How to Create a Client Investment Policy Statement

What Is an Investment Policy Statement (IPS)?

An Investment Policy Statement (IPS) is essentially a business plan for an investment portfolio. It is very common for financial advisors to create an IPS for their institutional clients such as retirement plan sponsors, foundations, and endowments. Many financial advisors will also draft one for their individual clients as well.

Having an IPS makes it easier to avoid panic-selling and take market corrections into account. By following a pre-set, written game plan, these investors can put their emotions aside and follow the rules that have already been established for their assets.

Key Takeaways

  • An investment policy statement (IPS) is a formal document that outlines the general investment rules for a portfolio.
  • An IPS is frequently used by pension funds, endowments, or foundations to guide investments according to the client's values and goals.
  • An IPS should state the client's investment goals and objectives, and the strategies that the manager may employ to meet these objectives.
  • An IPS should also include information on allocation, risk tolerance, and liquidity requirements.
  • An IPS will differ in scope and content depending on the type of client or investor type involved, from individuals to retirement plans and charitable endowments.

How an Investment Policy Statement(IPS) Works

An investment policy statement provides a roadmap for how clients should invest their money. What asset classes should be considered? What types of investment vehicles should be considered? These might include exchange-traded funds (ETFs), mutual funds, and other vehicles.

Further, an IPS will establish a target asset allocation for the portfolio. It will take into account the investor’s time horizon for the money and their risk tolerance. There should be criteria for selecting new investments and also criteria for replacing them.

In addition to specifying the investor's goals, priorities, and investment preferences, a well-conceived IPS establishes a systematic review process that enables the investor to stay focused on their long-term objectives, even as the market moves in the short term. It should contain all current account information, current allocation, how much has been accumulated, and how much is currently being invested in the different accounts.

Investment Policy Statements for Individual Clients

An IPS for an individual client should be an extension of their financial plan. This should reflect their reasons for investing, such as saving for college or retirement, as well as the client's time horizon, risk tolerance, and the level of returns needed to match those goals. These criteria will lead to the establishment of a target asset allocation and the types of investment vehicles to be used.

Generally, the target allocation will include a range of values for each type of asset. For example, large-cap stocks might have a target allocation of 20% with an acceptable range of 15% to 25%. If the actual percentage of large-cap stocks moves outside of that range, the investor might rebalance their portfolio.

The IPS should also include criteria to select, monitor, and replace the different investment vehicles. These might include performance relative to their peer group, costs, changes in management (for ETFs and funds), and other relevant criteria. The financial advisor and client should also agree on a benchmark metric that will be used to track the portfolio’s returns.

Many municipal or local governments use an investment policy statement in order to decide how to invest their budget surplus.

Investment Policy Statements for 401(k) Plans

In the context of a 401(k) plan, an IPS serves a similar but slightly different purpose. Drafting an IPS is one of the first things an advisor will do for a 401(k) plan sponsor. If an existing plan already has an IPS in place, the advisor should review this document and make revisions (or start from scratch) as needed.

The IPS should state the purpose of the plan, and the types of investment vehicles that the plan can purchase, such as mutual funds, collective trusts, stable value funds, and managed accounts, such as target-date funds or risk-based options.

The overriding reason that a 401(k) plan sponsor needs an IPS is for fiduciary protection. The IPS should document the procedures the plan sponsor and advisor will follow when they manage the plan's investments. When the investment committee meets, they should document what transpired and how their decisions reflect the IPS process.

The IPS should also set out how often the investment committee will meet to review the plan and who the plan’s service providers are. It should indicate that these service providers will be reviewed periodically. The IPS should also specify the criteria that will be used to select, monitor, and replace the investment options used in the plan.

While it may sound like a 401(k) IPS is for the benefit of the plan sponsor and mitigating their fiduciary liability, a 401(k) plan that follows a well-conceived IPS will usually provide better returns than one without.

IPS for Pensions, Endowments and Foundations

Endowments and charitable foundations use their investment portfolio to fund their operations, while pension funds invest to provide higher savings for their beneficiaries. These types of institutions need an IPS similar to that of a 401(k) plan, in that it should list all service providers and plan information.

An IPS for these institutions should set out the criteria for selecting, monitoring, and replacing the plan's investments, as well as allocations for the different assets and the target rate of return. For endowments and foundations, there should be language regarding the target level for annual withdrawals.

In some cases, the plan may also place restrictions on the types of investments that are allowed. For example, the IPS of an environmental organization might specifically exclude certain polluting industries.

As with other plans, an institutional IPS should set out criteria for monitoring returns based on a pre-arranged benchmark. This provides a level of fiduciary protection for pension plan sponsors and the investment committees of endowments, foundations, and other non-profits.

What Is the Purpose of an Investment Policy Statement?

An investment policy statement provides a strategic roadmap for managing the client's investments, allowing the portfolio manager to find the best assets to meet the client's financial goals. Having a clear IPS also makes it easier to avoid emotional trading in times of volatility.

What Should an Investment Policy Statement (IPS) Include?

An investment policy statement should set out the goals and risk tolerance of the investor, the duties of the financial advisor, and guidelines for the assets that can be purchased. Typically, this will include a list of acceptable asset classes and the target allocation for each. The IPS should also set out benchmarks for measuring the portfolio's performance and state often it should be rebalanced.

How Often Should an Investment Policy Statement (IPS) Be Updated?

The frequency of IPS updates should be determined by the client's needs. However, the CFA Institute recommends updating an IPS at least once a year, as well as whenever there are important changes in the client's situation. For example, a major change in a client's health, wealth, or the number of dependents should occasion an update to that client's IPS.

The Bottom Line

An Investment Policy Statement is an excellent tool for financial advisors to create a roadmap to manage client portfolios. Though the format may vary, an IPS is equally applicable for individual clients, 401(k) plan sponsors, and other institutional clients such as pension plans, foundations, or endowments.

Article Sources

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  1. CFA Institute. "Standard III(C) Suitability."

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