by: Virginia Munger Kahn
from: Business Finance
January 1999

Picture a disgruntled employee, a sharp lawyer and you, in a courtroom.  The lawyer is honing in on your company's 401(k) plan, asking questions about how you selected your plan's funds and how much attention you paid to the funds' performance.  If you're like most financial managers, you're confident you did the right thing picking the funds and even monitoring them, but you can't point to a document showing exactly what your standards for selecting and monitoring the funds were or how the fund performed in relation to those standards.

You need an investment policy statement.  These documents, which range in length from one page to 25 pages or more, depending on the complexity of the plan, spell out a plan's objectives, the responsibilities of those involved in managing it, and the standards and guidelines by which the plan's investments will be managed.

While the majority of defined benefit plans have such documents, 51 percent of 401(k) plans surveyed by Barra Rogers-Casey/IOMA in its latest defined contribution report do not.  Many plan sponsors figure that because investment decisions are being made by employees, not the employer, such a document is not necessary.  Moreover, many plan sponsors think they do not know enough to create an investment policy statement and that they don't have the time or resources to spend on an effort they view as having questionable value, the Barra RogersCasey survey found.

One entity that clearly sees value in these documents is the Department of Labor (DOL).   Even though investment policy statements are not required by law, consultants report that one of the first items their clients are asked to produce in DOL audits is an investment policy statement.  "The DOL has made a conscious decision to audit smaller and mid-sized plans," said Roxanne Fleszar, president and principal at Financial Resources Management Corporation, and investment advisor in Peabody, Mass.   "If you don't have one, that doesn't look very good," she said.

Many consultants and plan providers believe that formal investment policy statements reduce liability.  "If you don't have one, the standards used against you are defined by those who feel they've been injured," said Maureen Phillips, managing director, defined contribution plans, Putnam Investments, Boston.  "I'd much rather have a policy statement in which I've chosen the standards," she said.

By the same token, consultants and advisors feel such documents make good business sense.  What reasonable businessperson would set out to implement a plan without a clear set of benchmarks and objectives?  "It gives you a framework in which to operate.  I think it makes good business sense and good fiduciary sense," noted David Wray, president of the Profit Sharing/401(k) Council of America in Chicago.

Crafting the Policy Statement
How do plan sponsors create an investment policy statement?  For companies with defined benefit plans, the easiest place to start is with the statement for that plan.  "Every defined benefit plan has a formal investment policy statement.   Use it as a model," said Adele Heller, director of defined contribution services at Barra RogersCasey in Darien, Conn.

Companies without such plans can turn to investment advisors, consultants and even plan providers.  Both Putnam Investments and Fidelity, for example, will provide their clients with models of what they consider good 401(k) investment policy statements.   Investment advisors and consultants also often have experience writing such documents.

Some plan providers will actually write investment policy statements for their customers, for free.  However, companies like Fidelity and Putnam believe that the responsibility for these documents lies with plan sponsors and sponsors need to be closely involved in the process.

Other sources of well-known financial-services firms that provide guidebooks or software programs designed to help plan sponsors and their consultants draw up such documents.  Ibbotson Associates in Chicago provides a guidebook on diskette, while Charles Schwab Retirement Services introduced The Schwab Investment Policy Statement (IPS) CD-ROM Toolkit in September.

"The hardest part is just getting started - getting ideas for what should go into the statement," noted Drew Lawton, senior vice president at Fidelity Institutional Retirement Services Co., Boston.

Here are the eight key components of an investment policy statement:
1.  Briefly describe the purpose of the retirement plan.  The statement can be simple, such as, "the purpose of the plan is to provide participants with a comprehensive program of investment options that will help them meet their particular retirement goals and objectives," said Heller.

Or it can be more complex, depending on the structure of the plan and whether the 401(k) is the sole retirement vehicle provided by a company or is supplementary to a defined benefit plan, said consultants.

