Developing a Trustee Investment Advice Process
An overview by Julie Hutchison, Head of Estate Planning and Jenny Holt, Head of Investment Thought Leadership
Background
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For financial planners developing their professional connections, with a view to giving investment advice to trustee clients, it is vital to be able to confidently articulate your advice process and proposition for trustees. In one recent report, 84% of accountants said that an unclear proposition was one of the biggest deterrents when selecting an IFA firm to deal with.1 This article provides an overview of what a trustee investment advice process could look like in 2010.
Trustees can be viewed as a group of investors with specialist technical needs. Their investment powers have evolved over the years, to reflect changes in investment markets, philosophy and practice. Trustee Act 2000 in England and Wales, accompanied by the Charities and Trustee Investment (Scotland) Act 2005 and Trustee Act (Northern Ireland) 2001, create a legislative framework within which investment advice should be given to, and investment decisions made by, trustees. The process will be broken down into six steps:
- trust goals
- risk assessment
- asset allocation
- investment selection
- product selection
- monitoring and reporting
Trustee investing duties
Whilst the details of the various Trustee Acts differ, their core elements are similar, involving the need to consider the following:
- suitability;
- the need for diversification, to the extent that is appropriate for the circumstances of the trust;
- the need for "proper advice", which should be read as independent advice.
The over-arching statutory consideration of "suitability" is the key requirement in many ways, as this arguably brings in all six factors listed above. For example, in terms of the overlap of diversification/suitability, if a whole of life policy is gifted to trustees as the sole trust asset, with a view to the sum assured settling a future IHT liability on death of the settlor, the trustees are not obliged to encash it and purchase a diversified portfolio of investments as this would be contrary to the goals of the trust.
1. Trust goals
There are a variety of different types of trust goals, some of which arise by virtue of the type of trust involved. For example, in a life interest trust, there will be income beneficiaries and capital beneficiaries. The starting point with this type of trust is therefore to be aware of the differing investment requirements arising for these two groups, who have diverging needs. The dynamics of the family relationship also feature strongly here. Contrast these two scenarios:
- a Will trust pays income to the widow, with the capital ultimately to be paid to her step-daughter (her late husband's daughter from his first marriage). The widow and step-daughter are barely on speaking terms: in view of this difficult relationship, the trustees have to take particular care in not over-favouring income or prioritising capital preservation, as these beneficiaries will not be shy in challenging an investment strategy which one feels overly-favours the other beneficiary.
- The income of a trust belongs to someone with special needs, who could have a life expectancy of several decades ahead of him and who will always require support and care. The capital beneficiary is his sister, who takes the view that the priority is her brother's welfare. She knows that the entire trust fund may be spent supporting her brother, and the trustees use their power to advance capital to give extra support to her brother, but she is comfortable with that, as it represents the wishes of their parents, who had in any event made separate provision for her in their Wills.
These are just two examples of trust goals. Every trust has its own blend of family dynamics and drivers.
2. Risk assessment
For individual investors, this stage of the advice process involves assessing the individual's underlying attitude to risk with a view to constructing an investment portfolio with risk and return characteristics consistent with their individual risk appetite.
Trustee investing differs in that the level of investment risk taken will ultimately be determined by the requirements to operate within the legislative framework and meet the goals of the trust rather than by any one individual's underlying risk appetite – be that a trustee or a beneficiary. These overarching requirements and the potentially complex nature of the trust goals and underlying family dynamics can lead trustees to adopt a more cautious approach to investment. In addition, the trustees are effectively custodians of funds which are for someone else's benefit. Whilst they may be prepared to take more risks with their own money, that attitude to risk will not be replicated in relation to a trust, which often has asset protection as one of its goals.
Closely linked to attitude to risk is the concept of composure. Composure is a measure of an investor's emotional ability to withstand falls in the value of their investments. When faced with large paper losses, will an investor 'stay the course' and remain invested in anticipation of market recoveries or will they want to sell as the possibility of experiencing further falls is too much to bear? Understanding beneficiaries' potential reaction to falls in investment value will also influence the investment strategy adopted.
3. Asset allocation
The risk and return characteristics of an investment portfolio are largely determined by the underlying asset allocation which in turn should reflect both the goals and term of the investment, and the investor's attitude to risk.
The long term investment horizon of many trusts – for example where beneficiaries include grandchildren – means that even cautious trustees can consider adopting an asset allocation that includes riskier asset classes and benefit from the higher potential returns over the longer term. Regardless of attitude to risk, all investors can realise potential diversification benefits by adopting an asset allocation that includes a number of different asset classes.
