets so that you are able to compute your own bid-asked spread for an item the moment you see it. Fortified with solid preparation, you can competently seek out general sources of goods such as regional auctions, estate sales and even flea markets where bargains are to be found. RULE: Do focused, hands-on homework.

 

 

Buyers' Tip #2 Pull the Trigger

Armed with in-depth knowledge, trust your eyes. With surprising regularity, an item in your area of expertise will appear for sale. An opportunity arises whenever a quality piece is offered for less than your internally computed bid price. When this happens, don't second-guess your judgment. Move decisively.Don't lose the trade quibbling about price. (Make it a practice to carry some cash.) Buy the item and leave--preferably with the piece in your hands. RULE: Trust your instincts and act on them.

Buyers' Tip #3 Buy What Excites You

Acquiring an art object that appeals to you solely for its supposed resale potential is a mistake. A mediocre painting that leaves you cold will probably prompt the same response in others; don't kid yourself that it's "commercial". Use your skills and taste to find and purchase artworks and objects that merit interest. The middle rung dealers, collectors and runners who keep the fine art and antiques markets flowing are clients with discerning eyes. As a short-term investor, these are your outlets. Tempt them. RULE: Acquire interesting, quality items.

Sellers' Tip #4 Take It Home

If want to sell a French Barbizon School painting, take it to Paris. Fine art and antiques fetch the highest prices in the area where they were created. This is true of antiques and indigenous crafts as well. People living with accomplished craftspeople and artisans nearby tend to understand and appreciate those skills. This broadens the buying audience--well beyond a few connoisseurs--to include a large percentage of a regional population. Learn the location of the best market for your specialty and arrange a means of offering it for sale there. If that is not feasible, then cultivate a well-funded dealer or collector in your field. RULE: Sell your item where it is known and valued.

Sellers' Tip #5 Don't Be Greedy

In short-term trading, it's important to differentiate a fair price from full retail price. Visiting an elegant shop on Rodeo Drive, a generous fellow willingly pays top dollar when he treats his favorite lovely to an antique brooch. He happily pays the dealer for the chic ambiance, the fawning attention of the sales staff as well as the object. That same antique brooch, in less perfectly staged surroundings, will fetch a somewhat reduced price. As a short-term trader, you can forget about selling at retail prices. Retail is the province of those who wait. When flipping an item, your buyer will probably be a dealer or a savvy collector rather than a retail customer. Understand that a 20% profit earned repeatedly results in a handsome compounded annual rate. Don't expect to maximize the return on a short-term trade. RULE: Leave room for the next guy--eventually--to-make a buck. If these ground rules seem daunting, then this is not your game. For the tangibles collector with a more languid mental set, a relationship with a skilled short-term trader can be useful and symbiotic providing liquidity for the trader and offering a stream of value-priced acquisition opportunities for the long term investor.

 

 

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