A major element of estate planning is determining the assets, and their value, to be left to estate beneficiaries. However, the estate plan may not specify how the assets are to be invested and managed post-death and prior to distribution to beneficiaries. Unless the will specifies an approach and constraints, an executor (a.k.a. estate trustee) will have significant investment discretion. Given that even the simplest estates can take 12 to 18 months to settle, the executor has ample time, power and opportunity to invest estate assets.
The various provincial and territorial trustee acts summarize that the executor must abide by the prudent investor rule: the executor has an obligation when investing estate property to exercise the skill, care, diligence and judgment that a prudent investor would exercise in making investment decisions. The rule is subject to interpretation, and in myriad legal cases, executors have attempted to justify their actions by arguing that they abided by the rule. A common argument is that they diversified the portfolio and/or selected only low-risk investments.
Case law is clear that a trustee has an obligation to diversify a trust’s portfolio to the extent that diversification is appropriate, but diversification itself is not deemed sufficient to demonstrate that an executor acted as a prudent investor.
Fortunately, the trustee acts provide some guidance. For example, in Ontario the Trustee Act lists criteria that trustees are required to consider when investing trust and estate related property:
- general economic conditions at the time funds were invested;
- possible effect of inflation or deflation;
- expected tax consequences of investment decisions;
- role that each investment plays within the overall investment portfolio;
- expected total return from income and the appreciation of capital;
- needs for liquidity, regularity of income, and preservation or appreciation of capital; and
- an asset’s special relationship or special value to the beneficiaries.
If the executor invests estate assets in a manner that is inconsistent with a prudent investor, they risk personal liability for any losses incurred from imprudent investing. The focus is the reasonableness of the investment strategy adopted by the executor, not the estate’s investment gains or losses. An executor who invests estate assets in a prudent manner but suffers losses will not be held liable for those losses, and an executor who invests in an imprudent manner but enjoys favourable investment returns may be subject to a reprimand.
Recently, I had a discussion with a U.S. professional executor colleague who was uncomfortable with the subjective nature and “arbitrary” interpretation of the prudent investor rule. He said he has had too many disputes and legal claims in which he felt he was abiding by the prudent investor rule but the beneficiaries questioned his acknowledged “conservative” and “risk-averse” investment approach. He said he has been accused of focusing on minimizing his executor risk as opposed to doing what is best for the estate and beneficiaries.
He shared a situation that led to him requiring that an investment policy statement be included in the will for him to accept an executor appointment. He was the executor for an estate with a modest diversified investment portfolio, a testamentary trust and one significant private loan receivable with above-market interest-rate terms. The collateral for the loan was negligible, and the debtor had a poor credit rating but was meeting the interest and principal repayment terms. The will did not contain any terms or guidance on the private loan, and the beneficiaries were eager to get the estate settled and funds distributed.
The executor decided to call in the loan (as permitted by the loan agreement) with a penalty, and actually helped the debtor secure new financing. The beneficiaries received their estate proceeds but commenced a claim against my colleague, contending that he should have liquidated the loan asset at the most opportune time as opposed to feeling pressured to settle the loan as soon as possible. The beneficiaries included in their argument that the executor’s actions were inconsistent with the prudent investor rule, testator’s wishes and terms of the will. The claim was a bit of “smoke and mirrors,” the executor said, as the debtor was a relative of the beneficiaries and testator, and they wanted to save face. Regardless, my U.S. colleague incurred a lot of stress and legal costs defending his actions.
Investment policy statement considerations
If a client is considering incorporating an investment policy statement in their will, the will draftsperson should consider the following components:
Investment-related objectives. Specify the estate investment portfolio’s objectives, such as the targeted total investment returns that the executor should aim to achieve, time frames and whom to use for investment guidance.
Asset allocation. Specify a target allocation of income and growth investments.
Investment products selection criteria. Specify the types of investment products that the estate portfolio should include — cash, equities (Canadian, U.S., international), fixed-income instruments, ETFs, mutual funds, etc.
Quality guidelines. Specify rating requirements of debt and preferred securities. Possibly specify minimum market capitalization requirements (e.g., no investments with a market capitalization less than $250 million).
Diversification guidelines. Specify maximums or minimums associated with investments in any one company, sector or mutual fund. Additionally, how often does the portfolio need to be rebalanced to maintain proper diversification?
Advisors should discuss with their clients the prudent investor rule and the possible need for an investment policy statement to be included in their wills. The investment policy statement will assist the advisor and the executor in selecting appropriate securities and provide a performance benchmark. For the executor, the investment policy statement provides a framework to assist in the decision-making process and a paper trail in the event of litigation or dispute.
Michael Kulbak, MBA, CPA, CMA, TEP, is principal of Kulbak Trust Solutions in Mississauga, Ont.