An Investment Policy Statement (IPS) is an essential tool in helping plan sponsors develop and follow a fiduciary governance program. As a best practice, a good fiduciary governance program has an established process, ensures the process is followed, and documents each step in the program. The purpose of this article is to help plan sponsors understand what actions need to be taken before adopting an Investment Policy, why a Policy is necessary, what to include in it, how to effectively use it, and what pitfalls to avoid. It is our firm’s opinion that plan sponsors that follow these steps will be better prepared from a fiduciary governance standpoint.
The Fiduciary Role
First, it is important to review why fiduciary governance is so important. “Fiduciary” is derived from the Latin word, fiduciarius, which means to “hold in trust”. Plan sponsors “hold in trust” the retirement assets of the defined contribution and/or defined benefit plans for which they are responsible for overseeing. The Employee Retirement Income Security Act (ERISA) of 1974 requires that fiduciaries, such as the Committee members who make decisions about the plans, engage in a prudent process to manage and monitor their retirement plan or plans. As such, plan sponsors are bound to uphold their fiduciary duties as specified by ERISA.
ERISA is very clear that a fiduciary is to act exclusively in the best interest of plan participants and their beneficiaries. Therefore, all fiduciaries involved need to be aware of this when making plan decisions. There are other key fiduciary considerations as well such as: ensuring plan assets are diversified; understanding fee structures and paying only reasonable expenses; avoiding conflicts of interest; selecting and monitoring investment managers and service providers; and acting with the necessary skill, prudence, and due diligence. A well written Investment Policy Statement can go a long way in guiding an Investment Committee in meeting its fiduciary duties.
Pre-Investment Policy Statement Steps
As a best practice, before an Investment Policy Statement is drafted, one of the first things an organization should do (if it has not already been done) is to formally authorize the formation of the Investment Committee. This can be done through a board resolution or similar authorization establishing the Committee and granting its power to oversee and take action on the retirement plan or plans.
Once this has been established, an organization should consider drafting a Committee Charter. The Charter defines the structure, roles, and responsibilities of the Committee. It should emphasize levels of accountability, lines of authority, and responsibilities of the members as they relate to one another and the Investment Policy Statement. A well written Charter will detail items such as what organizational positions will be included as membership on the Committee, how often it shall meet, and the specific duties of the Committee and its members.
Once these two actions have been completed, an Investment Policy Statement can be developed to set forth the guidelines for the Committee. As a matter of preference, the Charter can be incorporated into the IPS. However, the Charter is a document of structure, setting forth the roles of the Committee, and the Investment Policy Statement is a document of process, setting forth the guidelines on how those duties are to be executed.
Why an Investment Policy Statement is Necessary
The most direct answer to why a plan sponsor needs an Investment Policy Statement is to demonstrate it has established a set of guidelines for following a prudent, fiduciary process. The official establishment of the Committee, followed by the adoption of a Charter, and then finally the adoption of an Investment Policy Statement is an exercise of due diligence, and one necessary for fiduciary protection.
Fiduciaries will face more scrutiny for the process or lack thereof that led to a decision versus the outcome of the actual decision. It cannot be overemphasized, acting in a fiduciary manner is about the process involved in decision-making and properly documenting the decision. The Investment Policy Statement supports this process and if applied consistently substantiates that a prudent process has been followed.
What to Include in the Investment Policy Statement
An Investment Policy Statement should be written in way that it is specific enough for Committees to fulfill its duties, but broad enough to provide a Committee with latitude and deference in making decisions. It needs to avoid ambiguity whenever possible so it is not only clearly understood by current Committee members, but future members, as well as outside parties. It should be able to stand the test of time, but will be subject to revision from time to time as objectives and/or regulations change.
At a minimum, a well written IPS should include the following:
- Background Section: This may include information on the establishment of the Plan and it may also reference the formation of the Committee through a resolution and/or mention the Charter.
- A Purpose Statement: This should give the Committee clear direction in what it will oversee and how it will carry out its duties. For example, the Committee will be responsible for selecting and monitoring investment options. Or if it is for a participant-directed plan such as a 401(k) it may reference intent to comply with ERISA Section 404(c).
- Guidelines for Fund Selection and Termination: This section should list the criteria the Committee will use to evaluate adding or removing funds. It is important to note that factors used in the evaluation process cannot capture everything or all scenarios so language should be specific, but written in a way to still afford the Committee latitude in decision-making.
- Monitoring of Investment Options: This section should describe the frequency and factors used in the monitoring process. The criteria used in the monitoring process should be consistent with the criteria for adding or removing funds. A best practice is to list the peer group and index used for benchmarking and evaluating each fund in the IPS.
- Investment Policy Statement Review: It is important to include a statement on how often the IPS is formally reviewed.
- Asset Allocation Targets: For a defined benefit plan, a list of the target asset allocation percentages, how often the asset allocation will be reviewed for rebalancing, and what triggers a rebalancing event should be stated. The clearer an IPS is, the easier it is to follow and document a prudent process.
