Directed trusts are an increasingly popular estate planning tool that allows for greater flexibility and control over trust assets after the death of the grantor. Unlike traditional trusts, where a singular fiduciary role (trustee) is responsible for all aspects of trust administration and investing, directed trusts divide responsibilities among different parties, enhancing efficiency and specialization.
In a classic directed trust structure, there are two fiduciary appointments: a trustee and an “Investment Director” (sometimes called an “Investment Advisor” or “Trust Director”). While the trustee has administrative responsibilities, they are “directed” on investments by the Investment Director and must follow their instructions on all aspects of trust investing. Thus, in a directed trust model, the responsibilities and liabilities are bifurcated between the trustee and Investment Director, with the latter solely responsible for all investment decisions related to the Trust without trustee oversight.
A directed trust offers benefits for both the grantor and the Advisor who is serving as Investment Director. Unlike a traditional trust, the grantor of a directed trust can choose their preferred investment manager instead of leaving that decision to the trustee, thereby creating more flexibility and control. A directed trust also alleviates the burden on the trustee (often a family member or friend), insofar as they are not responsible or liable for investment management of trust assets.
Additionally, should a trustee resign or be removed, that change has no impact on the Investment Director, as they are separate fiduciaries. This feature of directed trusts can create a more stable investment strategy across the life of the trust and maintain relationship continuity through any change of trustee. Of course, this benefits the Advisor as well by providing a layer of security in their role, as they are not tethered to the fate of the trustee, nor do they serve at their discretion.
The bifurcation of fiduciary duties in a directed trust model, while beneficial, gives rise to responsibilities and potential liabilities for the Advisor that are unique to this type of trust. A Financial Advisor considering service as an Investment Director, as well as those currently serving, should be aware of these differences and their potential impact.
While not meant to be inclusive, the below represents four key differences between traditional trusts and directed trusts.
In a Directed Trust, An Investment Director Serves in a Broader Fiduciary Capacity
In a traditional trust, the trustee often hires a Financial Advisor to invest the marketable securities in the trust. While the Advisor has a fiduciary duty to act in the best interest of the trust and its beneficiaries, she, from a legal perspective, is an agent of the trustee. The client agreement signed by the trustee dictates the terms of that relationship (fee, notices, termination, etc.) and the Investment Policy Statement (“IPS”) determines the scope. As to investing, while the Advisor recommends an investment objective and strategy that she believes is in the trust’s best interest, the trustee, as principal, needs to sign off and is responsible for oversight of the investments. The trustee, in its sole discretion, can replace the Financial Advisor at any time.
In a directed trust the Advisor is not hired by anyone; instead, they are either appointed as Investment Director in the trust agreement itself or as successor Investment Director through the relevant trust provisions. This appointment is a fiduciary role, like an Executor or Guardian. It is not a wrong approach to view the Investment Director as an “Investment Trustee” with expanded roles and responsibilities.
Unlike traditional trust models, with a directed trust, the scope and terms of the Advisor’s role and responsibilities are not dictated by a client agreement or IPS and the trustee does not have the discretion to fire the Advisor. Instead, the scope and terms are dictated by the trust agreement itself. The Investment Director’s allowable fees, resignation and removal provisions, governing law, powers, duties and so on are all identified in the trust document. If the trust is silent as to any of these matters, the applicable state law governing the trust, including the state’s Prudent Investor Act, fills the gaps, not any underlying client agreement. In fact, in a directed trust model there is no client, and therefore no enforceable client agreement. While that may seem foreign, the same is true of a trustee. Both are fiduciary roles created by the trust agreement.
In a Directed Trust, the Advisor Has Final Say on Investment Objective
When it comes to investing, the Investment Director must determine the appropriate assets and investment objective for the trust. The trustee has no authority to agree, disagree, or sign off on the Investment Director’s decisions as to allocations, asset selection, concentrations, or anything else investment related. Additionally, the trustee is not responsible for investment oversight; the trustee must simply follow the directions of the Investment Director.
In their fiduciary role, an Investment Director exercises full discretion over the investment of trust assets without the approval, supervision, or agreement of a third party. It is akin to a trustee exercising discretion on a disbursement. This is vastly different than in a traditional trust, or a typical individual managed account.
In a Directed Trust, the Investment Director Has Responsibility for All Assets
As mentioned above, in a traditional trust the Advisor is hired by the trustee to invest the marketable securities. Accordingly, if the trust holds unique assets, the trustee is responsible for investment decisions related to those assets, not the Advisor. This is not the case in a directed trust.
Unless expressed in the document differently, in a directed trust the Investment Director has investment responsibility for all trust assets. This includes, of course, marketable securities, but also any other asset in the trust which frequently includes real estate, land, artwork, and closely held entities. In a directed trust, investment discretion related to the sale or retention of these assets sits with the Investment Director, not the trustee. This responsibility is conveyed when the Investment Director accepts the appointment, absent express language in the trust document limiting their role.
This is a critical difference between directed and traditional trusts. Therefore, before accepting an appointment as an Investment Director, an Advisor should conduct due diligence to make sure she fully understands the contents of the entire trust portfolio, including whether the trust holds unique assets.
In a Directed Trust, the Trust Document Has Heightened Importance
The directed trust instrument controls all aspects of the relationship, roles, and responsibilities of both the trustee and Investment Director. Therefore, a complete understanding of all provisions is critical. An Advisor should pay close attention to all investment provisions, including those indicating investment restrictions or mandates, as well as those that dictate their powers and duties. Additionally, the Advisor will need to identify the governing law, as that will direct the Advisor to the applicable state Prudent Investor Act should any questions arise regarding their obligations under the directed trust. Finally, the Advisor should understand how they resign or are replaced, as that will be driven solely by the trust document and applicable state law.
To be clear, there are some similarities with traditional trusts with respect to the importance of the document. For example, to set an appropriate investment objective, an Advisor taking on the role of an Investment Director should review the trust’s dipositive provisions (distribution scheme) and analyze the needs of each beneficiary; their income, resources and financial station, and identify any terminating events to ascertain the appropriate time horizon. However, unlike a traditional trust, the Investment Director should make these determinations independently, not in complete reliance on information provided by the trustee.
SO, in reviewing these key differences, it may be beneficial for Advisors who are considering an Investment Director role, or that have directed trusts in their current book to:
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Carefully review the trust instrument to better understand and confirm their role.
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[For those Advisors who already serve] Revisit any client agreements, IPS’s, direct to holds, and other investment-related documentation that they may be using to inform investment strategy or selection. If the trust is a directed trust, these documents may be ineffective as the signor may lack authority to bind, confirm, or instruct.
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Verify with the trustee that there are no unique assets held in the trust (real estate, closely held entities, etc.).
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A firm may need to enhance compliance and oversight on directed trusts to monitor and address concentrated positions, uninvested cash balances, asset allocation drift and performance as their ability to rely on the trustee’s direction, authorization, approval, and oversight on these matters is not present.
Directed trusts offer a valuable alternative to traditional trust structures by distributing responsibilities among specialized fiduciaries. Advisors who understand the intricacies of directed trusts can help clients maximize asset protection, control, and efficiency, while navigating potential complexities. Proper planning, expert guidance, and knowledgeable fiduciaries are key to successfully implementing a directed trust strategy.
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