Importance of an Investment Policy Statement | Plante Moran
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Your Fiduciary Duty: The Importance of an Investment Policy Statement

“Ex-Baptist Foundation Execs Going to Prison for Fraud”
“California Attorney General’s Office Investigating the Farrah Fawcett Foundation”
“Wesleyan (University) Sues Ex-Endowment Chief for Fraud, Breach”

It happens more than we want to admit—not-for-profit organizations make national headlines for breach of fiduciary duty. Sometimes these situations are fraudulent; others are oversights that could happen to even the most well-intentioned organizations that fail to understand exactly what their fiduciary duty entails.

What is your fiduciary duty, and how can you be certain you’re meeting it? This article aims to explain not only that but also illustrate how it ties to the Uniform Prudent Management of Institution Funds Act (or, as it’s affectionately known, UPMIFA) and having an investment policy statement.

What Is Your Fiduciary Duty?

People in a position of trust or fiduciary relationship, such as board members, officers, directors, or high-level employees of an organization, owe certain duties to their participants/beneficiaries. Fiduciary duties require that the fiduciary acts solely in the best interest of the participant/beneficiary, free of conflicts of interest or other abuses for personal advantage.

Fiduciaries should follow these best practices to help protect them from liability:

  • Prepare a written investment policy statement (IPS) and document the process used to derive investment decisions.
  • Diversify portfolio assets with regard to the specific risk/return objectives of participants/beneficiaries.
  • Use professional money managers/mutual funds (“prudent experts”) to make investment decisions.
  • Control and account for all expenses.
  • Monitor the activities of all money managers and service providers.
  • Avoid conflicts of interest.

In addition to protecting the fiduciary, following these steps may improve your investment selection and lower your total fees.

All of these fiduciary best practices tie to the Uniform Prudent Management of Institution Funds Act (UPMIFA), which mandates the application of consistent standards for the management and investment of charitable funds so that the same standards apply regardless of whether a charitable organization is organized as a trust, a not-for-profit corporation, or another type of entity. Most states and territories have some version of UPMIFA (Pennsylvania and Puerto Rico do not), so it’s important to understand what it means for your not-for-profit organization.  As we discussed above, one of the most important pieces of the investment process is to prepare an investment policy statement. 

What Is an Investment Policy Statement?

An investment policy statement (IPS) is a critical document for the long-term success of an organization. But what’s worse than not having an investment policy statement is having one that’s not followed.

An IPS documents, among other things, background on the organization and its mission; an investment philosophy in light of this mission; spending policy; asset allocation policy; specific guidance around managing the investment portfolio, including security guidelines and money-manager selection; and control procedures, such as monitoring guidelines. Its benefits are numerous. It provides explicit understanding of the fund’s purpose and a clear definition for success in fulfilling objectives, and it provides continuity during periods of board or committee turnover. In addition, it documents a prudent investment process and serves as a unifying roadmap to current and future board/committee members (including delegation of responsibilities).

What Should an IPS Include?

A typical IPS should outline the following:

Purpose and Background

This section documents that the organization understands and intends to comply with applicable standards (such as your state-specific version of UPMIFA). It also outlines roles and responsibilities for the investment committee, investment consultant, investment manager, and custodian.

For example, the primary responsibility of the investment committee is to adhere to applicable standards; determine the risk tolerance and investment horizon and communicate that to appropriate parties; establish investment objectives, policies, and guidelines that will help direct the investment of the assets; select qualified investment professionals; regularly evaluate performance of investment managers and ensure adherence to policy guidelines; and develop and enact proper control procedures (such as replacing an investment manager) due to a fundamental change in the investment process or failure to comply with the established guidelines. The investment committee can also delegate this responsibility to professional experts and provide acknowledgement of fiduciary responsibility.

Whenever possible, it’s considered a best practice to separate the functions of the investment committee, investment consultant, investment manager, and custodian to avoid conflicts of interest.  If the “consultant” also acts as an “investment manager” for a portion of the portfolio, then there’s an inherent conflict of interest in the advice they may provide related to that portion of the assets (the proverbial fox guarding the hen house).

Statements and Objectives

This section provides an overview of the investment committee’s objectives related to financial requirements; the investment committee’s attitudes, goals, expectations, and ability to tolerate risk; and financial liquidity requirements.

It’s important to note that “objectives” are often confused with “investment policy.”  One common mistake seen in many IPSs is stating the return target of the investment portfolio in the objectives area of the document.  A return target is not an "objective" of the not-for-profit but rather a means to achieve the objectives.

Security Guidelines and Investment Policy

This section defines the following:

  • Investment time horizon.
  • Risk tolerance. Based on one’s ability to withstand long- and short-term variability, the board determines its risk tolerance, which can range from very low to very aggressive.
  • Return expectations given the fund’s spending policy, time horizon, risk tolerance, and inflation expectations.
  • Asset allocation mix between fixed income-type, equity-type and, if applicable, alternative-type assets. This mix should be set based on the stated return target, which in turn is based on liquidity needs, time horizon, and risk tolerance.  Prudent experts can be employed to assist in ensuring a stated return target is achievable given these constraints.
  • Description of each asset type, including restrictions, if applicable.
  • Portfolio rebalancing considerations.

Selection of Money Managers

This section defines and outlines the process and procedural due diligence related to the manager search and selection, including identifying, analyzing, and selecting qualified candidates, ongoing manager evaluation and review, and manager termination.

The investment committee should regularly evaluate the performance of each investment.  Some considerations include the following:

  • Has the investment option outperformed its peer group over an appropriate time frame? Peer groups are other investment managers that share the same investment style. For example, if you have a manager with a large cap growth strategy, the peer group would include a representative set of large cap growth managers. 
  • Has the investment option performed better than its respective benchmark? Here, investment managers track performance against a specific benchmark, which may or may not be different than what was used to benchmark the asset class in your IPS. Make sure the specific manager you’ve hired is outperforming the specific benchmark they have been hired to track.
  • Is the expense ratio associated with the investment option appropriate when compared to peers?
  • Does the manager have more than three years of history investing in the particular style?
  • Is the manager deviating from its investment style?

Control Procedures

This section outlines which party is responsible for ongoing reporting that summarizes activity, performance, and asset allocation as well as the frequency of the reports and board meetings.  It also documents how the portfolio will be benchmarked, what benchmarks will be used, and whether or not performance will be shown gross or net of all fees.

In Conclusion

Fiduciary duty is not to be taken lightly. To make informed decisions, it’s important to be educated and understand all of the associated responsibilities.

Next month we will discuss the importance of determining your organization’s annual spending policy (a component of an IPS) and the function it plays in fiduciary responsibility.  

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Todd McClain