Prudent-Person Rule

What Is the Prudent-Person Rule?

The prudent-person rule is a legal principle that is used to restrict the choices of the financial manager of an account to the types of investments that a person seeking reasonable income and preservation of capital might buy for their own portfolio.

The prudent-person rule might be applied to the manager of a pension fund or employee investment account, or to the guardian or trustee of an estate. It is intended as a general guideline for someone managing assets of value for another person or people.

Understanding 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.

How the Prudent-Person Rule Is Applied

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.

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

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

Defining the 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.

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.