What is Prudent Investing?

The laws that govern pension plans and private trusts set expectations for fiduciary conduct with regard to investments. Because fiduciaries have a duty of loyalty to the beneficiaries and a duty of care over trust or plan assets, legislators have stipulated that fiduciaries must invest the money "prudently".

But what is "prudent" fiduciary behavior? ERISA and the UPIA speak in legalese, but what do they mean in English?

First, the definition of the word "prudence" is commonly misconstrued. 

Prudence does not refer to:

• How well investments perform ("The trust made money, so I must be doing something right.")
• Type of investments chosen ("I have all the money in bonds, CD's and T-bills, so the money will be safe. I'm being prudent.")
• Degree of diversification ("I don't have all my eggs in one basket. I have over 20 money managers investing in every conceivable investment. I don't know what half of them are, but at least no one can say I'm not diversified.")

These misconceptions ring true to case law prior to the 1990's, when prudence was measured on an investment-by-investment basis.  However, more recently trust law has been modified to take into account the findings of Modern Portfolio Theory, which emphasizes the importance of the risk and return characteristics of the entire portfolio, viewed as a whole.
Further, the new laws define prudent investing as having more to do with the choices a fiduciary makes in designing and implementing the investment process rather than the final results. In fact, the New Jersey Prudent Investor Act, for example, states clearly that "The Prudent Investor Rule expresses a standard of conduct, not outcome." [N.J.S.A. §3B:20-11.9] Put simply, prudence is determined by the:

• Facts and circumstances existing at the time of the decision (as one court put it, fiduciaries have "no duty of clairvoyance"); and
• Exercise of reasonable care, skill, and caution in meeting the purposes and needs of the trust taken as a whole.
• Process by which fiduciaries determine the strategic goals of the Plan or trust, design a suitable asset allocation, select investment managers who implement the strategy, and provide oversight and monitoring of investment manager performance and the fees charged for services rendered.

A fiduciary needs to be able to prove that a thought process exists behind the investment strategy. Therefore, contemporaneous documentation is critical, and in fact is the essence of establishing prudence.

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