FINC Investments - Investment Policy Statement

benefits magazine december 201128

Leading the Way:

by | Brian D. Frick and Greg Coffey

A Clear Investment Policy Statement

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An investment policy statement is a plan-specific document designed to address the overall policies that govern investment-related activities of a pension plan.

F ollowing the credit and liquidity crises of 2008, multiemployer plans have been reexamining their asset allocation, plan liquidity and best practices with regard to fiduciary governance standards. Risk manage- ment and good governance practices have taken center stage as many plans struggle with fewer resources, funding levels and funding im-

provement or rehabilitation plans. Central to the idea of good governance throughout an investment program is

an investment policy statement (IPS). This article summarizes what an IPS is, the elements it should include and why it is important for multiemployer plans to have a well-defined governing document.

What Is an Investment Policy Statement? An IPS is a plan-specific document designed to address the objectives, con-

straints, unique circumstances and overall policies that govern invest- ment-related activities of the pension plan.

The document should set forth clear responsibilities for all par- ties involved in the investment program—the board of trustees,

investment committee, investment advisor/consultant, invest- ment managers and custodian.

A well-constructed IPS will present the plan’s financial objectives within the context of how much risk the trustees are willing to take on. The long-term strategic asset alloca-

tion of the portfolio should be detailed to help ensure that the portfolio is invested in accordance with the plan’s

long-term goals. The IPS should also set operational guidelines for constructing a portfolio to carry out the investment strategy.

Lastly, the IPS should set forth rules for monitoring and reviewing all facets of the investment program.

Constructing an IPS should be a dynamic pro- cess. While changes should be infrequent, the docu- ment needs to be reviewed on a regular basis to en-

sure that it is current and that all of the language is still appropriate. During the design process or review,

an investment committee should seek input from trusted plan advisors. Working with an investment consultant or ad-

visor can help identify additional risks and issues that may not be top of mind for committee and board members.

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Drafting an IPS should be an educa- tional process. Working through issues in the design process can help identify weaknesses in the committee’s current risk management structure and refine the setting of objectives, potential in- vestment strategies, and contribution and benefit policies. The result should be a portable document easily understood by all interested parties. (For example, if the plan hires a new investment man- ager or consultant, it should not require changes to the IPS solely because a new party is involved.) Finally, the document serves to protect all parties named in it. If a certain practice or investment strat- egy is subsequently questioned, the IPS can provide clarification.

Why Is an Investment Policy Statement Important?

A clear, well-defined IPS is impor- tant to the success of a multiemployer plan, as it plays a vital role in the overall governance structure of the fund. Well- defined objectives help ensure that the purpose of the fund can be achieved. Clearly defined objectives set forth in the IPS can help in the determination of appropriate asset allocation, to help ensure that future benefit levels aren’t impacted because of a drop in plan as- sets. In addition, by identifying the po- tential risks the pool of assets may face, the trustees will be in a better position to manage risks as they arise.

The IPS helps define all associated parties and their responsibilities. When all parties clearly understand their roles, they’ll likely spend less time in com- mittee meetings figuring out who is re- sponsible for which action item. That time can be devoted to more productive activities, such as managing the benefit and contribution structure of the plan.

Setting the target asset allocation, along with appropriate minimum and maximum allocations to individual as- set classes, is vitally important in the IPS; doing so will help ensure that the portfolio is invested in accordance with the plan’s long-term objectives even during times of market uncertainty.

The IPS should help to remove emo- tions from the investment process in times of market stress, when individu- als are more likely to act emotionally. With the collapse of Lehman Brothers in September 2008 and the correspond- ing financial market downturn, some plans concerned about a continued drop in portfolio values contemplated moving to 100% cash. While such a move may seem to be a good strategy during a market collapse, cash does not rally when the equity and bond markets

turn around. A committee with a poorly designed IPS—or none at all—might have found it perfectly acceptable to move to cash despite straying signifi- cantly from its long-term strategic as- set allocation. However, the commit- tee with a well-defined IPS would not make such a move easily, as doing so would violate its own guidelines.

Vital Elements of an IPS Depending on the level of detail,

an IPS can range in length from a few pages to a much longer document. The contents will differ based on the specific needs of each plan; however, every well- written IPS should contain certain ele- ments: purpose and scope, definition of duties, objectives, investment strategy and asset allocation, unique circum- stances, monitoring and review process,

Brian D. Frick, E.A., is a senior client executive for Russell Investments’ Americas institutional business. He is responsible for assisting clients with investment issues relating to defined benefit and defined contribution plans as well as endowments, foundations and other not-for-

profit organizations. Frick works with clients in the development of appropriate investment policies, performance measurement criteria and long-term strategic asset allocation parameters. Frick holds a B.S. degree in mathematics from Santa Clara University. He is an enrolled actuary, an associate of the Society of Actuaries and a member of the American Academy of Actuaries.

Greg Coffey, CFA, is a client service manager for Russell Investments’ Americas institutional business. Based in Seattle, he assists clients with investment issues relating to defined benefit and defined contribution plans, as well as endowments and foundations and other not-for-profit

organizations. Coffey provides Russell’s direct investment management clients with investment reviews, performance evaluations, investment objective setting, asset allocation advice and development of appropri- ate investment policies. He holds a B.S. degree in finance from Seattle University.