Effectively Integrating the Investment Policy Statement with Committee Functions
The IPS should be integrally linked with Committee activities. When a Committee gathers to meet to review the plan it should do so based on the guidelines in the IPS. Then it can be documented in the meeting minutes proving that a prudent decision-making process has been followed by the fiduciaries.
One of the many fiduciary duties to uphold is the selection and monitoring of investments within the retirement plans. A recent Vanguard study found that making investment decisions was the top issued faced by Committees. To help illustrate how to do this effectively, consider the following hypothetical scenario:
- A Committee’s Investment Policy Statement requires investments to be reviewed four times per year.
- In the Committee’s first quarterly meeting, a manager change in the ABC Fund is reported.
- One of the monitoring criteria in the IPS is organizational change, so the Committee decides to put the fund on the watch list for additional review at the next quarterly meeting.
- At the next quarterly meeting, the Committee learns that the new manager of the ABC fund will be changing the investment strategy from growth to value.
- Therefore the Committee decides to conduct a search to replace the fund with another growth option because the plan already has a different value option.
- At the third quarterly meeting, the Committee reviews replacement alternatives for the ABC Fund and decides on the XYZ Fund.
- All of this is documented in the meeting minutes.
In this scenario, the Committee had a process outlined in the Investment Policy Statement, then followed that process, and documented the results.
Since investment monitoring is a large portion of meeting time, a best practice is to have investment monitoring reports directly linked to the IPS. If the IPS states that investments are measured versus a specific index and/or benchmark, any investment monitoring report should reflect this. If there is a discrepancy, the IPS or investment monitoring report needs to be modified to be consistent.
Another best practice to demonstrate adherence to the Investment Policy Statement is to have an executive summary in an investment monitoring report that directly states how the investments performed in relation to the IPS criteria. For example, if a fund failed certain criteria and needed to be put on a watch list, it would be documented in the investment monitoring report.
Then this is further memorialized in the meeting minutes. At the following meeting, this fund should again be documented in the investment monitoring report executive summary and noted in the minutes. If this is done in a consistent manner, it will clearly demonstrate that an IPS was in place; the Committee followed the Policy and took appropriate action, if any.
Pitfalls to Avoid
As important as it is to have one, an Investment Policy Statement can be a document that exposes plan sponsors to unnecessary fiduciary risk. Therefore, it is important to be mindful of pitfalls to avoid. This is not an all inclusive list, but it represents pitfalls commonly found in Investment Policy Statements.
- Failing to Comply with the Policy: The most important pitfall to avoid is having written policies within the Investment Policy Statement that are not being followed. If it states that the Committee meets quarterly to review investments, it should not be meeting only semi-annually.
- Overly Restrictive Language: For example, if Policy language states that a fund needs to be removed if it falls below the peer median for the five year trailing return period for two consecutive quarters. A fund that falls below the peer median over a five year trailing return period will probably remain so for more than two consecutive quarters as one calendar year of severe underperformance can weigh on this metric. Determining if these funds should be removed or not should not hinge on one factor within IPS monitoring criteria, but rather allow the Committee the ability to review multiple factors and then make a determination for a cause of action.
- Lack of Specific Language When Necessary: For example, pension plans have target asset allocation percentages in various asset classes. However, not including rebalancing triggers for a pension plan or similarly, having rebalancing language that is unclear will cause issues as well. There are sections of an Investment Policy Statement that need to give the Committee some discretion, but there are other sections that need to be specific and non-discretionary. Determining which sections fall into these categories is something each Committee needs to address.
- Review Process Inconsistent with the IPS: For example, if the IPS lists specific indexes and peer groups to monitor investments it is important that investment monitoring reports includes these indexes and peer groups. A plan sponsor would not be meeting the IPS criteria if the XYZ Fund is stated to be benchmarked to the large blend peer group and the S&P 500 Index, but instead is monitored against the large growth peer group and the Russell 1000 Growth Index.
A well crafted Investment Policy Statement should make carrying out fiduciary duties easier. The IPS should be written in a way that the Committee understands it and can use it effectively to meet its fiduciary duties. There are no definitive rules to length or format for an IPS. Therefore, with so many ways to create an IPS, plan sponsors should consider relying on outside experts such as consultants and attorneys to develop a Policy that meets their needs.
The best way to reduce fiduciary liability is to have a process, follow it, and then document it. The IPS is one part of the fiduciary governance process and one of the first building blocks of an effective fiduciary governance program. Hopefully after reading this article it will have confirmed the strength of your current Investment Policy Statement or highlighted areas of possible improvement.
 fiduciary. Dictionary.com. Online Etymology Dictionary. Douglas Harper, Historian. http://dictionary.reference.com/browse/fiduciary (accessed: September 19, 2011).
 Stockton, Kimberly A. “Investment Committee Decision-Maker Study”. The Vanguard Group, Inc. 29 September 2009.https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvResSurveyResults (accessed September 29, 2011).