An Investment policy statement (IPS) is a document, generally between an investor and the assisting investment manager, recording the agreements the two parties come to related to issues relating to how the investor's money is to be managed. In other cases, an IPS may also be created by an investment committee (e.g., those charged with making investment decisions for an endowment or pension plan) to help establish and record its own policies in order to assist in future decision-making or to help maintain consistency of its policies by future committee members or to clarify expectations for prospective money managers who may be hired by the committee.
The presence of an IPS helps to clearly communicate to all relevant parties the procedures, investment philosophy, guidelines and constraints to be adhered to by the parties. It can be seen as a directive from the client to the investment manager about how the money is to be managed, but at the same time, the IPS should provide the guidelines for all investment decisions and responsibilities of each party. As a policy document rather than an implementation directive, the IPS should provide guidance for how investment decisions will be made; it should not be a list of the specific securities to be used.
When the investor is an individual client, as a general rule, the investment manager (or financial advisor) has the responsibility of creating the document, since the manager is generally more familiar with its purpose and normal content. Both the manager and the client generally sign the document, indicating acknowledgment of and agreement to its several parts. This can serve to protect both parties in the event of a future disagreement, as long as they have respectively adhered to the content of the IPS.
Regulations
There are two levels of legal and regulatory oversight: the legal requirements for clients who are fiduciaries or trustees for an account, and the regulations applicable to an advisor's practice. It is important to understand the requirements for each.
ERISA
An investment policy is required under virtually all investor circumstances, with the exception of individual investors. According to the US Employee Retirement Income Security Act of 1974, as amended (ERISA), for every qualified company retirement plan (e.g., 401[k], profit sharing, pension, 403[b]) there are certain fiduciary responsibilities for managing the plan assets with the care, skill, prudence and diligence of a prudent expert and by diversifying the investments of the plan so as to minimize the risk of large losses. The IPS documents these fiduciary responsibilities and ensures fiduciaries are adhering to these responsibilities.
When auditing an ERISA plan, the U.S. Department of Labor regularly asks to review the associated IPS. This is due to ERISA regulations requiring that employee benefit plans are managed to ensure that investment firms meet their financial responsibility to the employees covered by such plans.[1] Under ERISA, all qualified plan trustees have a special responsibility to “prudently” manage their plan assets for the sole benefit of the plan participants. ERISA and the Department of Labor have established the following prudent procedures for plan trustees:
A properly written IPS should help ensure compliance with these required procedures. The IPS sets forth the objectives, restrictions, funding requirements and general investment structure for the management of the plan's assets, and provides the basis for evaluating the plan's investment results. By establishing the criteria and procedures for selecting investments and investment managers, an IPS can minimize “Monday morning quarterbacking” if investment performance is disappointing.
An IPS also can help trustees communicate a plan's investment guidelines and procedures to those assisting in the investment process, such as investment advisors or money managers. Finally, and most importantly, an IPS provides a guide for making future investment decisions. Having and using the policy statement compels the trustees to be more disciplined and systematic, which in itself should improve the odds of meeting the investment goals.
UPIA and other legislation
The US Uniform Prudent Investor Act (UPIA) is state-adopted legislation that governs the investment conduct of private family trusts. First enacted in 1994, it serves as the hallmark of subsequent legislation (as well as how the courts now interpret such requirements relating to ERISA). UPIA requires a written investment policy for every trust in which trustees manage assets for the benefit of others. UPIA formally requires a focus on the total portfolio, rather than following its earlier regulatory guidance that individual investments should be evaluated independently of whether or not they were appropriate for portfolio inclusion. The total portfolio is now the fiduciary's central consideration when judging the trade off between risk and return. There are no more restrictions on the types of investments that can be included in the portfolio; the trustee can invest in anything that helps achieve the risk/return objectives of the trust and that meets the other requirements of prudent investing.
UPIA specifies that diversification is part of the definition of prudent investing. It also makes clear that if appropriate investment processes are in place and followed, the trustees will not be held responsible for the results. Under UPIA, the delegation of investment and management functions is permitted and encouraged. Establishing and maintaining an IPS facilitates such delegation.
Government and institutional funds
The following two acts are substantially similar to UPIA; both require a written IPS.