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and an appendix with a strategy statement for each permis- sible asset class.

Section 1: Purpose and Scope Typically, the first section in an IPS is “Purpose and

Scope.” It provides a broad overview of the material in the IPS. It should include the general objectives of the plan and broadly state the scope of the document and which roles the investment policy covers. This section should also include some language on fiduciary duty. Generally, there will be lan- guage stating that committee members should exercise pru- dent and appropriate care in accordance with the Prudent Investor Rule of the Employee Retirement Income Security Act of 1974 (ERISA), and that all actions taken by the com- mittee should be in the best interests of the beneficiaries.

Section 2: Definition of Duties It is important for the IPS to clearly state the duties of all

involved parties, so that they may fulfill their duties effec- tively. At a minimum, the parties should be listed and their duties described. Examples of these duties are:

• Board of trustees: The board has the ultimate fiduciary responsibility for the multiemployer fund’s investment portfolio. The board is responsible for ensuring that appropriate policies governing the management of the portfolio are in place and that they are implemented. Typically, the board sets and approves the IPS and del- egates responsibilities to the investment committee for implementation and ongoing monitoring.

• Investment committee: This committee is responsible for implementing the investment policy. Typically, the investment committee is responsible for approving in- vestment strategy; hiring investment managers, the custodian and investment consultants; and monitoring portfolio performance on a regular basis (quarterly, at a minimum) to ensure compliance with investment policy.

• Investment managers: The duty of the investment man- ager is to implement the strategy for which it has been retained. For example, a large-cap growth manager would be responsible for investing in large-cap growth- oriented stocks. It is the responsibility of the investment committee to ensure that investment managers remain in compliance with the investment policy.

• Investment consultant: An investment consultant is re-

sponsible for assisting the investment committee in all aspects of managing and overseeing the plan’s invest- ment portfolio. At a minimum, consultants should provide asset allocation advice, help with manager se- lection, provide portfolio-level performance reports, review current managers, monitor the overall health of the plan and provide investment committee education. At a minimum, an investment consultant should be hired as a fiduciary per ERISA Section 3(21).

• Custodian: A custodian is a financial institution respon- sible for safeguarding the assets of the plan. The custo- dian is also responsible for the settlement of securities bought and sold, collecting dividends and interest pay- ments from the securities held by the plan, and admin- istering corporate actions on securities held, such as stock splits and dividends. The custodian also typically provides monthly and annual accounting reports and disburses funds for the plan’s benefit payments.

• Implemented consulting provider: A growing trend in pension fund management is plan sponsors hiring orga- nizations to assume more discretion on behalf of the trustees in managing the plan’s assets. In addition to pro- viding consulting services, the company retained is given discretion and is responsible as a fiduciary per ERISA Section 3(38) to hire and terminate managers, rebalance the fund’s assets per the IPS guidelines, manage the fund’s day-to-day operational needs and, in some cases, accept a fiduciary role for custody duties. If the trustees elect to move in this direction, the IPS should clearly state what areas of discretion will be assigned and the constraints around the discretion being assigned (e.g., see rebalancing guidelines in Section 4).

learn more >> Education Investments Institute April 23-25, 2012, White Sulphur Springs, West Virginia For more information, visit www.ifebp.org/investments.

From the Bookstore Multiemployer Plans: A Guide for New Trustees, Second Edition by Joseph A. Brislin. International Foundation. 2010. For more details, visit www.ifebp.org/books.asp?6733.

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Section 3: Objectives Every IPS should clearly state the

investment objectives of the portfolio. Clearly defined objectives will help set the investment strategy and strategic asset allocation. One of the key ele- ments in these objectives is a statement of the rate of return the plan would like to achieve over a market cycle. While it is plan-specific, for many plans this rate of return should be large enough to cover the annual benefit payments; pay expenses incurred by investment managers, consultants, the custodians and other plan professionals; and keep pace with inflation. For a multiemployer plan, this rate of return will often match the assumed rate of return set by the plan’s actuary.

Other items worth mentioning in the objectives include:

• Any portfolio liquidity require- ments

• Time horizon of the pool of as- sets

• Any additional constraints the fund may face that could inter- fere with its objectives.

Section 4: Investment Strategy and Asset Allocation

Once the overall objectives of the plan are clearly defined, the broad in- vestment strategy can be broken down to more specific detail and the long- term strategic asset allocation defined. This is usually accompanied with lan- guage dictating that a comprehensive review of current and projected finan- cial requirements will be considered in setting the investment strategy. It is important in this section to acknowl- edge that although investing is risky, the committee will create a strategic as- set allocation that attempts to manage risk through asset class selection and diversification.

Once the strategy is detailed, it is important to define which asset classes will be used in the strategic asset al- location. These could include equities, fixed income, hedge funds, real estate, other alternatives, etc. In making asset allocation decisions, best practice is to include language declaring that while asset allocation should be monitored regularly, frequent changes in response

to subtle changes in the financial mar- kets are not expected.

