OVERVIEW: THE PRUDENT INVESTOR RULE
The Uniform Prudent Investor Act (UPIA) (1995), adopted in some form by all 50 states, applies to the investment of private trust funds. The Prudent Investor Rule, which forms the core of the UPIA, also applies in other contexts, such as to guardians, conservators, executors of estates, trustees of charitable trusts, fiduciaries acting for ERISA-covered pension and defined contribution plans, and the trustees or governing bodies of certain public funds.
The Prudent Investor Rule, as set forth in the Employee Retirement Income Security Act (ERISA), enacted in 1974. ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a), provides that “a fiduciary shall discharge his duties …. with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims ….”
The UPIA draws upon the revised standards for prudent trust investment promulgated by the American Law Institute in its Restatement (Third) of Trusts: Prudent Investor Rule (1992) (“1992 Restatement”). In so doing, the UPIA made major changes in the law governing trust investments:
(1) The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. In the trust setting the term “portfolio” embraces all the trust’s assets. UPIA § 2(b).
(2) The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration. UPIA § 2(b).
(3) All categoric restrictions on types of investments have been abrogated; the trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investing. UPIA § 2(e).
(4) The long familiar requirement that fiduciaries diversify their investments has been integrated into the definition of prudent investing. UPIA § 3.
(5) The much criticized former rule of trust law forbidding the trustee to delegate investment and management functions has been reversed. Delegation is now permitted, subject to safeguards. UPIA § 9.
APPLYING THE PRUDENT INVESTOR RULE TO ALL CLIENTS’ PORTFOLIOS
I have previously suggested that all clients of financial advisors require that their portfolios be invested under the requirements of the Prudent Investor Rule, a far tougher duty of care than that generally applicable to financial advisors (which requires only a “reasonable basis” for investment decisions). See “Ten (Tough) Questions You Should Be Asking Your Financial Advisor.”
I suspect most clients of investment advisers and broker-dealers believe that their portfolios are to be invested “prudently,” although such clients often lack knowledge of the Prudent Investor Rule and its tough requirements.
THE PRUDENT INVESTOR RULE AND THE DUTY TO INVEST TAX EFFICIENTLY
As set forth in Section 2.c. of the UPIA, the investment manager subject to the Prudent Investor Rule has a duty to consider taxes in both the selection of an investment strategy, as well as its implementation and the ongoing management of the investment portfolio.
(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, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
(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 or more of the beneficiaries.
Comment to Section 2 states, in pertinent part: “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).”
The comment continues with this observation: “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.”
IS THE DUTY TO INVEST TAX-EFFICIENTLY ALSO A GENERAL, NON-WAIVABLE DUTY TO INDIVIDUAL CLIENTS OF INVESTMENT ADVISERS AND BROKER-DEALERS?
In my view, yes. Even in situations where the Prudent Investor Rule is not applicable, the general duty of care possessed by investment advisers and broker-dealers, as recently interpreted by SEC staff, regards “taxes” (i.e., tax drag) as a “cost” which must receive adequate attention during portfolio design and management.
Generally, on April 20, 2023, the U.S. Securities and Exchange Commission (SEC) published a staff bulletin with an expansive view of the duty of care for broker-dealers and investment advisers under Regulation Best Interest (Reg BI) and the investment adviser fiduciary standard, respectively. See SEC, Staff Bulletin: Standards of Conduct for Broker Dealers and Investment Advisers Care Obligation, (April 20, 2023).
For a more detailed explanation of this issue, please refer to my previous post, “Fiduciary Paper #10: Is Proper Tax-Efficient Portfolio Design and Management a Duty, and is it Scalable?“
See also this summary of the SEC Staff Bulletin from the Sidley Austin LLP law firm: “The bulletin states that a financial professional will need an understanding of an investor’s tax status not only when the professional or investor “identifies a goal with tax implications” but also when providing advice “on a particular investment or investment strategy relative to other options” to which tax considerations are relevant. The bulletin’s examples of situations in which tax considerations are relevant show that the staff understand ‘tax status’ to include not just a customer’s tax bracket but also (at least) information about where a customer pays taxes; one example given is ‘whether an out of state 529 plan is in the best interest of a customer who lives in a state that offers tax benefits for investing in the home state’s plan.’ The examples are also broad enough to suggest that wherever a tax-advantaged investment is considered as a reasonably available alternative, the financial professional should have an understanding of the investor’s tax status in order to evaluate the appropriateness of this alternative … The staff may not find it sufficient for a financial professional to provide a disclaimer that the customer should seek tax advice elsewhere and to then make a recommendation of an investment or investment strategy absent application of information about the customer’s tax status.” Sidley, “SEC Publishes Additional Interpretive Guidance on Reg BI and Investment Adviser Standard of Care” (May 23, 2023).
I would further observe that while the duty of care is generally non-waivable by a client or customer, and not subject to disclaimer by an investment adviser or broker-dealer, there are situations in which tax-efficient investing may not be required, or at least not fully required to be implemented.
For example, consider the investments for a client who only possesses traditional 401(k) / traditional IRA investment assets. Tax-efficient investing, as by allocating different investments to different types of accounts, may not be “doable” in the general sense. Although, even then, it is appropriate to determine if additions to such accounts, or instead to taxable or Roth accounts, is warranted. And whether Roth IRA conversions should be undertaken, at appropriate times, or withdrawals undertaken during years when marginal income tax rates are lower for the client.
As another example, I possess one client who came to me after realizing hundreds of thousands of dollars of carryforward capital losses when they were with their former advisor. The need to invest “tax-efficiently” – at least with respect to realization of capital gains in taxable accounts – is substantially diminished. But, by modeling out a longer-term tax strategy for the client, I discerned that should the client survive into her late 80’s, a tax-inefficient equity portfolio would result in consumption of all of the carryforward losses; hence, some tax-efficient investment techniques are employed within the portfolio, at low cost, in order to extend the probability of using carryforward losses through later ages.
IN CONCLUSION
I continue to observe, far too often, investment portfolios that are designed and managed in a tax-inefficient manner.
The time has come for all investment advisers (and investment adviser representatives), as well as brokers (and registered representatives), when providing investment strategy design, and portfolio implementation and management services, to seek to minimize the long-term tax drag upon their clients’ and customers’ investment portfolios. Other considerations may, of course, be taken into account, such as the need for diversification as a means to minimize idiosyncratic risk, as well as the dictates of the client or customer.
Investment strategies that may be appropriate for tax-exempt investors, or for investors with very large tax-deferred investment accounts (and much smaller taxable accounts), may not be appropriate for investors with substantial holdings in taxable accounts. In the implementation of investment strategies, such as in the selection of appropriate mutual funds and ETFs, or choice of separate account managers, the tax-efficiency of the investment vehicle should often be a primary consideration, given the goal of securing for client the desired level of after-tax returns.
There are also many financial planning decisions – such as the funding of tax-advantaged accounts during years of employment, the timing of withdrawals from tax-qualified accounts, and many more – that come into play.
It is time for us, as financial advisors, to “raise the bar” – as has been done by SEC Staff. This begins with more notice (through articles, blog posts, etc.) about the NECESSITY of tax-efficient investing. And for a renewed emphasis on mastery of the tax aspects of investment decision-making.