This blog has been written by Robert Boyd, Director, Scotiatrust.

The blog is the first in a series focusing on Fiduciary Investing that will cover a range of practical topics.

When one approaches the topic of fiduciary record keeping, there is room for forgiveness for those who tune out (or nod off). It’s not a topic that gets people excited, although the litigation that can occur from incorrect management of fiduciary accounts may certainly wake them up, somewhat abruptly.

Under the common law, trustees have a fiduciary duty to provide accounting to the beneficiaries as well as a duty of impartiality. When these duties are combined with another common trust requirement to separate income from capital, accounting can become complicated and often liability is created without the knowledge of the trustee(s).

As a simple example:

A Testamentary Trust flows from the Estate of Pat Spillane in 1999. The trust provisions provide for the income of the trust to be paid to his spouse for her lifetime. On the winding up of the trust (death of spouse), the capital shall be paid to the deceased’s children from a previous marriage. For simplicity, there are no capital encroachment provisions.

A trust account is established and the funds are invested through an investment advisor with an objective to generate as much income for the spouse as possible considering the encroachment constraints. All income is paid to the spouse monthly. One statement is provided to all classes of beneficiaries.

20 years after the trust is established, the spouse passes away and the funds become distributable. The capital beneficiaries note that the assets haven’t grown in line with the markets, and collectively decide to hire a forensic accountant to do an analysis of the activities over the past 20 years.

The analysis reveals the following:

1. A number of assets provided a return of capital payment that was routinely paid as income to the spouse (Approximately $5k per annum)
2. Fees were collected from cash held in the account and there was no way to differentiate between income and capital cash held in the account, although it is reasonable to deduce that the majority of fees were in fact paid out of income cash as the account was fully invested. (Total fees of $10k per annum)
3. A high portion of the portfolio was invested in high yield bonds that did not provide for any capital appreciation. In fact, the portfolio decreased in value over time. The fund has not grown from its initial value of $1 million dollars and at distribution the funds total $970,000. A mix of equity and fixed income assets with a modest growth objective would have grown to an estimated value of $1.5 million dollars, after considering the annual payments of income to the spouse.

The compounding effect of 20 years leave a potential liability for a trustee of $100k for incorrectly distributed capital, $100k (50% of total of fees) in fees paid solely by the income beneficiary and $600k in lost investment growth for the capital beneficiaries all of which the trustee may be personally liable for.

How could these circumstances have been avoided?

1. Utilize software that separates capital and income automatically. (or open two accounts and separate manually)
2. Use the above solutions to split fees equally between income and capital. (or in line with the trust agreement provisions)
3. Create an appropriate investment policy statement that caters for the needs/rights of all classes of beneficiaries and review periodically.
4. Avoid investment vehicles that may provide return of capital.

The old idiom “a stitch in time, saves nine” rings true. When acting as a fiduciary or advising clients who are acting as a fiduciary, setting a correct course from day one (or adjusting when identified) will minimize the risks of compounding liabilities.

Fiduciary Investing Series

Blog #1   How to avoid compounding liability in trust accounts
Blog #2   Fun, fun, funds
Blog #3   Powers of Attorney and Investment Portfolios
Blog #4   Don’t REIT around the bush