In deciding which asset classes to include, being able to demonstrate suitability is key. For example, it may well be possible to demonstrate that including alternative asset classes such as hedge funds or private equity can provide additional diversification benefits but the risk appetite of the trustees or the liquidity requirements of the trust goals may rule-out such strategies. Alternatively, if either the trustees or beneficiaries have a low tolerance for falls in portfolio value then other strategies such as absolute returns may be appropriate for inclusion in the portfolio. There are a number of different investment approaches adopted by funds within the absolute returns category but they generally aim to provide positive returns in all market conditions over a specified time horizon. While such strategies have not all delivered positive returns in all conditions over shorter time periods, the aim is generally to deliver less volatile returns than equities and this potential for reduced volatility may be appealing to some investors.
Similar suitability considerations apply in deciding whether to adopt a strategic or tactical asset allocation approach. For example, the use of tactical asset allocation strategies to enhance portfolio returns may be of secondary importance to some trustee investors and the potentially higher transaction costs may not be justifiable.
4. Investment selection
In years gone by, a lawyer involved in dealing with a client's trust might simply have recommended that the trustees have a conversation with a stockbroker. In this way, many trust portfolios were built around FTSE100 shares, directly held, with no evidence of collectives to diversify and manage risk. Historic methods stand in contrast to the six steps outlined here. For lawyers who refer clients to stockbrokers for advice, there is also a challenge in terms of whether such a referral amounts to a pre-determined judgement that the trust fund should be invested in equities, and lawyers may wish to reflect on whether it is appropriate for them to be making that judgement.
Just as asset allocation decisions depend on trust goals, the selection of investments within each asset class will depend on the capital and income requirements of the trust and, in particular, whether or not distributions to beneficiaries will be met from dividend and/or interest payments or by disinvesting assets. If the latter approach is adopted, then liquidity will be an important factor.
Investment style is another consideration. If maximising investment return is not the primary goal of the trust then a passive investment approach may be suitable. This approach may also have advantages in managing beneficiary relationships as the returns achieved are perhaps more easily explained by reference to published indices such as the FTSE100. On the other hand, adopting an active investment approach can have advantages in managing the risk and return profile of the portfolio or where the goals of the trust require a more bespoke investment strategy.
Whether choosing to follow an active or a passive approach, collective investments can provide an effective means of achieving the required level of diversification through a smaller number of investments, and can also provide access to asset classes which trustees would not be able to invest in directly.
A final consideration is cost. Trustees need to be able to demonstrate responsible management of the trust fund so need to understand and be comfortable with the costs associated with a particular investment strategy. In this context, less is not always more. If lower cost comes at the expense of service received or investment outcomes that do not deliver against the trust goals it can be a false economy.
5. Tax sells – product selection
Tax compliance costs can sometimes be the reason for a trust to be wound-up, where administration fees relative to the value of the trust fund make the trust uneconomic to operate. Opinions vary on the cut-off point for the viability of a trust, with some views ranging from £100,000 to £200,000. One way to allow a trust to continue is to minimise the tax compliance costs, and an investment bond is one option here when it comes to product selection. Where this is the sole trust asset, and annual withdrawals are within the 5% level, there are no income and gains to report and the trustees can agree with HMRC that no tax return is needed until that position changes.
Tax efficiency is also a factor in product selection. Some products, such as investment bonds, allow segments to be assigned to beneficiaries. Whilst a discretionary trust might now pay income tax at the rate of 50% in tax year 2010/11, where a bond has been assigned to a beneficiary who pays a lower rate of tax, this is one way of mitigating tax and maximising the benefit enjoyed by the beneficiary, where any chargeable event is triggered in their hands rather than the trustees'.
6. Monitoring and reporting
In terms of trust governance, it is important that trustees can evidence their decision-making process. An Investment Policy Statement (IPS) is a statutory requirement in English and Northern Irish law where trustee investments are being delegated to be managed on a discretionary basis. Whilst not mandatory in all situations and jurisdictions, it is entirely sensible for trustees to use an IPS in any event to document the investment strategy being followed, which can then be reviewed each year. This also assists with managing composure, where having a documented process can prevent potentially detrimental emotional decision-making if all parties agree to "stick with the plan". An IPS can also be a very useful defensive document in the event of a beneficiary challenge.
Trustee investing brings with it many technical challenges, and also rewards in terms of potential client relationships and referrals. Standard Life's Trustee Investing Proposition, with a range of technical information and business consultancy support, can be found at www.adviserzone.com/estateplanning