The Best IPS
Adviser John Pickett is dumbfounded that, in this day and age of heightened plan litigation, he still comes across retirement plans without investment policy statements (IPS). “I am forever amazed that I come across substantial plans of $100 million plus without them, or not following them, or have them and can’t find them,” says Pickett, a Senior Vice President at RBC Dain Rauscher, in Dallas, Texas An IPS is a must for all retirement plans, but all too often forgotten. Overall, 72.6% of plans have a written IPS for their defined contribution plan and, according to the 2007 PLANSPONSOR Defined Contribution Survey, plans with less than $5 million in assets are least likely to have a written IPS, (only 53.2% of micro-plans surveyed have a written statement).
Even if an IPS does exist, it might be out of date and/or not followed. Whether or not a plan sponsor has let an IPS fall into disuse, it is often up to the adviser to help get the statement back in order. Preparation and maintenance of the investment policy statement is one of the most important functions performed by an investment adviser, says Don Trone, President of the Foundation for Fiduciary Studies in Moon Township, Pennsylvania. A well-written IPS, says Trone, will address how each of the fiduciary practices will be fulfilled; it’s the business plan that outlines how the fiduciary is going to fulfill all of its fiduciary roles and responsibilities.
Why Have an IPS?
The main objective of an IPS is to outline the processes that a plan sponsor will use in selecting and monitoring plan investments or investment options. “It is the road map by which the plan sponsor operates the plan,’ says Pickett. It also facilitates relations between an adviser and client. “A well-drafted investment policy statement serves as the business plan for all fiduciary practices associated with a client engagement,” says Trone.
The main reason for having an IPS is the plan sponsor’s fiduciary duty under the Employee Retirement Income Security Act (ERISA) to prudently select and monitor investment options, says Scott Revare, Chief Executive Officer at the Center for Fiduciary Management LLC in Overland Park, Kansas. “The IPS demonstrates that the plan sponsor has thoughtfully developed a plan for selecting investments and investment retention in accordance with ERISA,” he says.
Despite the fact that there is no legal requirement in the ERISA statute for a written document, sponsors without one do so at their own risk, since ERISA has been interpreted by one court as requiring fiduciaries to act as though they have one. A federal district court found that the lack of an IPS was a breach of the prudent man rule in ERISA section 404(a). Essentially, the judge found in Liss v. Smith (S.D.N.Y. 1998) that “a policy [an IPS] is necessary to ensure that the plan investments are performing adequately and meeting the…needs of the [plans]…the absence of such a policy coupled with other acts and omissions by the trustees…, constituted a breach of fiduciary duty.” Although courts outside New York are not bound to follow this ruling, it does provide a warning.
Pickett notes that, even though there is no legal requirement for a written IPS, every time the Department of Labor audits his clients, it asks for the IPS. “You don’t go into business without a business plan, you don’t go into a football game without a game plan, and you don’t operate a retirement plan without an investment policy statement,” he says.
Furthermore, adds Trone, the IPS protects clients from “market noise.’ For example, he says, if there is a bull market in dot.com stocks, clients may pressure an adviser to purchase such stocks. Or, if there is a market correction, the client may want to sell stock at the bottom. The IPS, says Trone, anchors a plan to an investment strategy so that the client is less prone to react to market fluctuations.
A well-drafted IPS also can protect the adviser, in addition to the plan sponsor. Among other things, says Trone, the IPS memorializes discussions with clients as to how the plan is to be run “However, if you put it in writing and don’t follow through, it could expose an adviser to more liability,” he warns. If the adviser is a co-fiduciary, then the adviser also is responsible for the selection and monitoring of investments, notes Revare, so the IPS could protect the adviser from being found liable should a lawsuit be filed by participants. Of course, some argue that an investment adviser to a plan is always a fiduciary.
What It Should Say
As with everything, different fashions for IPS documents cycle in and out of favor. Up until several years ago, says Revare, the trend was to have IPS language be nonspecific so that it was easier to follow. However, as plans were subjected to more scrutiny and more attention was paid to investment options, the trend changed and the trend now is to have very specific language as to the monitoring and terminating of investment options, he says. The problem with providing more specific plan objectives and measurement criteria, says Revare, is that you provide a way to specifically identify whether the IPS is being followed or not. By leaving things fuzzy, plan sponsors had more leeway to say they were following their IPS, he says.
In drafting the IPS, the adviser should ask the sponsor questions so that the policy meets the sponsor’s specific needs, says Pickett. His firm uses a checklist of questions. “I really feel that an adviser/consultant should listen and let the client talk. Talk to the client and do not come in with a boiler plate IPS. It’s a lot more work, but then the plan sponsor has ownership of the policy,” he says.
If an IPS is well-crafted, says Trone, any competent third party should be able to implement it. There should be enough detail, he says, that, if handed over to another investment adviser, that adviser should be able to implement with no additional questions. “The IPS will only be a meaningful document if there is a clear understanding of the client’s goals and objectives by the adviser and the client comprehends the investment strategy that the adviser is considering,” says Trone.
