Economic conditions, securities markets, people, and philosophies tend to be in a perpetual state of flux. Constant change can undermine commitment to a long-term investment plan; however, when an organization has a comprehensive investment policy statement (IPS) that sets forth long-term strategic direction, investment guidelines, and accountability standards, the course is well established and, over time, goals are more likely to be achieved.

A well-drafted IPS helps give organizations the discipline to face the uncertainties of challenging investment environments.

Removing emotion from the equation positively correlates with better results for the investment portfolio, leaving the organization better positioned to fulfill its mission.

Executive Summary

An IPS is an investment management document drafted by a plan sponsor, often with the help of an investment manager or consultant. The document serves as a strategic guide to the management of the client assets specified in the IPS and outlines the fiduciary responsibilities of those groups and individuals involved in the oversight of the assets.

Documentation of the client’s objectives and constraints is critical in determining the strategic asset allocation (SAA) that may help achieve the client’s long-term investment goals. Portfolio parameters may also be established which identify suitable investment styles and vehicles to employ in the portfolio, as well as tactical asset allocation ranges that managers may use in order to take advantage of market dislocations. Risk management control procedures, performance, and client service/reporting requirements may also be outlined.

The entire process of developing the IPS should be an educational experience for the client, as it entails a detailed discussion of how investment decisions are made, who is responsible for each aspect of this process, and clearly lays out expectations.

The development process has value to the investment manager as well, as it allows the adviser to get to know the client better. Ultimately, the IPS provides clarity around guidance for investment decision making.

We recommend that the IPS be reviewed periodically and as a response to material changes in an organization’s circumstances or capital market assumptions. The IPS is meant to be a portable document that can be easily understood by anyone involved in the investment process. It is important that parties involved in the oversight of assets review and acknowledge they have reviewed the client’s most recent IPS.

In this piece, we focus on the components of an IPS for a defined benefit plan.

The Components of an IPS

To help organizations develop a robust IPS, below we have outlined the sections commonly included. In this paper, we will try to explain the “what” and “why” of each section, and note any special considerations.

  1. Governance
    1. Purpose & Scope
    2. Investment Philosophy
  2. Objectives & Constraints
    1. Purpose & Scope
    2. Statement of Goals
    3. Risk Tolerance
    4. Liquidity Requirements
    5. Unique Circumstances
  3. Portfolio Parameters
    1. Purpose & Scope
    2. Asset Allocation
    3. Benchmarks
    4. Selection and Retention
    5. Types of Securities
  4. Risk Management
    1. Purpose & Scope
    2. Control Procedures|
    3. Performance Objectives
  5. Client Services
    1. Purpose & Scope
    2. Communications
    3. Reporting
  6. Acknowledgement of IPS

Part One: Governance

Governance largely defines two elements: the purpose and scope of the IPS, and the definition of duties for parties outlined in the IPS.

The purpose and scope often serve as a table of contents or summary of what the IPS will include and will also identify the specific assets governed by the IPS. The definition of duties identifies key stakeholders, those individuals or groups with fiduciary responsibilities, and may outline how they are accountable toward the assets governed by the IPS.

Purpose and Scope

This section should clearly state the general goals and objectives of the organization and of the investment policy statement. Providing a clear understanding of the purpose of the funds can help the investment managers to meet your organization’s investing objectives.

This section may further detail what assets are covered by the IPS: specifically, which assets should comply with the SAA set forth within the document.

Definition of Duties

The definition of duties outlines the roles and responsibilities of boards, committees, staff, and service providers. Some of the more important responsibilities for which individuals or groups should be identified as responsible for include:

  • developing and executing investment policy;
  • development and affirmation of capital market assumptions inputs;
  • preparation and review of investment performance and risk management reports;
  • annual review and updates to the IPS; and
  • selection and removal of consultants and investment managers.