Financial Industry Regulatory Authority (FINRA) member firms and Registered Investment Advisors (RIAs) are subject to two primary obligations in terms of consumer protection: “suitability” and “fair dealing.” RIA firms must satisfy additional fiduciary standards of care and client protection. Well thought-out procedures are critical to satisfying these requirements. An IPS can help satisfy regulatory auditors by documenting the appropriate implementation of these procedures.
FINRA member firms are subject to a “suitability” requirement; this is described in the Financial Industry Regulatory Authority (FINRA) Rule 2310. When a broker recommends that a client buy or sell a particular security, that broker must have a reasonable basis for believing that the recommendation is suitable for that client. In making this assessment, the broker must consider the client's risk tolerance, other security holdings, financial situation (income and net worth), financial needs and investment objectives, among other things. Registered Investment Advisors are subject to fiduciary standards for suitable recommendations.
In addition to the suitability requirement, brokers are subject to a “fair dealing” requirement which is also described in FINRA 2310. According to this rule, sales efforts will be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed. An “obligation of fair dealing” means that brokers must have reasonable basis for believing that their securities recommendations are suitable for and appropriate to certain customers in light of the customers’ financial needs, objectives and circumstances.
A well-crafted IPS will include all the relevant information needed for the broker to establish that both the suitability and fair dealing requirements have been satisfied.
Additional requirements for Registered Investment Advisory firms
RIA firms must be registered as providing investment management services with either the U.S. Securities and Exchange Commission (SEC) or with the equivalent state office. RIAs have an even higher standard of care established by fiduciary standard to carry out their responsibilities with “good faith, honesty, integrity, loyalty and undivided service of the beneficiary’s interest.” The good faith clause requires RIAs to act reasonably in order to avoid negligent handling of the beneficiary's interests, and not to favor anyone else's interest, including the fiduciary's, over that of the client.
Whether or not fiduciary responsibilities have been satisfied is not determined by investment performance, but by whether prudent investment practices and standards were followed. To establish those practices and standards, the preparation of the IPS is one of the most important functions of the RIA. To emphasize its importance, in some SEC districts, SEC auditors are asking to see the IPS for a sampling of client relationships.
IPS and the investment process
The investment process can be seen as occurring in six steps, as described below. Many experts believe that the creation of the IPS is the single most important step in this process.[6] All the other steps either lead into the IPS, or are directed by the IPS.
Initial discovery: The initial discussions and sharing of documents that allows both the client and the advisor to learn about one another. On the one hand, this might include learning about the client's circumstances, goals, income needs, restrictions, current holdings, risk tolerance, etc. The client should also attempt to learn as much as possible about the investment manager's investment philosophy, practices, and procedures.
Discussion and agreement: All the issues related to what is to happen between client and advisor should be placed on the table. Where there are questions or a lack of clarity exists, further discussion may be needed. Eventually, the client and advisors need to come to agreement on issues such as the degree of client involvement, the asset allocation to be used, the kinds of instruments to be utilized (or not), how tax considerations will be treated, investment goals, needs for liquidity or income, investment restrictions, investment methodology, and responsibilities of each party to the other.
Creating the IPS: Once the agreements have been reached on the full list of issues and policies to be followed, they need to be recorded. This document will become the IPS. The client(s) and the advisor sign the document, signifying each party's acknowledgment of the agreements.
Investment implementation: Until there is an agreement between the advisor and client about the policies to be followed, no investment trades can responsibly happen. Once the IPS has been signed by all parties, the initial and ongoing trades can be implemented according to the road map provided by the IPS.
Ongoing communication: Meetings, reports, and other communications will occur between advisor and client, generally as suggested in the IPS.
Monitoring and adjustment: Rarely does a portfolio stay as originally structured. The IPS should describe how the portfolio will be monitored for poor performers, how good performers will be identified, how (and if) rebalancing and tax loss harvesting opportunities will be implemented, and it should address any other ways in which the investment manager will try to ensure that the portfolio will stay in line with the objectives set forth in the IPS.
Clients and their needs change over time. It is therefore important that the advisor periodically returns to the first step "discovery" to make sure the client's then-current needs and wishes are being addressed. Every year or two, the IPS should be reviewed by the client and the advisor to ensure continued agreement with its provisions.
Required components
Nothing should be included in the IPS to which the advisor or client cannot commit and be sure will be implemented.
An IPS usually has five major components that should be unique to each client.
1. All key factual data about the client, including where the client's assets are held, the amount of their assets under the management of portfolio manager, and the identification of the trustees or interested parties to the account. This can be as detailed or as simple as desired.
