PR 07235.017 Indiana
A. PR 03-051 RSI -- Indiana -- Determination of Prudent Man Investor Rule for D.J. H~, SSN: ~ Your File No.: 02P053 Our Ref. No. 02-P-065
DATE: November 26, 2002
The Chicago Region requested a legal opinion on whether the investment of a beneficiary's conserved benefits in certain mutual funds is proper under the prudent investor rule in Indiana. In this case, the investments appear to be inadequately diversified to meet the prudent investor rule/standard.
You asked whether the investment of RSI benefits by the representative payee in certain mutual funds is proper under the prudent investor rule in Indiana. Indiana state law, which is applied in these circumstances, indicates that a representative payee must use reasonable care, skill and caution with the interest of the beneficiary as the key element. We conclude that the investment vehicles proposed do not appear to meet that standard.
It appears that D.J. H~ is the representative payee for the conserved funds of Eric W. H~. (Stephen H~ is listed both as a contact person and “payee” in one agency note.) In about August - September 2001, the payee had invested $22,744.00 in four Putnam Mutual funds: (1) Voyager; (2) Capital Appreciation; (3) New Opportunities; and New Century Growth. The notes in the file show that the Agency contacted Mr. Jack D~, an investments adviser at a bank in Columbus, Indiana in August 2001, and that Mr. D~ described the investments as “an aggressive portfolio with a well known fund with a good track record.” Report of Contact, August 16, 2001. Mr. D~ would not comment as to whether or not this investment met the prudent investor standard. Id.
In particular, Mr. D~ stated that the Capital Appreciation and New Opportunities funds were “highly volatile,” and the New Century fund was “more volatile.” Id. He indicated that the Capital Appreciation fund had a two-star rating (on a five-star scale); the New Opportunities fund had a three-star rating; and the two other funds were too new to be rated. Id. Mr. D~ also stated that historically Putnam funds have been good funds, that the market was down, and that lots of good funds were down. He added that these funds were “more volatile” because they were new funds and also because they were “aggressive.” Id.
Federal regulations provide that, after a representative payee has used Social Security benefit payments for the current maintenance of the beneficiary, any remaining amounts are to be conserved or invested on the beneficiary's behalf. See 20 C.F.R. § 404.2045(a). Any such “[c]onserved funds should be invested in accordance with the rules followed by trustees.” Id. We look to state law to determine how trustees should invest funds. See Program Operations Manual System (POMS) GN 00603.040(A). Generally, states tend to follow a “prudent investor” rule, and that rule is applied in Indiana. See Indiana Code (IC) 30-4-3.5; Six State Survey, Investment of Conserved Funds, 2001-08 SSA 01-P-06 (Gumm, Region V).
The regulations state that the preferred investments for excess funds are United States Savings Bonds and deposits in an interest or dividend paying account in a bank, trust company, credit union, or savings and loan association which is insured under either Federal or State law. 20 C.F.R. § 404.2045(b). Similarly, operating procedures require that excess benefits be conserved or invested with minimum risk, with preferred investments being United States Savings Bonds. Benefits may also be invested in accordance with state law governing the investment of trust estates by trustees. POMS GN 00603.001.
The prudent investor rule is found at Indiana Code (IC) 30-4-3.5. No specific types of investments are required or restricted. No specific investment or course of action is, taken alone, prudent or imprudent. The trustee may invest in every kind of property and type of investment, subject to the prudent investor rule. IC 30-4.3-5-2(e). Indiana case law does not provide much guidance in this area. However, we located one case that discussed transactions in stocks generally. In Malachowski v. Bank One, Indianapolis, 590 N.E. 2d 599 (Ind. 1992), the court discussed whether the sale of Eli Lilly stock breached the trustee's fiduciary duty, and found that it did not.
In addition, a trustee in Indiana is required to consider the purposes, terms, distribution requirements, and other circumstances of the trust. A trustee exercises reasonable care, skill, and caution. IC 30-4-3.5-2(a). The decisions must be evaluated, not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust. IC 30-4-3.5-2(b). Funds should be diversified, unless it is in the best interest of the beneficiary not to diversify. IC 30-4-3.5-3; see also Malachowski, 590 N.E. 2d at 564. A trustee should review the funds reasonably soon after taking over the funds. IC 30-4-3.5-4. A trustee must use reasonableness, prudence, and diligence and must be impartial with no conflict of interest. IC 30-4-3.5-6. A trustee may delegate investment decisions, provided that the trustee exercises reasonable care, skill, and caution in selecting an agent. IC 30-4-3.5-9. Thus, investment in a managed fund, such as a mutual fund, would be appropriate, if otherwise reasonable. Further, compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of a trustee's decision or action and not by hindsight. IC 30-4-3.5-8.
