Building a Comprehensive Investment Policy

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by Bill Dickens

For our clients and friends who are involved as committee members and/or trustees in charitable foundations, endowments and other institutional endeavors like pension and retirement plans, the first quarter of the New Year likely signals an annual review of your organization’s Investment Policy Statement.  As fiduciaries, you and those providing advice have an obligation to periodically review the Investment Policy Statement to ensure its appropriateness and consistency with the institution’s needs and long-term objectives.

The Association of Small Foundations estimates that over 30% of its constituents do not have an Investment Policy Statement and even more do not regularly review their existing policies.  A well crafted Investment Policy is critical to the long-term success of an investment strategy and acts as a guidepost for all parties involved.  It mitigates the impact of emotions and subjectivity, and addresses conflicts of interest. In fact, having an Investment Policy Statement is generally considered a “best practice” for qualified retirement plans, certain trusts, foundations and endowments.

The following is a brief overview of the components of a comprehensive Investment Policy Statement. Many institutions and organizations will have their own unique styles and approaches to their statement; however, the following are components that every policy should address:

  • Investment objectives
    • Return – Here the desired or expected rate of return is addressed. Each institution will have its own unique set of circumstances and needs.  A common place to start in determining the return objective for many institutions is:

Return Objective = Spending Rate +Inflation Rate + Professional Fees

The return objective will drive the entire investment design process and should be considered carefully.  Variables such as projected short and long-term cash inflows and outflows, market expectations and asset allocation should all be considered when determining the return objective.

In investing, there are few variables one can control outside of the spending policy.  An annual review of an institution’s spending policy is critical to its return objectives and overall long-term success.  Many adopt a simple approach of 5% of plan assets, or more, when markets are rising.  Of course, markets do not always rise and higher spending levels during a market decline may trigger a spending down of principal.  It is critical that the short and long-term capital needs of the institution remain consistent with its return objectives and a contingency plan be considered for the inevitable market declines.

  • Risk – Understanding and clearly defining risk tolerance and capacity are just as important as defining the return objectives of the institution. The degree of risk that is deemed acceptable by the fiduciaries of the institution generally correlate to the return expectations.  It is important that the personal biases of the individuals entrusted to manage the institution’s assets do not influence risk and return decisions.

Education is a key tenet when determining risk tolerance and capacity.  Modeling portfolio asset allocations using current capital market assumptions and past performance can be useful tools in setting future expectations as well as quantifying risk.  The more clear an institution is when discussing risk (e.g. volatility ranges, allowable asset classes,  deviation ranges within target asset classes, etc.) the more effective a committee or third party advisor will be in caring for the institution’s assets.

  • Portfolio Constraints
    • Liquidity – This is the recognition of expected cash outflows and inflows from the institution’s investment portfolio by all parties entrusted to care for it. In many situations, it is prudent for all Investment Policy Statements to include some allocation of the institution’s assets to cash and money market reserves for near-term and extraordinary needs.  These liquid funds can act as insulation against short-term volatility and as a reserve for potential investment opportunities outside of the traditional investment portfolio.

In addition, liquidity may be required over multiple time periods.  An understanding of this is important in portfolio design and should be taken into consideration in an institution’s Investment Policy Statement as well.

  • Time Horizon – The investment time horizon should be clearly stated as many linkages exist between it and the risk objectives of an institution. Different from personal financial planning, where there may be a finite time period, an institution will often invest in perpetuity.

In some instances, multi-stage planning may be necessary where an institution may have short, intermediate and long-term needs.  The asset allocation decision should consider these various time horizons as longer time horizons will generally afford the institution an ability to take greater risk, while shorter time horizons will generally dictate that the institution be exposed to less risk.

  • Legal and Regulatory Factors – These are often external constraints that can include specifying asset classes that are not allowed or placing limitations on the percentage of the overall portfolio that can be invested in a single security.
  • Tax Considerations – Pension funds, retirement plans, endowments and charitable foundations are tax-exempt thus special attention to the tax implication of particular investments and/or investment strategies is unnecessary.   Trusts or for profit institutions are taxable and the Investment Policy should acknowledge the taxability of investments and contain a discussion regarding the institution’s approach to its investments’ taxability.
  • Unique Circumstances – These represent an organization’s special concerns and biases. A faith based institution or university may place restrictions on certain investment holdings such as tobacco, alcohol or defense products.   An investment committee may state its preference for using index funds over actively managed funds or individual stocks.  This section of the Investment Policy should state those special concerns and preferences of the committee and institution.

A clear and concise Investment Policy Statement is critical to removing the subjectivity of portfolio management and ensures a consistent direction for future committee members and fiduciaries alike.  A comprehensive Investment Policy Statement is the cornerstone to a successful investment process and also displays good stewardship to those who support the organization’s cause.

Need assistance in reviewing your organization’s Investment Policy Statement?  Your Moneta Team is happy to help.

© 2015, MONETA GROUP INVESTMENT ADVISORS, LLC. ALL RIGHTS RESERVED. THESE MATERIALS WERE DEVELOPED FOR INFORMATIONAL PURPOSES ONLY AND DO NOT TAKE INTO ACCOUNT YOUR INDIVIDUAL NEEDS, FINANCIAL OR OTHERWISE, AND SHOULD NOT BE RELIED UPON BY YOU WHEN MAKING ANY PARTICULAR FINANCIAL RELATED DECISIONS. THE INFORMATION HEREIN WAS DERIVED FROM SOURCES DEEMED TO BE RELIABLE BUT HAVE NOT BEEN INDEPENDENTLY VERIFIED, AND NO REPRESENTATIONS OR WARRANTIES ARE MADE WITH RESPECT THERETO.