Prudentmanrule

Key Takeaways

• The prudent-person rule is a legal principle guiding fiduciaries to make sensible investments with reasonable risk.
• Applied to trustees and estate guardians, the rule emphasizes intelligent decisions benefiting beneficiaries.
• The rule is similar to ERISA standards, which require prudent actions to minimize investment risks.

What Is the Prudent-Person Rule?

The prudent-person rule is a legal guideline that requires individuals who manage investments for others, such as trustees, financial managers, and guardians. These individuals must manage the money as carefully as they would their own. The rule sets clear expectations for responsible asset management by emphasizing conservative decisions that aim to preserve capital while achieving reasonable returns. Understanding how this rule applies across different situations, who it affects, and why it matters can protect investments from unnecessary risk and unwise choices.

Deep Dive into the Prudent-Person Rule

The prudent-person rule is intended to protect investors using the services of an investment advisor from shady, risky, or otherwise questionable investments, such as penny stocks.

The law does not require a person with a fiduciary responsibility to have extraordinary expertise. However, the prudent-person rule sets a reasonable expectation that the person will make rational, intelligent decisions when making investment choices on behalf of the client.

Applying the Prudent-Person Rule in Investment Management

The rule can also be applied to an individual who has been granted stewardship or guardianship of an estate on behalf of another person or people. For example, a pension fund manager hired to run a fund in behalf of the employees of a company is required to make investments that have a reasonable possibility of turning a profit.

Clearly, no hard and fast rules are possible. Generally speaking, the funds may not be invested entirely in high-risk investments. The assets may not be diverted to investments that would enrich the pension fund manager or some third party.

This rule does not require that all the investments made must be lucrative or consistently generate outsized profits. However, if a fiduciary were given control of an estate during a period that its owner was unavailable, the rule would prohibit the fiduciary from putting all the funds into money-losing endeavors.

Important

Federal pension plan guidelines require pension plan managers to minimize the risk of large losses and avoid conflicts of interest.1

The investment decisions must be made according to what a person of average intelligence would deem as appropriate.

Who Qualifies as a Prudent Person?

Some of the language in the Employee Retirement Income Security Act (ERISA) is comparable to the prudent-person rule. This 1974 law sets down requirements and safeguards for the management of pension plans in the U.S.1

ERISA does not set specific job qualifications for a fiduciary. Rather, it requires a fiduciary to "run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses." Further, it says that fiduciaries "must act prudently and must diversify the plan's investments in order to minimize the risk of large losses." It also warns them to avoid conflicts of interest.1

U.S. Department Of Labor. "Fiduciary Responsibilities." Accessed July 18, 2021.

U.S. Department Of Labor. "Fiduciary Responsibilities." Accessed July 18, 2021.

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