The IPS should enumerate clearly the responsibilities and expectations of all parties involved. Some of the main parties and responsibilities may include[1]:

  • The board of directors typically has fiduciary responsibility for the investment portfolio and general responsibility for establishing and maintaining the IPS, including reviewing the IPS for accuracy and relevancy. Ultimately, the board is accountable to care for and protect the assets of the plan.
  • The investment committee typically is responsible for hiring and firing consultants and/or investment managers, reviewing fund performance, providing oversight and coordination of assets while in the investment managers’ care, and implementing the IPS in a timely and accurate manner. If there is no investment committee, these responsibilities generally remain with the board of directors.
  • The asset management firm is responsible for guiding the board of directors and/or investment committee in all areas of investing that relate to the assets being managed. These include, but are not limited to, recommendations for and review of the IPS, asset allocation, ongoing investment manager selection (internal or external), portfolio review, and performance assessment.
  • Investment managers implement the IPS. The investment committee should specify exactly what the investment managers are being hired to do in addition to the level of discretion and authority the investment managers have over the portfolio. Whether tasked with maintaining a diversified portfolio or implementing a single strategy, the investment managers are responsible for investing within the confines of the IPS. In some cases, a consultant may also serve as an investment manager.
  • The custodian and/or trustee is in charge of safeguarding specific financial assets. Toward this end, responsibilities might include administering the distribution of any trust assets to plan participants and beneficiaries as directed by the plan sponsor, controlling access, settling trades efficiently, collecting investment income and principal, and/or collecting and disseminating investment portfolio performance.

Part Two: Objectives and Constraints

An investor’s long-term SAA is the culmination of two work sets: capital market expectations and objectives and constraints. Investment managers may work with an investment strategist to produce the former, but the latter requires input from your organization.

When defining objectives and constraints, we recommend certain categories be addressed: statement of goals, risk tolerance, liquidity requirements, and unique circumstances. In this part, we will address what we believe may be appropriate to consider when defining these factors.

Statement of Goals

The primary purpose of a defined benefit plan is to fund the payment of pension liabilities.

Secondary goals can include minimizing the year-to-year volatility of future contribution payments, minimizing funding status volatility, or increasing year-over-year funded status. Furthermore, the goals should be sufficiently specific to be meaningful, but adequately flexible to be practicable. These objectives are designed to establish an attitude and philosophy that will guide the investment managers toward the desired policies and performance.

Risk Tolerance

The risk tolerance of a defined benefit plan is determined by the plan and plan sponsor characteristics. Specific factors include the current financial condition of the sponsor and the time horizon and liquidity needs of the plan.

Unlike required return, which an organization can solve for quantitatively, evaluating risk tolerance is one area that may be difficult to assess. This difficulty may be exacerbated by the need to aggregate the risk preferences of many board or committee members.

Some of the factors that affect risk tolerance include funded status, plan status (open, closed, frozen), contribution policy, benefit structure, and organization objectives. An example of a risk tolerance statement is as follows:

“It is understood that a defined benefit plan should balance risk tolerance, defined as funded status volatility, with return requirements.”

Liquidity Requirements

For defined benefit plans, a given plan’s liquidity requirement is equal to the net cash outflow in a given year.

Net cash outflow is defined as benefit payments minus pension contributions. Explicitly stating the expected net cash outflow and/or schedule of expected net cash outflows can help the investment managers to match the time horizon of plan assets with that of plan liabilities. This is important because of the generally positive correlation between time horizon and return expectations: taking too short of a time horizon with investments reduces return potential, while taking too long can cause liquidity risk for the plan.

Unique Circumstances

In this section, an organization can list any special objectives, constraints, rules around abnormal distributions (for example, for emergency purposes), or any other policies that could affect the investment program. An example of this is socially responsible investing. Here, the organization would list any preferences, such as following the U.S. Conference of Catholic Bishops (USCCB) investment guidelines; they may expect investment managers to follow to the fullest extent permissible under applicable law. This section can also include whether the investment program is allowed to invest in alternative assets, in addition to any policies around the approval process (for example, if the board or committee needs to approve each alternative investment).

