Dear Prudence

A fiduciary must be prudent. But what exactly is prudence? A recent blog entry broaches the subject.

In “Dear Prudence,” an entry in the blog The Research Puzzle, Tom Brakke writes that “at the core” of laws and regulations that guide those who assist others in managing their assets “is the prudent man rule,” which first arose as a concept almost two centuries ago.

Among those laws is ERISA, which says that a fiduciary must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

Brakke zeroes in on ERISA’s language “the circumstances then prevailing” and asks what that means. “Does a general decline in rates of return constitute a reason to get more aggressive in order to meet the financial plans of an organization, or should it instead lead to a reassessment of assumptions and strategies?  Which is ‘prudent’?” he asks.

Brakke argues that this consideration is at the heart of the matter, and that it merits more discussion. “Generally speaking, there isn’t enough discussion among fiduciaries about what constitutes prudence and what doesn’t,” he writes. But Brakke argues that should change.

“A robust evaluation of investment beliefs should occur on an ongoing basis,” says Brakke. Why? Because “those beliefs are the standards to which members of an investment committee should hold each other, and there should be regular debate about the application and continued appropriateness of them,” he explains.

Brakke says that standards and practices change over time, and that typical pension plans and endowments now are in a much different position now than they used to be. He argues that being too cautious is a risk, but that most asset owners “are at a greater risk of being to aggressive.” Similarly, he says that the way private equity is regarded is “vastly” different than it was in the past, even though the environment for it now is “more challenging.”

“There is no one answer” to the question of what constitutes prudence, Brakke says. “It depends on many things, including the nature of an asset owner’s organization, its existing portfolio, its access to sufficient expertise, and its ability to realistically assess the possibilities ahead (rather than recite and depend upon the results of the past),” he writes.  

“Acting with prudence involves understanding (and admitting) what you don’t know — and discussing the inherent uncertainties involved in a strategy and its weaknesses, along with the arguments in favor,” says Brakke. “Investment prudence is a concept that shouldn’t be hidden away — it should ‘greet the brand new day.’ A fiduciary’s job is not to do what others are doing, but to make decisions in an enlightened way,” he writes.