Fiduciary duties on trial

Having previously been guided by a weighty body of case law, trustees have had their duties codified by the Trustee Act 2000 (for other UK jurisdictions see Trustee Act (NI) 2001, and the Charities and Trustee Investment (Scotland) Act 2005).

The legislation applies even to trusts predating the Act, so that trustees who were fairly inactive, and tended to invest restrictively because of the old 'narrow' or 'wide' powers of investment imposed by older legislation (see Trustee Act 1925 and Trustee Investments Act 1961 and their Scottish and NI equivalents), or because of the trust wording, find unexpected new responsibilities thrust upon them.

Trustees are sometimes frightened by investment-related responsibilities, perhaps because without effective investment, a trust's ability to provide for beneficiaries is constrained, and its objectives thwarted.

Taking a cautious line by adhering to the narrow powers of investment granted by the Trustee Act 1925 is no longer good enough. A helpful commentary on the US Restatement (Third) of Trusts says that, 'trust doctrine caused... liability for losses ... to sit ... on the shoulder of every trustee, the threat of losses encouraged investments in low-risk ventures only. Today ... it is the corrosive effects of inflation that create the greatest threat for trustees.' (Phillips, W Brantley Jr, Chasing down the devil: Standards of prudent investment under the Restatement (Third) of Trusts, Washington and Lee Law Review, Winter 1997)

Now the new Act seems to recognise the problems posed by 'caution at all costs' because it obliges trustees to apply standard investment criteria, diversify investments, and review them. It also acknowledges the challenges faced by non-professional trustees in investing trust property by imposing a duty to seek professional advice.

Investment of trust property

'Standard investment criteria' means, in short, that trustees must treat a trust investment as if it was any other type of investment, and apply the same criteria to it. This relates to the underlying investment as well as the product 'wrapper'.

The wrapper is often influenced by tax considerations, but tax tails must never wag investment dogs: the underlying investment is key to the trust delivering its objectives.

The Restatement (Third) of Trusts goes into detail about Modern Portfolio Theory and academic investment research. It refers to diversification, spreading funds across a range of variously correlated asset classes, the ingredients in William Bernstein's diversification free lunch (Bernstein, William, The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, McGraw-Hill 2000) to expunge non-systemic risk and reduce volatility. Risk is the investor's friend: provision of capital to financial markets should ultimately be rewarded by a return; but we seek to capture systemic risk, by diversifying away everything else.

It also says, in effect, that the chosen asset classes should, by default, be captured passively. A number of considerations support this view:

1. Risk - attempting to beat the market by buying more or less of a particular constituent of an asset class disturbs the risk/return metric, and an element of avoidable, non-systemic, risk is introduced. Unnecessary volatility costs money; for a given arithmetic mean return, a higher level of volatility will mean less cash in the investor's pocket, so introducing unwarranted risk costs money.

2. Cost '“ the resources required to produce the research for an actively managed fund cost money. In the UK equity sector, the average active fund has a total expense ratio of 1.58 per cent compared with 0.91 per cent for the passive equivalents (Fitzrovia UK Fund Charges January 2008). This omits the performance drag caused by portfolio turnover, which the FSA calculates at 1.8 per cent (James, Kevin R, FSA Occasional Paper 62, 2000).

3. It doesn't work '“ a 2007 study showed that the FTSE All-share rose by an average 8.99 per cent per annum between 1992 and 2003 but the average equity fund managed just 6.93 per cent. Of greater concern was that the average investor achieved only 4.91 per cent! (Schneider, Lukas, An Examination of the Difference Between UK Fund Returns and UK Investors' Returns, 2007).

Taking advice

The Act says that trustees must obtain advice unless it is unnecessary or inappropriate to do so (Trustee Act (Northern Ireland) 2001 5(3)). This could be taken to mean that, should a trustee not take advice, he implies that he is suitably qualified to invest the trust property, with all the responsibility thus conferred.

Prudent trustees will seek advice. Taking advice, however, does not absolve trustees from their responsibility to act in the best interests of beneficiaries, and it is important that the correct investment adviser is chosen. Simply put, trustees must have a robust process in place to select investment advisers. As David Coldrick writes, 'simply passing financial services work indiscriminately to a pal is not very professional.' (Coldrick, David and Howes, Lewis, Coldrick on Modern Trustee Investment: Law, Theory & Practice, Ark Group 2006').

This process should ensure that fiduciary responsibilities are shared by all professionals involved in the provision of investment advice. Solicitors act in a fiduciary capacity; trustees have a fiduciary duty imposed by the Act. Why, then, would a solicitor acting as a trustee, or providing legal advice to trustees, contemplate an investment adviser to the trust who does not also behave as a fiduciary?

For the avoidance of conflicts of interest, fee-based arrangements, with no commission, are preferred. Without commission, there is no incentive to an adviser to recommend, unscrupulously or unconsciously, one product over another (or refrain from recommending any product) simply on the grounds of commission.

Fees must be dealt with openly and fairly. The best financial advice is a 'value-added service' that pays for itself many times over. It is much easier to see the justification for a fee if it is based on time spent and the value added by the planner.

Part of any financial planner's service must be a review process. This is a duty of the trustees under the Act with good reason '“ regular reviews are in the best interests of the trust and its beneficiaries. Any planner acting as a fiduciary must deliver this part of their service properly. Expect, therefore, an ongoing fee to pay the planner for farming, rather than abandoning your client to go off hunting for remunerative new business.

Remuneration arrangements must align the interests of planner and client '“ pay the planner only for activity that benefits the trust. Fee arrangements, both initial and ongoing, can accomplish this '“ commission arrangements, in general, do not.

Robust systems

Wise trustees can protect their interests as fiduciaries when seeking investment advice, by selecting advisers that understand this responsibility and themselves behave like fiduciaries. A fee-based, value-added remuneration structure is key, with robust systems for all parts of the planning process including reviews. And make sure they use passive investment strategies or have a very sound reason why not.