How to Create a Client Investment Policy Statement

Recent stock market volatility again pointed to the need for investors not to react and make investment decisions out of a feeling of panic, but rather to have a plan and an investing strategy that takes market corrections into account. The benefits of this type of approach were borne out during the financial crisis of 2008-09. Sadly, many investors sold out of their equity positions at or near the bottom of the market, booking losses and then missing out on some or all of the ensuing bull market that began in March of 2009. Fear was their guide, not a plan.

An Investment Policy Statement (IPS) is essentially a business plan for your portfolio. It is very common for financial advisors to have one in place for their institutional clients such as retirement plan sponsors and foundations and endowments. Many financial advisors will also draft one for their individual clients as well.

Essentially an IPS provides a roadmap for how clients should invest their money. What asset classes should be considered? What types of investment vehicles should be considered? These might include exchange-traded funds (ETFs), mutual funds and other vehicles. Further, an IPS will establish a target asset allocation for the portfolio. It will take into account the investor’s time horizon for the money and their risk tolerance. There should be criteria for selecting investments to be included in the portfolio and also criteria for replacing investments.

An IPS for an individual client should be an extension of their financial plan. The reason(s) for their portfolio should be reflected such as saving for college and retirement and should reflect the client’s goals in terms their time horizon, as well as the level of returns that need to be targeted to achieve those goals. Their risk tolerance and the amount already saved for those goals. This will lead to the establishment of a target asset allocation and the types of investment vehicles to be used.

Generally, the target allocation will include a range. For example, large-cap stocks might have a target allocation of 20% with an acceptable range of 15% to 25%. In other words if the actual percentage of large-cap stocks is within the range there is no need to rebalance that part of the portfolio. Criteria to select, monitor and replace the investment vehicles should be outlined. These might include performance relative to their peer group, costs, changes in management (for ETFs and funds) and other relevant criteria. These criteria should be the basis of period portfolio reviews with the client. There should be a benchmark to enable the client and financial advisor to track the portfolio’s returns.

In the context of a 401(k) plan, an IPS serves a similar but slightly different purpose. Financial advisors working with 401(k) plan sponsors should draft an IPS for the plan as one the first things they do. An existing plan may have an IPS in place and if so the advisor should review this document and make revisions (or start from scratch) as needed. The overriding reason that a 401(k) plan sponsor needs an IPS is for fiduciary protection. The IPS should document an investment process that will be followed by the sponsor in conjunction with their financial advisor to manage the plan. The periodic investment committee meetings should document what transpired and how decisions made reflect the IPS process. In light of recent 401(k) court cases this is even more important than ever.

The IPS should state the purpose of the plan, which will be along the lines of providing a retirement savings vehicle for the organization’s employees. The types of investment vehicles that will be used should be outlined. These could include mutual funds, collective trusts, stable value funds and managed accounts, such as target-date funds or risk-based options. The asset classes to be offered should be spelled out as well.

The IPS should discuss how often the investment committee will meet to review the plan and who the plan’s service providers are. It should indicate that these service providers will be reviewed periodically. The IPS should also specify the criteria that will be used to select, monitor and to replace the investment options used in the plan. These might include relative performance of the mutual funds as compared to their peers, a change in fund management, a pronounced increase or decrease in assets under management or a change in the fund’s investment style. Investment expenses should also be noted as a major factor here as well.

While it may sound like a 401(k) IPS is for the benefit of the plan sponsor and mitigating their fiduciary liability, a 401(k) plan that follows a well-conceived IPS will invariably provide a better retirement savings vehicle for the plan’s participants then one that doesn’t have an IPS.

The IPS for a pension, foundation or endowment in some respects will be similar to an IPS for an individual client. In other aspects it is like an IPS for a 401(k) plan in that all service providers and plan information should be listed. There is generally a single portfolio and there will be a goal(s) for that portfolio. In the case of an endowment or foundation it will likely be to fund all or a portion of the operations of the educational institution or non-profit organization. In the case of a pension the goal will be to provide benefits for the beneficiaries of the pension plan and to meet actuarial funding requirements.

There will be criteria for the section, monitoring and replacement of investments. A target asset allocation should be included as should a target rate of return. For endowments and foundations there should be language regarding the target level for annual withdrawals. In some cases there may be restrictions listed as to areas available for investment. For example, a Catholic organization may want to refrain from investing in companies that sell birth control products.

There needs to be monitoring criteria for the investments and for the portfolio’s returns based on an agreed upon benchmark. The IPS and the investment process outlined provide a level of fiduciary protection for pension plan sponsors and the investment committees of endowments, foundations and other non-profits.

An Investment Policy Statement is an excellent tool for financial advisors to create roadmap, a game plan if you will, to manage client portfolios. Though the format may vary a bit, an IPS is equally applicable for individual clients, 401(k) plan sponsors and other institutional clients such as pension plans, foundations and endowments.