2. A discussion and review of the client's investment objectives, investment time horizon, anticipated withdrawals or deposits, need for reserves or liquidity, and attitudes regarding tolerance for risk and volatility.
3. Any constraints and restrictions on the assets, such as liquidity and marketability requirements, diversification concentrations, the advisor's investment strategy (including tax management), locations of assets by account type (taxable versus tax-deferred), how client accounts that are not being managed (if any) will be handled, and any transaction prohibitions.
4. The security types and asset classes to be included in or excluded from the portfolio, and the basic allocation among asset categories and the variance (rebalancing) limits for this allocation.
5. The monitoring and control procedures and responsibilities of each party.
The IPS and the advisor–client relationship
The IPS development process lays the foundation for a successful relationship between advisors and clients. An important benefit of utilizing and IPS in clarifying needs, procedures and expectations is that clients have a better understanding of what the advisor is going to do with their money, and of their advisor's approach. Clients have an opportunity to understand the reasons why each action is to be taken. As a result, clients tend to have more confidence in the advisor's abilities.
Having that increased level of understanding and confidence becomes important when markets go through a down period. The IPS establishes investment guidelines and a framework for long-term investment thinking and can help calm nerves when things are particularly volatile.
Sources
Prudent Investment Practices: A Handbook for Investment Fiduciaries, published by the Foundation for Fiduciary Studies
“Investment Policy: Winning the Losers Game,” Charles Ellis, Irwin Publishing
“The Management of Investment Decisions,” Trone, Albright & Taylor, McGraw-Hill
Notes
↑ Part 2509 of Title 29 of the Code of Federal Regulations. Department of Labor 29 CFR 2509.94-2 Interpretive bulletin relating to written statements of investment policy.including proxy voting policy or guidelines.
↑ Department of Labor Interpretive Bulletin 29 CFP 2509.94-2
↑ Creating an Investment Policy Statement: Guidelines and Templates by Norman Boone and Linda Lubitz, FPA Press, 2004
Related Research Articles
The Employee Retirement Income Security Act of 1974 (ERISA) is a U.S. federal tax and labor law that establishes minimum standards for pension plans in private industry. It contains rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was enacted to protect the interests of employee benefit plan participants and their beneficiaries by:
A fiduciary is a person who holds a legal or ethical relationship of trust with one or more other parties. Typically, a fiduciary prudently takes care of money or other assets for another person. One party, for example, a corporate trust company or the trust department of a bank, acts in a fiduciary capacity to another party, who, for example, has entrusted funds to the fiduciary for safekeeping or investment. Likewise, financial advisers, financial planners, and asset managers, including managers of pension plans, endowments, and other tax-exempt assets, are considered fiduciaries under applicable statutes and laws. In a fiduciary relationship, one person, in a position of vulnerability, justifiably vests confidence, good faith, reliance, and trust in another whose aid, advice, or protection is sought in some matter. In such a relation, good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts.
A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.
The term soft dollars refers to a Wall Street practice, especially in the asset management and securities industries, and means the benefits provided to an asset manager by a broker-dealer as a result of commissions generated from a financial transaction executed by the broker-dealer for client accounts or funds managed by the asset manager. In a soft dollar arrangement, the investment manager directs commissions generated by a client's or fund's transactions to a broker-dealer or other trading venue. Soft dollars, in contrast to hard dollars which have to be reported, are incorporated into brokerage fees and paid expenses, which may not be reported separately. Most investment managers follow the limitations detailed in Section 28(e) of the Securities Exchange Act of 1934. In particular, if soft dollar arrangements are entered into with respect to registered investment companies and pension plans, compliance with Section 28(e) is generally required. However, hedge funds, which are generally not registered, may not be subject to the limitations of Section 28(e) and, thus, in some cases, the fund's commissions may be used for the adviser's benefit. In situations where fund commissions are used outside of the Section 28(e) safe harbor, full and comprehensive disclosure must be provided to fund investors.
National Association of Personal Financial Advisors (NAPFA) is an American financial planning trade organization created in 1983 to expand the use of fee-only financial advisors by individual consumers. NAPFA established the first set of professional standards for fee-only financial advisors and has updated them to reflect changes in industry practices.