A well-crafted IPS should have a long shelf life as well. So, although detail is important, too much could be a bad thing. It may be prudent to put details likely to change frequently in an appendix and not the body of the IPS, says Trone. “You don’t want anything so specific to an investment option or provider that, if it changes, the IPS needs to be changed,” agrees Pickett.
For example, while the body of the IPS could state that a 401(k) plan will include a large-cap growth fund as an asset class, the name of the specific fund should be in the appendix. “Because of periodic changes to the lineup, it’s easier to amend the appendix rather than the IPS body,” says Trone.
Pickett explains further: In benchmarking performance an IPS should say “the investment is expected to perform above the appropriate passive index and/or median of its peer group” as opposed to spelling out the index in the policy. As there are several indexes investment managers can use for small-cap growth, for example, he says a plan should benchmark the manager’s performance against the index the manager uses in construction of the portfolio. Pickett also recommends against referencing a provider’s specific product. For example, stating the default is the age-appropriate target-date fund instead of saying age-appropriate Fidelity Freedom Fund.
The main purpose of an IPS is to provide overall guidelines for investments and the selection of investment options. Therefore, investment strategies should be spelled out clearly, and asset-allocation decisions reflected, if the plan is a defined benefit plan.
An IPS should identify the requirement for provision of lifecycle funds if that is what the plan sponsor desires, says Revare. The rub is how lifecycle funds are evaluated for selection and monitoring. Criteria to evaluate lifecycle funds usually need to be different from criteria for asset class-specific funds, says Revare, and what criteria to use are currently being debated. “This is where leaving things a little less specific might be to the plan sponsor’s advantage,” he says.
Monitoring of target-date funds can and should be very involved, says Pickett. First, he says, comparing returns of like ending-date funds tells very little, because all 2030 funds are not similar in asset allocation, asset class diversification, or investment history, among other characteristics. Instead, Pickett suggests, examine the following points for each specific ending date of a target-date series: stock, bond, and cash mix compared to a universe of target-date funds of the same ending date. Asset-class allocation including alternatives such as TIPS, emerging market equity and fixed income, real estate, high yield, hedge funds and other alternatives also can be examined.
Underlying funds, says Pickett, should be examined not only for performance but also portfolio characteristics in order to understand if each fund is adding diversification or overlap. Additionally, he says, some fund families have experienced a great deal of manager turnover in the underlying funds in the last few years. The plan sponsor needs to be monitoring these changes, he says, as well as monitoring the changes the provider makes to the glide path and underlying funds.
In particular, the IPS should detail the processes of investment selection, monitoring, and termination, says Revare. A defined contribution plan IPS should provide for an appropriate mix of investments so that employees can meet their investment objectives as well, says Trone. Additionally, the processes for reporting of investment returns also should be in the IPS.
An IPS for a 401(k) plan also always should define what the qualified default investment alternative (QDIA) (see “Choose Your Designated Hitter,” page 62, and “Default Vault,” page 71) is for any participants who do not select their own investment options, says Pickett. This is particularly important in the wake of the Pension Protection Act, he says.
Advisers may need to consider time horizon in putting together a long-term investment strategy for the plan, notes Trone. For example, he says, the IPS for a small medical office profit-sharing plan with one doctor retiring in five years needs to take into account that a big chunk of money will come out of the plan. Otherwise, he says, a fire sale of securities to pay out the retiring doctor could drive down the account balances of the remaining participants. Similarly, in planning the time horizon for larger defined contribution plans, advisers should review participant demographics. If demographics are older, the IPS should call for more fixed income and stable value options. If younger, then more equity, he says. It’s very consistent with lifecycle funds, says Trone, which are going to reduce equity exposure as the participant base nears retirement. Trone advocates diversification; he says that it’s just the number of funds per broad asset class that are being made available to participants. For example, if a sponsor with an older participant base wanted to provide participants with 10 funds, it should offer more fixed-income funds than equity.
A well-crafted IPS also always should include several other important sections. For example, the IPS should detail the roles and responsibilities of all parties involved, including the investment manager, adviser, recordkeeper, and actuary, says Trone. An IPS also should outline how proxies are to be voted, and have provisions on how often the IPS will be reviewed, says Pickett. It is also prudent to have a section on how fees and expenses will be monitored, adds Trone.
Additionally, Trone says that it may not be a bad idea to spell out the types of share classes that are to be used. Pickett, however, takes a different view. “We would not specifically state the type of share class, as some funds will not offer all classes,” he says.
Once the IPS document is created, the plan sponsor and adviser need to implement and oversee investments in accordance with the statement. Once implemented, the IPS should be reviewed annually, say Trone and Pickett, and more often if facts and circumstances dictate it. For example, any time there are changes to ERISA or the plan, the IPS language should be reviewed, says Revare.
Most importantly, once a good IPS is in place, the main objective should be to actually follow it. “It sounds simple, but one of the biggest problems with an IPS is that it often is not followed,” says Revare, and that can open the sponsor (and possibly the adviser) up to potential liability under ERISA. “The only thing worse than not having an IPS is having one and not following it,” agrees Pickett.