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How to Construct an Appropriate Investment Policy Statement in 9 Easy Steps

October 06
21:28 2009

What worries individual trustees and fiduciaries most? After achieving sustainable viability for their organization, individual trustees and fiduciaries – whether they be plan sponsors for corporate retirement plans or directors for not-for-profit endowments – most worry about their responsibility for investing institutional funds – and the inherent fiduciary liability such duty brings. Constructing an appropriate investment policy statement (IPS) – one that truly unites the corporate vision and mission with the investment objective – represents the best method to alleviate this concern.

What is an ‘Appropriate’ IPS?
There exists at least one codified framework legislated to provide individual trustees and fiduciaries with some liability protection. Many states began passing some form of the “Prudent Investor Act” more than ten years ago. In addition to these state laws, corporate retirement plans fall under the jurisdiction of ERISA, regulated by the federal Department of Labor.

A written IPS can act as the cornerstone to regulatory and legal compliance. With this written IPS, the fiduciary has documented the justification of the appropriateness of the institution’s mission and investment objectives. From this, the fiduciary can better evaluate and monitor the institutional fund’s investment performance. Therefore, the objectives of an ‘appropriate’ IPS include:

• State the Institution’s Vision and Mission Statements
• Insure the IPS is consistent with the institution’s corporate goals
• Provide the Fund’s mission statement
• Avoid the most common mistakes of Modern Portfolio Theory
• Be thoroughly documented and clearly written and understood by all interested parties
• Include Procedures for Trustees’ Education
• Accommodate all other interested parties (if any)
• Provide meaningful objectives
• Properly address risk and the institution’s demographics
• Identify a method of evaluation
• Be reviewed and updated periodically

How to Create a Structure for the IPS
We can assimilate the above in an intuitive, easy-to-understand table of contents. We’ll break these down and follow each with a brief explanation of how to create them. Bear in mind, this process involves a substantial degree of due diligence and should be completed with the help of your fiduciary consultant.

I. Objective of IPS
This can be as simple as incorporating some form of the above paragraph “What is an appropriate IPS” as modified to meet the needs of the specific institution. For example, if there are specific regulatory criteria the plan must address, it should be stated here.

II. Statement of Corporate Vision
The components of corporate vision fall into three categories. These refer to those elements that define the rigid parameters within which the institution maneuvers as it seeks to achieve its corporate legacy. Fiduciaries must fully understand these rigid parameters before they can even begin to define the Fund’s mission statement and its IPS. Typically, this section would include: 1) a brief paragraph describing the institution; 2) a list of the institution’s core values and beliefs; 3) a statement as to the institution’s overall purpose (i.e., its ideal role in society); and, 4) a statement of the mission of the institution (i.e., its tangible goal). The tangible goal(s) derived from the mission statement is used to identify the Investment Objectives and Method of Due Diligence in Sections V and VI below.

III. The Fund’s Mission Statement
Unlike the Corporate Mission Statement, which usually identifies dollar denominated financial goals and needs, the mission statement of the investment portfolio contains broader language as to the general intent of the fund and its investments.

IV. Summary of the Fund’s Vital Information
Here we list all the key individuals, including trustees, advisers and service providers, of the institution as they pertain to the investment portfolio. In the specific case of retirement plans, we’ll also include plan demographics.

V. Outline of Investment Objectives

The IPS now begins to define the broader investment objectives that will permit the portfolio to accomplish its stated mission. First and foremost, the fiduciary must determine if a “Total Return” or “Assigned Asset” methodology will be used. The Total Return method utilizes the entire portfolio to meet a financial goal. The Assigned Asset method assigns a specific portion of the portfolio to meet a specific goal. This section then outlines meaningful investment objectives that seek to accommodate all constituencies. These broadly defined objectives must outline and address the issues identified above.

In general, the Investment Objectives will consist of differing weights of the following standard objectives:

  1. Wealth Accumulation (usually receives a higher weighting)
    This Investment Objective is appropriate for investors wishing to grow assets over time. It implies a long-term time horizon. As such, it places long-term growth at a higher priority than reducing short-term volatility.
  2. Wealth Preservation (usually receives a lower weighting)
    This Investment Objective is appropriate for investors wishing to begin using assets in the very near future. It implies a short-term time horizon. As such, it places a greater emphasis on reducing short-term volatility rather than long-term growth.
  3. Wealth Distribution (commonly used in specific circumstances)
    This Investment Objective is appropriate for investors who seek to implement an asset distribution plan over time. The time period may be short-term or long-term. As such, this goal typically incorporates elements of Wealth Preservation depending on the exact nature of the distribution plan.

Finally, the IPS should explicitly state how it plans to satisfy some of the more common negative issues surrounding Modern Portfolio Theory. Because much of the industry still commits these mistakes, the fiduciary should pro-actively address them through the IPS. For example, many academics now acknowledge the use of standard deviation (or similar statistical models) as a measure of risk may be no longer appropriate.

VI. Method of Due Diligence and Evaluation
The IPS must define the specific criteria used to determine specific qualifications and evaluation parameters of the investment adviser. The Corporate Mission will typically identify cash flow assumptions. The fiduciary, often with the help of the fiduciary consultant, uses this data to calculate the portfolio’s Goal-Oriented Target (GOT). Portfolio management and evaluation must then be conducted to conform to this GOT. The institutional portfolio’s GOT is often a much better evaluation benchmark than industry indices or averages, which too often rely too heavily on relative performance (as opposed to the absolute needs of the institution).

VII. Trustee’s/Fiduciary’s Education Plan
It is generally a good idea to formulate a plan to provide ongoing education to individual trustees and fiduciaries. The fiduciary consultant can provide this service.

VIII. Plan for Other Interested Parties
The institution might have other interested parties (e.g., employees in a retirement plan or beneficiaries in a not-for-profit endowment) that will have needs that are appropriately addressed in the IPS.

IX. Compliance Review Plan
Lastly, the IPS should delineate a Compliance Review Plan taking into consideration the specific circumstances of the particular institution for which it is written. This section will address three areas: 1) the Annual Review of the IPS; 2) a Service Provider Analysis; and, 3) a Compliance Review and Audit. The degree of specificity of each of these areas will depend on the nature of the institution and the regulatory environment in which it exists.

Summary and Conclusion
Creating an appropriate Investment Policy Statement should not intimidate any individual trustee or fiduciary. The process represents a structured methodology meant to comprehensively address the fiduciary concerns of an individual who may or may not be a financial expert. Indeed, the end result of the process leads to the delegation of that duty – and at least a portion of the fiduciary liability – to a professional specifically trained for such services.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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