A trustee is a fiduciary, owing duties to the trust and its beneficiaries.
One of the most fundamental, and at times challenging, responsibilities for each trustee is to invest trust property. There is inherent risk in managing investments, and beneficiaries rely on the returns generated by the trust to provide financial security or support.
While investing for trusts is complex, nuanced and distinct, here are three of the most pertinent issues for all trustees.
A trust deed will contain specific provisions setting out the trustee’s investment authority. The settlor may include as narrow or as broad language as she wishes in the deed. In many instances, the investment provisions direct the trustee to choose only investments that are authorized by law for trustees.
What are investments authorized by law for trustees? The scope of this authority has certainly evolved over the last few decades. Historically, trustees had to invest in accordance with an approved list of investments. This so-called “legal list” was enshrined in provincial statutes and regulations.
Modern Portfolio Theory
Over time, this prescribed approach became subject to increasing criticism. It did not line up well with the realities of the investment and securities markets and was out of step with widely adopted investment approaches such as modern portfolio theory (MPT).
MPT focuses on constructing diversified portfolios that optimize expected returns within a given level of risk. It got to the point where following the legal list of investments and not employing an MPT-driven approach could be seen to be imprudent, since no knowledgeable investor would otherwise follow the legal list. The MPT approach of evaluating trust portfolios as a whole, and as part of the overall investment strategy, was seen as being more appropriate than legal lists which reviewed individual trust investments in an isolated manner.
Prudent Investor Rule
Provinces have since updated their statutes, enabling trustees to invest according to the “prudent investor rule” which states that when investing trust property, a trustee must exercise the same care, skill, diligence, and judgment a prudent investor would exercise in making investments.1
The evolution to the prudent investor rule formally incorporated MPT into trust investing and allowed trustees to develop an investment strategy in the context of specified risk and return objectives appropriate for the trust. With this change, the options for trust investing were significantly expanded.
Another key consideration when investing trust property is the application of the “even hand rule.” Under this principle, trustees are to make sure beneficiaries, who have unique interests, receive what they are entitled to under the terms of the trust. No more and no less. Subject to the trust deed, no advantage or burden is to be given to a beneficiary (or class of beneficiaries) over another.
Being even handed means trustees need to ensure the needs of beneficiaries who currently rely on trust income as well as those who expect to eventually inherit capital are both met. There needs to be active balancing of those who will directly benefit from the trust funds now versus those who will do so at a future date. Balancing the needs of both types of beneficiaries can be a delicate exercise, as the beneficiaries in these two groups are different people, whereas in a non-trust context it is often the same person who will benefit in both the short and long term.
Notwithstanding the application of the even hand rule, the prudent investor rule results in trustees being able take a broader portfolio view of risk and return, use diversification to improve return expectations while reducing risk, and seek an optimal total return from investments.
There are many ways to structure a trust. Traditionally, trusts separated investment returns into two buckets: income and capital. From a trust administration point of view, income generally consists of interest and dividends while capital growth is generated in the form of capital gains. A common example would be a spousal trust that states: “Pay all trust income to my spouse during her lifetime. Once she has passed away, pay the capital to my children.” In this scenario, the spouse wants maximum income, and the children want maximum capital gains. From the outset, there’s a built-in conflict, especially if a second marriage is involved.
In contrast to this traditional model, we frequently recommend discretionary trust terms which allow a trustee to distribute funds shaped by the beneficiaries’ needs (or purpose of the trust), rather than the source of the return, thereby removing the traditional income versus capital gains distinction. This discretionary trust model is more flexible and adaptive to future circumstances.
Market realities are constantly changing and unpredictable. Especially in low-yield environments, a narrow focus on generating traditional trust income in order to meet an income beneficiary’s needs may frustrate beneficiaries and cause divergence from the even hand rule. A fully discretionary model allows a trustee to seek the optimal balance of risk and return, based on total investment return, not separate buckets of income and capital gain.
Family relationships and related dynamics are likewise not static. The traditional model may incent competing beneficiaries to focus too narrowly on specific investment outcomes, such as maximizing dividend income. A discretionary trust model aligns the beneficiaries’ interests in seeking the optimum total investment return consistent within a suitable risk tolerance. The trustee can focus on meeting overall beneficiary needs instead of refereeing disputes over investment strategy.
Considering Investment Provisions Carefully
Although trustees need to be more involved and active in managing trust property, the move to a more flexible prudent investor rule provided trustees with the ability to access a broader range of investment options, often with stronger returns and less risk than under the legal list regime.
Trust investing is not the same as making investment decisions for one’s own portfolio. An individual has the ability to subjectively accept a level of risk or adopt an investment strategy that may not be acceptable when making investment decisions for the benefit of others. The purpose and terms of the trust deed will provide a trustee with guidance on how to invest trust property.
When creating a trust, we encourage you to speak with the drafting lawyer to understand the potential impact of the investment provisions on the returns that may be generated and the payments made to the beneficiaries.
1. See Trustee Act RSO 1990, C T.23, s.27(1) for a sample statutory provision setting out the prudent investor rule. Analogous legislation in other provinces contains similar wording