The prudent man rule is based on common law stemming from the 1830 Massachusetts court formulation, Harvard College v. Amory The prudent man rule, written by Massachusetts Justice Samuel Putnam (1768-1853), directs trustees "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested."
The Uniform Prudent Investor Act(UPIA), which was adopted in 1992 by the American Law Institute's Third Restatement of the Law of Trusts ("Restatement of Trust 3d"), reflects a "modern portfolio theory" and "total return" approach to the exercise of fiduciary investment discretion.
In finance, securities lending or stock lending refers to the lending of securities by one party to another.
A custodian bank, or simply custodian, is a specialized financial institution responsible for providing securities services. It provides post-trade services and solutions for asset owners, asset managers, banks and broker-dealers. It is not engaged in "traditional" commercial or consumer/retail banking like lending.
A financial adviser or financial advisor is a professional who provides financial services to clients based on their financial situation. In many countries, financial advisors must complete specific training and be registered with a regulatory body in order to provide advice.
LPL Financial Holdings Inc. was founded in 1989 and is considered the largest independent broker-dealer in the United States. As of 2021 the company had more than 17,500 financial advisors, over US$1 trillion in advisory and brokerage assets, and generated approximately $5.9 billion in annual revenue for the 2020 fiscal year.
A registered investment adviser (RIA) is a firm that is an investment adviser in the United States, registered as such with the Securities and Exchange Commission (SEC) or a state's securities agency. The numerous references to RIAs within the Investment Advisers Act of 1940 popularized the term, which is closely associated with the term investment adviser. An investment adviser is defined by the Securities and Exchange Commission as an individual or a firm that is in the business of giving advice about securities. However, an RIA is the actual firm, while the employees of the firm are called Investment Adviser Representatives (IARs).
United States trust law is the body of law that regulates the legal instrument for holding wealth known as a trust.
A performance fee is a fee that a client account or an investment fund may be charged by the investment manager that manages its assets in addition to its management fee.
Principles for Responsible Investment is a United Nations-supported international network of financial institutions working together to implement its six aspirational principles, often referenced as "the Principles". Its goal is to understand the implications of sustainability for investors and support signatories to facilitate incorporating these issues into their investment decision-making and ownership practices. In implementing these principles, signatories contribute to the development of a more sustainable global financial system.
Houlihan Smith & Company was an investment banking firm that provided financial advisory and financing services to public and private businesses. Houlihan was founded in 1996 and reorganized as Houlihan Capital in 2011.
Jones v. Harris Associates L.P., 559 U.S. 335 (2010), is a case decided by the United States Supreme Court in which investors claimed that the fees they paid to an investment advisor were too steep, violating the Investment Company Act of 1940.
HiddenLevers is a financial technology company with headquarters in Atlanta. It provides risk applications and analytics to financial advisors, portfolio managers and executive teams in wealth management. HiddenLevers is also known for its scenario library, a visual compendium of several economic outcomes in the financial zeitgeist, created and updated by the HiddenLevers economic research team. As of April 2019, the company remains self-funded, against a backdrop of record investment in fintech worldwide, hitting $55 billion in 2018, double the year before.
Personal fiduciary services are fiduciary services provided by a financial institutions or advisors to an individual or family that are typically wealthy or high net worth individual. They are often referred to as private trust, private client, private wealth management, or private banking services in the United States.
The Retail Investor Protection Act is a bill that would delay some pending regulations being written by the United States Department of Labor until the Securities and Exchange Commission has finalized their own rules. The rules in question are rules that would describe "when financial advisors are considered a fiduciary, which means they must work in their clients' best interest." The bill passed the United States House of Representatives during the 113th United States Congress.
Securities market participants in the United States include corporations and governments issuing securities, persons and corporations buying and selling a security, the broker-dealers and exchanges which facilitate such trading, banks which safe keep assets, and regulators who monitor the markets' activities. Investors buy and sell through broker-dealers and have their assets retained by either their executing broker-dealer, a custodian bank or a prime broker. These transactions take place in the environment of equity and equity options exchanges, regulated by the U.S. Securities and Exchange Commission (SEC), or derivative exchanges, regulated by the Commodity Futures Trading Commission (CFTC). For transactions involving stocks and bonds, transfer agents assure that the ownership in each transaction is properly assigned to and held on behalf of each investor.
This page is based on this Wikipedia article Text is available under the CC BY-SA 4.0 license; additional terms may apply. Images, videos and audio are available under their respective licenses.