2.  State the document's purpose.  Many policy statements discuss the purpose of producing the statement - for example, to identify the investment policies of the plan and provide an objective process for managing the plan so that it complies with the law and helps participants meet their goals.

3.  Spell out the duties and responsibilities of each party involved in managing the plan.  Many people responsible for managing 401(k) plans figure they know full well what they, the trustee, the investment managers, and custodian do.   But it is worthwhile to spell out these duties so that all the parties understand exactly what is expected of them, said Fleszar.

4.  Explain the investment philosophy.  This is the heart of the document:  the design, selection and monitoring of the investments themselves.   Begin with a broad statement of investment philosophy.  For example, "the investments have been selected to represent a range of asset classes that are suited to the employee base."  Many companies discuss the demographic makeup of their workforce in this section and how the plan is designed to meet their employees' needs.

5.  Describe investment options.  State the number and types of investment options or funds that are being offered and why they are in the plan - to provide clearly defined asset allocation choices along a risk/return spectrum, for example, or to provide income or capital appreciation, etc.  "Basically, you're documenting the criteria for designing the investment menu for the plan," said Lawton.  This also is a good place to address whether mutual funds, other pooled investment vehicles or separate accounts will be used in the plan.

6.  Discuss how funds or money managers are selected to fit asset-class specifications.  The criteria might include a minimum asset size, performance in the top 75 percent  or 50 percent of a peer group, a minimum five-year track record, and fees that are average or below average for the group.

7.  Address ongoing monitoring and evaluation of investment options.   This means addressing performance standards, what benchmarks will be used to evaluate the options, how often the options will be reviewed, style restrictions, and grounds for putting funds or managers on a "watch list" for possible termination.

Some plan sponsors also choose to include a section that addresses participant education.  That's part of the governance of such plans, according to Carolyn Smith, director of Watson Wyatt Investment Consulting in San Francisco.  However, many consultants do not feel it is necessary to include participant education in the statement.

Most consultants advise that any administrative or recordkeeping standards, such as timeliness of participant statements, be addressed in a separate document.   "Keep the document focused on investments," said Heller.  "It really emphasizes the investment aspects rather than the communications and administrative aspects" of a plan, she said.

8.  Tread carefully with enforcement issues.  What should the document say about dealing with options that consistently fail to meet a plan's standards?  On one hand, an investment policy statement provides an objective, rational process for deciding when a manager needs to be terminated.  On the other hand, plan sponsors need to be careful not to paint themselves into a corner in these situations.  "You don't want to be in a situation where if A happens, then your reaction is B," says Smith.  "The world is too gray."

There's no need to be very detailed in this section, agreed Lawton.  "Give yourself the flexibility to act in a way that's prudent," he said.

Once an investment policy statement has been drafted, it should be shown to an attorney.  "After all, these are legal documents," said Lawton.   Indeed, one reason some plan sponsors shy away from investment policy statements is the perception that if they commit themselves to specific goals and actions in writing, they'll increase their vulnerability to lawsuits, said Heller.

That's not an unreasonable fear, said some attorneys.  "Once you express specifics for choosing, you set yourself up for criticism if you don't follow those specifics," said Andrew Oringer, a partner at Rogers & Wells LLP in New York.   "It's more important to discuss the considerations, not necessarily establish rules and guidelines," he said.

On the other hand, as long as plan sponsors write policy statements they know they can live with, there should be no problem, countered Larry Goldberg, a partner at Ludwig Goldberg & Krenzel in San Francisco.  "You're supposed to act in a prudent way.  You want to show you really have a thought-out decision making process," he said.  Just make sure you can follow the document and review it every year, he an others advised.

Investment policy statements make good business sense.  As Smith noted, those responsible for managing 401(k) plans often move on to other jobs and responsibilities.   An investment policy statement helps ensure that the plan is managed on a consistent basis and that the long-term goals developed for the plan are not forgotten.