Part Three: Portfolio Parameters

This section of the IPS should lay out the investment process: the strategic asset allocation and benchmarks, rules for manager selection and retention, and the types of securities allowed.

SAA and Benchmarks

We recommend that the target asset allocation reflect both the organization’s long-term strategic view and the stated goals for the designated funds. How specific the asset allocation guidelines are will vary by organization. Some organizations may prefer broad parameters, setting targets for equities, fixed income, and cash. Other organizations may be more precise, segmenting the major asset classes into smaller categories such as large capitalization (cap), mid cap, and small cap equity. This section of the IPS may also set restrictions on how much or how little an investment manager may deviate from the allocation target for a given asset class or category. With that said, restrictions should be considered carefully given there are potential benefits to allowing investment managers to tactically allocate assets on the basis of prevailing market opportunities and conditions. While narrow ranges may overly restrict asset managers, too much latitude may allow asset allocation to deviate from the overall investment objective.

Some organizations will establish a derisking strategy, or glidepath, that changes the asset allocation targets if, for example, funded status changes. If a glidepath is established for the portfolio, we recommend referencing it in this section and including the full glidepath in the appendix.

We also recommend using this section to establish the benchmarks for measuring the relative performance of each asset and sub-asset class. Further, we recommend establishing an absolute benchmark, or hurdle rate, which serves as a measure of success in meeting the overall goals of the investment program. Investment returns below the absolute benchmark could imply the program is failing to meet its objective; above this number could imply that it is meeting or exceeding its objective.

Selection and Retention Criteria for Investments

Managers should be given discretion to manage the funds entrusted in accordance with the style for which they are employed, provided they comply with the restrictions and limitations set forth in the IPS. Important criteria for selection may include: the investment style and discipline of the proposed manager; past performance, considered relative to other benchmarks and other strategies having the same investment objective; historical volatility and downside risk management; the size of the organization as measured by the amount of assets under management with respect to the investment style under consideration; length of the manager’s track record; and the experience of the organization as measured by the tenure of the professionals with respect to the investment style under consideration.

Types of Securities Allowed

While risk and volatility are present with all types of investments, it should be stated that high levels of relative risk are to be avoided in every asset class. Diversification by asset class, sector, industry and issuer limits, maturity limits, and, to the extent possible, management style can be used to reduce risk. We recommend that this section also clearly outline investments that are prohibited, as well as any other restrictions such as types of securities, weighting limits, quality standards, or liquidity requirements. Further, if mutual funds are utilized, their investment objectives should be consistent with the investment guidelines set forth in the IPS.

Exclusions and limitations can help reduce risk, but they also reduce the investment opportunities available to managers. With that said, a list of prohibited investments can proactively prevent the inclusion of security types that the board/investment committee is not familiar with and/or does not desire.

Part Four: Risk Management

This part may cover both the operating and investment risks of the investment program. We recommend that the control procedures section discuss the schedule of reviewing the portfolio for both performance and compliance. Performance objectives should define how success for the purposes of the investment program will be measured.

Control Procedures

In this section, the plan sponsor may reiterate its performance expectations in addition to establishing a schedule to review the portfolio and performance with the investment managers. This section can also make clear what performance periods are important to the organization: while performance may be best measured over full market cycles, as it may more accurately reflect progress toward the organization’s stated goals, analysis of shorter time periods may help explain the impact that certain investments are having on the portfolio.

Furthermore, it is important to herein state the focus of the reviews, including topics such as investment managers’ adherence to the policy guidelines; comparison of results to the benchmarks; and material changes in the investment managers’ organizations, such as philosophical or personnel changes. Along the same lines, it may be stated here the circumstances for which termination of an investment manager will be considered, such as deviation from the IPS guidelines; substantial deviation from investment disciplines and processes; or when the client’s representatives have any material problem or concern regarding the investment managers.

Performance Objectives

The fund’s investment performance should be reviewed regularly, such as on an annual basis.

However, the emphasis with regard to performance should be focused on results achieved over a full market cycle (typically a three- to-five-year period). Furthermore, overall policy and investment objectives should be reviewed periodically and adjusted, if necessary, after consultation with the appropriate parties.