Likewise, the Restatement (Third) of Trusts, § 227, sets forth similar standards. It indicates that the “prudent investor rule,” followed by most states, does not classify specific investments or courses of action as prudent or imprudent. Although the rule imposes a duty to use caution and a degree of conservatism in investing, “reasonably sound diversification is fundamental to the management of risk,” and “trustees ordinarily have a duty to diversify investments.” Id. Under the rule, “the permissible investments of trustees are not confined to 'reliable' securities of governments and 'established' corporations.” Id. “Higher risk domestic and foreign stocks are also permissible investments for trustees under the prudent investor rule,” and “the stocks of small, expanding companies ('venture capital') are not abstractly characterized as impermissible trust investments.” Id.
Our research shows that Putnam Investments has various funds listed under the names of the funds you provided to us, but that the New Century Growth fund has been merged into the Voyager II fund (a large capital growth fund). See http://www.morningstar.com. As of this date, the Morningstar website indicates that the Putnam Voyager funds have 3-star ratings (large capital growth funds); the Capital Appreciation fund has 1-star ratings (multi-capital core blended funds); and the New Opportunities funds have 1 or 2-star ratings (multi-capital growth funds). Morningstar currently recommends a “wait-and-see” posture towards the Voyager and Capital Appreciation funds and an “avoid” posture with regard to the New Opportunities funds. See http://www.morningstar.com; http://www.putnaminvestments.com. Looking at these investments with a very “broad brush,” we note that, as would be expected, these funds have lost significant value in 2001-02, and those losses exceed by about 10 percent the losses in a more diversified portfolio, as exemplified by the Thrift Savings Plan (TSP) C fund for equities. See http://www.putnaminvestments.com; http://www.tsp.gov. We do not know, however, whether the representative payee still has the monies in these funds.
In any case, it should be noted that the prudent investor standard is not applied in hindsight. See IC 30-4-3.5-8. In addition, despite the language in the regulations and POMS indicating a preference that conserved funds be held in instruments of very low risk, see 20 C.F.R. § 404.2045(b), POMS GN 00603.001, it is clear that the law allows the use of mutual funds. See, e.g., IC 30-4-3.5; IC 30-4.3-5-2(e); Restatement (Third) of Trusts, § 22. We have reviewed the prior opinions from various jurisdictions regarding the application of the prudent investor rule to conserved funds, and we have located only one such opinion indicating that an investment plan did not appear to meet the requirements of the rule. This is the June 10, 2002, opinion from the Office of the General Counsel, Region VII, Kansas City, found on PolicyNet at POMS PR 07305.030-Nebraska. In that case, a bank trust officer stated that the subject mutual fund investments in college/education funds standing by themselves did not meet the “prudent person” standard, and that greater diversification in resource allocation was needed, suggesting that the representative payee should have four to five mutual funds, including growth and income, large cap, small cap, etc. In that case, the writer relied on the opinion of the trust officer that the subject investments did not meet the requisite standards. See POMS GN 00603.040B.
In the instant case, however, the investment banker consulted by the Agency declined to give an opinion on that matter. The investments at issue here are not, however, significantly diversified, and it is clear that the law requires diversification in most circumstances. See, e.g., IC 30-4-3.5-3; Malachowski, 590 N.E. 2d at 564; Restatement (Third) of Trusts, § 227. Mr. D~ described the portfolio as aggressive and highly volatile although he indicated that Putnam investments, historically, were reliable. All of the other opinions reviewing particular investments under the prudent investor standard were significantly more conservative investments. While the Agency may not want to be in the position of giving investment advice, especially without an opinion by a financial consultant, we believe that, based upon the facts presented, the investments do not appear to meet the standard required by the regulations and Indiana law. We suggest that Mr. H~'s current investment of conserved funds be reviewed and that, if the portfolio remains “aggressive” and “volatile,” or otherwise lacks diversification, that the Agency suggest that he reallocate some of the funds to more conservative mutual funds or other investments.
Indiana has incorporated the Prudent Investor Act within its laws. Under Indiana law, the investments Mr. H~ has made appear to be inadequately diversified to meet this standard, especially in light of the fact that the entire portfolio is considered aggressive and volatile. We suggest that the portfolio be reviewed, and that, if the investments remain undiversified and volatile, that it be suggested that Mr. H~ begin the process of reallocating some of the funds.
DONNA L. C~
ACTING REGIONAL CHIEF COUNSEL
Carole J. K~
Assistant Regional Counsel