Investment Policy Statement

Properly structured, an Investment Policy Statement (IPS) is a roadmap to fiduciary compliance for plan investments and should describe the ionvestment structure. ERISA's legal requirements and fiduciary best practices, the selection process and criteria, the monitoring process and criteria, and other investment duties. The IPS should be periodically reviewed and amended, as necessary. Once an IPS is adopted, a plan sponsor's fiduciary liability and its attendant risk can be best managed by establishing an on-going investment process, including; (i) maintenance of due diligence files and (ii) on-going analysis of each key provision in an IPS, including the retention of records concerning the subject and facts of discussion and questions and the conclusions reached on various issues.

Prudent Investment Process

In determining whether a fiduciary has acted prudently, the focus of the inquiry is how the fiduciary acted in its selection of the investment, and not whether the investment succeeded or failed. As explained in a leading case: "(ERISA's) test of prudence....is one of conduct, and not a test of the result of performance of the investment." Department of Labor (DOL) guidance over the years provides some evidence as to what constitutes investment prudence. In selecting investment alternatives, a fiduciary should initially create an overall scheme of what investment choices there should be while identifying appropriate asset classes and investment styles, then identify a range of appropriate funds (taking into account such key factors as performance and fees), followed by an examination of relevant information such as prospectuses, and finally, make a decision on that basis. Thus, while neither ERISA nor its attendant regulations specifically require an investment policy statement ("IPS"), its general fiduciary provisions do appear to require a document setting forth guidelines for funding procedures, including selecting and monitoring investment options and investment managers.

Market Returns!

Most investors have failed by a long shot to achieve market rates of return. Based on the Dalbar Study, the average investor has failed significantly to achieve market returns. While the S&P 500 has earned 10% over the last 20 years the average mutual fund investor has earned 4%. This is a stunning failure. Research shows the average actively managed mutual fund underperforms the market by two to three percent per year. Accepting this fact, the investor's job of allocating assets is greatly simplified. The investor only needs to allocate his/her assets into various asset categories to achieve market returns and remain disciplined over long periods of time. This is easier said than done and most often requires the aid of a coach. By focusing on market returns, there is no stock picking at all. No forecast, no prediction. There is no gambling on beating the market. You just own every single stock in that asset category. That's what we talk about when we refer to market rates of return.

Use Market Forces. Don't Fight Them!

In a free capitalistic society the capital market rates of return are there for the taking. The basic underlying working mechanism of capitalistic markets is to earn a return on your investment capital. Don't fight market forces by attempting to beat the market because the vast majority of hyperactive managers fail to achieve market returns. Harness the power of free markets by owning structured market portfolios that are designed to deliver market rates of return. These funds are typically available to only the most sophisticated investors. These funds buy a cross section of all the stocks in any given asset category, and often employ highly effective trading strategies to minimize trading costs to their portfolio. Investors are often surprised and delighted to learn how generous market rates of return have been over long periods of time.

Fiduciary Breaches

Previously we discussed ERISA's Fiduciary Obligations. If any such duty is breached, a fiduciary may be held personally liable, for among other things, any losses resulting from the breach. Corporate protection over individual liability and personal assets does not apply when a person breaches a fiduciary duty. In addition, a fiduciary may be liable for another fiduciary's breach ("co-fiduciary liability"), if the first fiduciary knowingly participates in or concelas the other fiduciary's breach, enables the other fiduciary to commit a breach by failing to carry out its general liability duties, or fails to make reasonable efforts under the circumstances to remedy the other fiduciary's breach. Thus, ERISA imposes significant risks for investment fiduciaries

ERISA's Fiduciary Obligations

Fiduciaries are subject to the following basic standards of conduct and responsibilities under ERISA:1) Duty of Loyalty-a duty to act solely in the interest of plan participants and beneficiaries and for the exclusive purpose of providing benefits and minimizing expenses; 2) Duty to Act Prudently-a duty to act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use the conduct of an enterprise of a like character and with like aims; 3) Duty of Diversification-a duty to diversify the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so; 4) Duty to Follow Plan Documents- a duty to act in accordance with the documents and instruments governing the plan insofar as such documents and instruments are not inconsistent with the provisions of ERISA including the plan's investment management agreements and investment policy statement. Next week we will discuss some consequences of any breaches of fiduciary duty.

The Problem with Financial Planning

The primary purpose of financial planning was developed to run sophisticated analyses and spreadsheets to compute investors' insurance needs, and also do retirement cash flow analyses as well as both income and estate tax calculations. Armed with all of these facts, the goal was for independent and unbiased recommendations to follow. The concept of the financial plan was quickly hijacked by the commission-driven brokerage and insurance world, and used to push product, Financial plans were soon being used to sell investment products. Helping the client achieve true peace of mind was seldom the topic of discussion at the trade show booths of financial planning vendors. The emphasis was squarely placed on how much insurance or investment products could be sold. In several ways the planning process was flawed. Based on garbage in/garbage out, any plan is only as good as the goals it was established with. Most people have "fuzzy goals." They have so many opportunities and choices and they are rarely perfectly clear on what they really want to achieve with their money and lives. Most plans make simple assumptions, like retire at age 65, reduce taxes, and minimize my investment risks. Rarely does the plan take into account personal visions, values, and dreams, thus aiding in the development of concrete goals, strategies, and action plans to live a more fulfilling life. After all, none of that was required to move product and earn commissions. Quite the contrary, if this was done, it would postpone the product sale itself. Many financial plans create complexity, information overload and fear.