We recommend that manager performance be measured against policy objectives and for consistency with the total return objectives, evaluated on a net-of-fees basis. With regard to benchmarking, the overall portfolio should be measured against an appropriate, often blended, index that measures both the return and risk profile of the portfolio. This blend should be based on the strategic allocation, incorporating the target levels of equity, fixed income, and/or alternative assets comprising the portfolio.

Part Five: Client Service

This section may include what your organization expects from the investment managers and/or consultants with respect to communications and reporting. This section may also address the frequency of in-person meetings and the method(s) of communication. Clearly establishing these expectations at the onset can help a board or committee to better manage the investment program and lead to better interactions between the organization and those assigned to manage the organization’s assets.

Communications

As earlier discussed, it is important that the investment managers provide performance evaluations on a regular basis. This section may require that the managers provide regular accounting of transactions, portfolio holdings, yields, current market values, summary of cash flows, and calculations of the portfolio’s total rate of return.

It is additionally important that a reasonable, baseline frequency of communication be established, such as on the basis of “as market conditions and the portfolio warrant,” to allow for full transparency. Along these lines, it may be stated that significant changes within the investment managers’ operations or personnel, and the anticipated impact on the portfolio, should be brought to the attention of the committee.

Reporting

Setting the expectations for reporting can facilitate transparency and access between the plan sponsor, investment managers, and all other relevant parties. With this in mind, a schedule for reports containing portfolio activity and asset holdings, in addition to tactical and strategic updates, may be established at the onset of the relationship. The language may also further specify that the investment managers are responsible for frequent and open communication with regard to all significant matters pertaining to the investment of assets.

With regard to the schedule of reporting and account reviews, it is important that the schedule is framed around reasonable and appropriate timing. End-of- quarter and end-of-year reports take time to produce: reviews and reports scheduled soon after a period’s end will necessarily lack some of the details and clarity that reports scheduled later on can provide. We recommend balancing the need for urgency with the level of detail desired, accounting for the fact that the two are sometimes mutually exclusive.

Part Six: Acknowledgment

The last part of the IPS should document the organization’s recognition of the importance of following the guidelines, rules, and best practices incorporated within the document. A sample acknowledgment would be as follows:

“The Plan Sponsor certifies that this Investment Policy Statement was adopted on [     ].”

Thus, the acknowledgment signifies all parties as having read the investment policy statement and states the mutual intention to follow both the letter and the spirit of the document.

Conclusion

In summary, the points to address in your plan’s IPS include naming those with fiduciary responsibilities, documenting objectives and constraints, outlining a strategic asset allocation, defining how success is measured, and setting standards and a schedule around performance reviews.

Every IPS should address the preceding points in some detail.

When addressing each point, the organization should be certain to set forth not only what the point is, but also why the point is necessary. Once a draft of the statement is complete, the entire document should be carefully reviewed to identify and resolve inconsistencies. When all points are consistent and the organization’s leadership is in agreement, the plan’s fiduciaries should adopt the final document.

Thus, the IPS may serve as the blueprint for institutional investment programs. In addition, it may serve as a foundation for the plan’s overall governance structure and determine that all fiduciaries are fulfilling their responsibilities and obligations. At PNC, we believe that an IPS created with such a level of care can result in an investment experience that is fully integrated and aligned with the needs and objectives of the overall organization, thus increasing the likelihood and probability of success over the long term.

Consultation with Legal and Other Advisors

We recommend that you consult with your legal, actuarial, and other financial advisors when drafting an IPS for a defined benefit plan. A well-drafted IPS should be customized for the particular governance and operational structure of your plan, as well as reflect your investment goals. Your investment manager will play a key role in helping you develop the investment, risk, and portfolio parameters in the IPS. Your legal and other advisors, however, will play a key role in helping you customize the purpose and scope, duties, and performance objectives of the IPS to reflect the unique characteristics of your plan and your ultimate goals.

For more information, please contact your PNC Representative.