The investment committee is tasked with developing and adopting guide- lines for broad allocation on a long- term basis. In setting the asset alloca- tion, it is appropriate to develop ranges around asset classes so that minor tac- tical shifts can be made in response to market conditions. However, the IPS language should discourage commit- tees from acting on pure emotion in times of market distress. A table is a common way to document the policy targets and ranges.

Within the asset allocation section, it is appropriate to list all asset classes that the plan finds appropriate for in- vesting. Equally important is to include investments that are prohibited from use within the plan.

Typically, the last item presented in the asset allocation section is the re- balancing policy. While the asset allo- cation ranges specified in the IPS can be very large, most plans find it appro- priate to rebalance when asset classes deviate from the target policy by more than 2-5%. Usually this is done on a specific date, such as month or quarter end. It can also be useful to state that cash inflow and outflow will be used to bring the plan back closer to target.

When trustees are working with a provider that is assigned more discre- tion (sometimes called an implemented consultant), another growing trend is to widen the rebalancing bands. In these scenarios, trustees allow their imple- mented consultant to place tilts on the portfolio when the consultant thinks there is opportunity to enhance re- turns. These tactical tilts would be con- strained by the IPS detailing acceptable investments, the asset allocation policy

TABLE Sample Strategic Asset Allocation* Asset Lower Target Upper Evaluation Class Range Allocation Range Benchmark U.S. equity 20% 30% 50% Russell 3000® Index Non-U.S. developed equity 10% 20% 30% Russell Global

ex-U.S. Index Emerging markets equity 5% 10% 15% Russell Emerging

Markets Index Fixed income 15% 20% 30% BC U.S. Aggregate

Bond Index Hedge funds 0% 10% 20% HFRI FOF Index Real estate 0% 10% 20% NFI-ODCE-EQ-EF

* Sample provided for illustrative purposes only and is not representative of any actual portfolio.

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and clearly defined expanded rebalancing bands, which are typically 5-10% versus 2-5%.

Section 5: Unique Circumstances All investment policies should contain a section detailing

any circumstances unique to a multiemployer plan. Such cir- cumstances might include avoiding investing in companies that use unfair labor practices or a preference for socially re- sponsible funds and green investing. The unique circumstanc- es section is an opportunity to include items the trustees would like to highlight that are not covered elsewhere in the IPS.

Section 6: Monitoring and Review Process Once the asset allocation, investment strategy and spend-

ing rate have been established, it is important to create a well-defined monitoring and review process to ensure that the objectives of the fund are achieved. The review mecha- nisms should be centered on the investment objectives of the plan. Client-specific, common elements that might be found in this section include:

• The investment committee seeks to achieve or outper- form the target return objective as defined in the asset allocation section over a full market cycle (five years or longer).

• The investment committee does not expect that this objective will be attained every year and recognizes that during various time periods, investment managers may produce significant underperformance and/or outperformance relative to the markets.

• The overall health of the plan will be monitored by comparing the value of plan assets against plan liabili- ties, and tracking the changes of each to determine whether the benefits need to be adjusted. This exercise should be performed no less often than annually.

• Portfolio returns should be monitored quarterly to as- sist in evaluating the effectiveness of the investment strategy.

• Individual investment managers’ guidelines will be re- viewed as stated in each asset class strategy statement.

• The investment committee and/or board of trustees will undertake a detailed review and assessment of the pro- gram’s overall strategy and investment structure at least every three years. Any changes to the policy should be communicated in writing to all appropriate parties.

Section 7: Acknowledgment Typically, the last section in an IPS is the acknowledg-

ment section, which is signed by the board of trustees or investment committee before copies are distributed to all parties. An example of an acknowledgment statement is as follows:

“We recognize the importance of adhering to the mission and strategies detailed in this policy and agree to work to fulfill the objectives stated herein, within the guidelines and restrictions, to the best of our ability.”

Section 8: Appendix: Asset Class Strategy Statements

Following the acknowledgment section, many multiem- ployer plans choose to include an appendix that provides more specific guidelines to investment managers. Gener- ally, the fund sets forth a specific set of guidelines for each asset class. This section provides elements such as strategic role in the portfolio, investment objectives, equity strate- gies, leverage guidelines and how the trustees will monitor and review the investment manager. It is appropriate for the plan to list in this section any strategies it wants its invest- ment manager to avoid, such as short sales or the use of margin.

Conclusion Having a well-defined and articulated IPS is vital in to-

day’s challenging investment landscape. The IPS should serve as the blueprint for multiemployer plans seeking to meet their objectives while minimizing plan risk. The IPS fills an important role in helping to complete the overall governance structure of a multiemployer plan.

takeaways >> •  An IPS helps trustees manage risks as they arise and helps

to remove emotion from the investment process.

•  An IPS serves to protect all parties—such as the board of trustees, investment committee, investment managers, consultants and custodian—named in it.

•  Although an IPS should not be changed frequently, it should be reviewed regularly.

•  A monitoring and review process should be spelled out to be sure fund objectives are achieved.

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