Though there is no legislation or regulation that requires retirement plan fiduciaries to have an investment policy statement (IPS), it is widely considered a best practice.

Plan sponsors may not know how to begin, but an investment adviser can help. Plan accountants (for defined benefit [DB] plans) and attorneys may also have ideas, says Scott K. Laue, J.D., CFP, a financial adviser in Savant Capital Management’s Rockford, Illinois, office.

“Usually an IPS is created by a plan committee with the help of an investment adviser,” says Fred Reish, partner in the employee benefits and executive compensation practice group of Faegre Drinker Biddle in Los Angeles, and chairman of the firm’s financial services ERISA (Employee Retirement Income Security Act) team. “It’s good to have a group of people develop it. When people operate as a group, they operate more formally, and it brings discipline to the process.”

In meetings to discuss the creation of an IPS, a committee brings a variety of perspectives, questions and  suggestions for different elements to include, Reish adds. With the input of an adviser, it gets approved, completed and signed. “It can languish if just one individual is responsible for creating it,” he says.

Laue points out that the purpose of an IPS is to make sure the plan sponsor effectively supervises, monitors and evaluates plan assets. While plan sponsors may designate a fiduciary investment manager to handle these tasks, they are ultimately responsible for decisions, he says.

Elements of an IPS

According to Reish, when considering the elements to include in the IPS, the main things defined contribution (DC) plan sponsors need to look at are workforce demographics and other characteristics—age, investment sophistication, how much income employees make, etc. “Plan sponsors want to create an investment lineup for the plan that’s appropriate for their workforce,” he says. “For a law firm or mutual fund manager, the IPS may call for a large variety of investment alternatives, up to or including a brokerage account. A company with a lot of blue-collar workers, on the other hand, would create something that participants have a greater chance of using successfully. There’s more fiduciary concern.”

Reish adds that it is not necessary, but may be helpful, to find out what types of investments competitors offer. “Many plan sponsors want to make sure their plans are at the very least comparable to competitors’ for employees,” he says.

There are different points of view on what elements should go into an IPS, Reish states. He notes that there are different forms available on the internet that plan sponsors may use as a guide.

These considerations will help with what Reish calls the starting point, which is to determine what investment categories plan sponsors want to include in their investment lineups or investment portfolios. For DC plans, he says it is almost inevitable that plan sponsors will want to include target-date funds (TDFs). But plan sponsors should also consider whether they want aggressive or conservative, less volatile investments. “There may be a wide range of options for a workforce that consists of sophisticated, or high-income investors, but plan sponsors with a less sophisticated workforce may want more conservative, less volatile investments,” Reish says.

In addition, plan sponsors may want to offer participants an investment choice in which they can have someone manage their accounts for them, if plan sponsors think it would help them be more successful.

Laue says these decisions should be made solely in the interest of plan participants. “Plan sponsors should use the prudent person theory in selecting the type of investments to include, and there should be adequate diversification,” he says. Laue also suggests plan sponsors include in the IPS that a robust education program will be put into place to help participants understand all their choices.

Reish says the next step in creating an IPS is to develop an objective and repeatable process for selecting which investments and services to include in DC plan investment lineups or DB plan portfolios. He says a plan adviser is important for the first step, but is critical for this next step.

The IPS should include the criteria to consider when selecting investments. Reish says some are obvious—for example, investments should have a fairly below-average expense ratio—and some are more complicated—picking the right share class, for example. “As a plan gets bigger, it has more share classes available to it. Instead of retail shares, plan sponsors should choose institutional shares. There’s been a lot of litigation over this,” he notes.

Laue says some statements are very detailed. For example, a thorough IPS will list sub-asset classes within investments such as TDFs or funds-of-funds.

The IPS should also state how past performance will be measured, Reish notes. He says the plan’s adviser will be able to help spell out how to do so, as well as how to look at the quality of investment management companies and whether to use services provided for that, such as those from Morningstar or fi360.

“The criteria for how to measure performance should be repeatable so the investment committee will know each time what it is going to do,” Reish adds.

Finally, the IPS should include an investment monitoring process. Reish says this should include how to monitor investments and how to change investments. He points out that there are various scenarios to consider—investment managers leave organizations or change within them; organizations merge, are bought or can even deteriorate; and some investments may be good decisions when they are selected but, for various reasons, become bad choices.

Part of the monitoring criteria to include in the IPS is what to do when a fund has been underperforming and the plan committee is worried about it. “What typically happens is the IPS says the investment will be put on a watch list,” Reish says. “It’s not a legal concept; it’s something the industry has developed. But it has become a very formal part of the monitoring process and the IPS.”

Reish explains that, typically, when an investment is put on the watch list, the committee will investigate what changed and what the change means. Investments may be on the watch list for six months or even a year until the committee can decide whether it was just a bump in the road or if the investment needs to be removed and replaced. The process should be specified in the IPS, including how to remove a fund from the investment lineup or portfolio and the method for replacing it. “Usually, the IPS says a fund of the same type will be selected because the IPS specifies types of funds to use,” Reish notes.

With all of the elements mentioned, “I don’t think you can have a true IPS without these parts,” he states.

Specific or Not?

Of course, an IPS can, and often does, include other elements. An IPS trend Laue continues to see—“probably for the better,” he says—is a focus on fee transparency and disclosing fees to participants.  He adds that criteria for participant education about investments is also critical. “It should be done by those licensed and with credentials to do so,” he says. “Plan sponsors don’t want to give advice.”

The IPS may have a description of the responsibilities of different parties to the plan, Reish says. “The recordkeeper will perform this function, the investment adviser these functions, the plan committee, etc. Descriptions of roles is helpful for everyone to do their job, but it’s not necessary,” he says.

Some retirement industry sources warn not to make the IPS very detailed, as it may make it easier for plan sponsors to find themselves out of step with the policy or lock them into something that is no longer a practice. However, Reish and Laue feel differently.

“I’m all about more is better,” Laue says. “The more the IPS identifies parameters, constraints and objectives, the less that is left to interpretation. We pay close attention to abiding by what the IPS calls for.”

That being said, Laue suggests plan sponsors review their IPS more often than they review service providers. “The market changes, products change, there are new trends. I would say review the IPS annually, just to make sure everything is relevant.”

Reish also prefers the IPS to be quite specific. But, he says, it should have a caveat that the policy provides guidelines and that the plan or investment committee is not required to follow those guidelines if it is in the best interest of participants to do something different. “I think it’s easier to follow very specific steps,” he says. “If it is too vague, the committee in its fiduciary capacity won’t know what to do. But add in that these are guidelines and the committee has the discretion to do what is best for participants. Sometimes it’s better to do something else, but also the committee may inadvertently not follow IPS criteria.”

In addition, while not essential, Reish says a provision that may be included in the IPS is that the committee can amend it at any time. It can be amended by a document approved by the plan committee. He adds that if the committee makes a decision to operate differently than what the IPS provides, that decision should also be an amendment to the IPS. For example, the committee may think it is better to add a new or take out an old category of investments. It doesn’t want that to be seen as a violation of the IPS, so it would be protected by an amendment.