Put It in Writing – Practice Management
By Norman Boone and Linda Lubitz Boone. First published November 1, 2008.
A PDF version of this article can be downloaded here (1 mb).
Bank advisors have lots of reasons to avoid writing investment policy statements (IPS). They’ll say:
- “It takes too much time to go over all the issues with my client and then write an IPS, and get my client to read and approve it.”
- “Clients expect me to start managing their money right away, so it doesn’t make sense for me to delay just to write an IPS.”
- “I’m afraid that by writing an IPS, I’m just giving my client the tools with which to sue me. In fact, my attorney tells me not to put anything in writing if I can avoid it.”
- “My broker-dealer doesn’t allow me to write an IPS.”
- “I like the idea of an IPS, but I’m not sure how to explain the process to my clients or what should go into it.”
This article will address these concerns with an eye toward helping you successfully adopt IPSs as part of what is increasingly considered a “best practice” in the investment world. In these frightening markets it might be particularly helpful to have such a document to refer to. It’s important, first, to recognize that virtually all institutional clients, by law, must have an IPS. This includes all employer-sponsored qualified plans (pensions, profit-sharing plans or 401(k)s) and all trusts, where one person or group is making decisions for the benefit of others (charitable trusts, endowments, foundations, and many family and insurance trusts). Failure to have an IPS in those situations puts your client at risk, which in turn puts you, as trusted advisor, at risk.
Recently, the SEC included a review of IPSs as part of its audit checklist for registered investment advisors in some parts of the country. If legislators and regulators have determined that an IPS is critical to protect institutional clients, how can anyone rationalize that it’s not important for individual clients? We would argue that it’s even more important for individuals to have transparency with their advisors because they are, in general, less knowledgeable.
Clients want transparency in their advisory relationships because they want to know what to expect: How are things going to work? How and when will decisions be made for them and when will they be asked for a decision? They want to know how often they’ll get reports or have meetings and what kinds of securities will be included in their portfolios.
They want acknowledgement of their concerns about risk and how these concerns will be included in portfolio decisions.
Most advisors talk to their clients about these issues, and an IPS simply puts the essence of these conversations into a written document, so there’s a record of what was said. This not only builds trust with your clients, but it should also buffer you from the convenient memory lapses of unhappy clients. Since you should already be having these discussions with your clients, it shouldn’t take that much longer to write down the agreements that have been reached and have the client acknowledge them with a signature. We suggest that the advisor also sign it.
Some advisors confuse the engagement contract with the IPS. These are different documents with different functions. The first is the legal agreement by which the client enters into an advisory relationship with the advisor, agrees to pay the specified fees and charges, and which obligates each party to assume certain responsibilities.
Although written by the advisor, we think of the IPS more as a set of guidelines from the client, establishing what the advisor will do to manage the client’s money. The engagement contract will usually be identical from client to client, whereas the IPS should be unique for each client.
Nuts and Bolts
What should go into an IPS? There are two parts: information that is unique to each client; and a description of things that are (or should be) consistent from one client to the next within the advisor’s practice. Issues that are likely to be unique to each client include:
- Investment objectives—target return and cash flow needs;
- Expected additions or withdrawals (what institutions call a “spending policy”);
- Risk tolerance and the capacity to take on financial risk;
- Asset allocation;
- Any asset class or specific security limits or restrictions;
- Any socially responsible desires the client may have for the portfolio;
- Any concentrated positions and how/whether they will be diversified;
- Tax-related issues, including basis, loss carry-forwards and tax bracket;
- Time horizon for any particular investment goals; and
- Reserves or liquidity needs.
In order to be efficient and ultimately more effective, every advisor should have a fundamental approach to asset management for clients, a way to reach or make portfolio decisions that they follow for each client. In other words, if you have a process, you should have a pretty good idea about what you will and will not be doing, so you can confidently document your process and philosophy in an IPS; you shouldn’t be inventing that description each time you write an IPS.
Issues that are likely to be consistent across clients include:
- How and if you will be using individual securities, funds or separate account managers;
- Your unique investment strategies and how they will be applied to client portfolios, including your approach to timing or tactical moves;
- Whether your investment implementation style uses passive or active managers or some combination of both;
- Whether and how you rebalance the portfolio;
- Whether you use a taxable or tax-deferred account as you decide where to locate particular assets;
- Whether and how you incorporate client “play accounts,” heavy cash holdings or outside investments, into the portfolio;
- If and how you incorporate tax-management strategies;
- How you report investment performance;
- How you evaluate current and potential investments;
- How you will monitor the portfolio;
- Criteria for how often you’ll review the IPS, investment managers or investments;
- How you will audit and adjust for any requirements specified by the IPS;
- What responsibilities you expect of your clients (for example, vote proxies, attend meetings on time, read the prospectus, etc.); and
- The degree of discretion you retain in implementing recommended changes to their portfolio.
There are no “required” topics that must be in an IPS. So, if you feel uncertain about your ability to deliver any of the above consistently or if you feel that discussing any of these topics might unnecessarily disclose your unique “magic,” then don’t include them. If you’re uncertain about whether your decisions or procedures will be predictable (if you don’t know whether you will actually be doing a particular action or following a specified procedure), then don’t include that in the IPS either. Since the advisor writes the IPS for the client, you are in control of what topics you address and how each is described. commit to doing something in the IPS that you may not do. Saying you’ll do something and not doing it would give a disgruntled client the ammunition to sue you. So only include statements in the IPS that you know are and will be true. Any system, including software, will help you be consistent about what you say and how you describe what you will be doing.
Never
The idea of the IPS is simply to document what you and your client talk about and agree on. This will help avoid misunderstandings and will serve as a baseline to which you can return when the markets are tough and the client starts to wish for a change in approach. Being brought back to the ideas expressed in the IPS, reflecting a time of more rational discussions, can be soothing to the client and help you both focus on long-term success.
How does an IPS fit into the investment process? The investment process can be divided into six steps, the first two help create the ips and the last three are derived from the IPS.
- Initial discovery. We learn about the client’s circumstances, goals, income needs, restrictions, current holdings, what will be included in the portfolio, risk tolerance, time horizon, etc. We do this through conversation, questionnaires and documents from the client.
- Discussion and agreement. We talk with clients about the issues and choices that must be agreed upon before we can manage their money. This gives us an opportunity to educate, set expectations, and find agreement on issues like the degree of discretion, appropriate asset allocation, our approach to taxes, our investment philosophy and a host of other policy concerns. It is these first two steps which, when done well, really take time. If you rush through them so you can start managing the assets, it’s very likely that your expectations will be out of sync with those of your client.
- Creating the IPS. Once we have agreement on the full list of issues (ideally systematized through a questionnaire to help ensure all issues are addressed), we record these agreements in the IPS. We and the client both sign the document, in acknowledgement of those agreements.
- Investment implementation. Until the IPS is signed by both client and advisor, no trades should take place in the client’s accounts. Once signed, you should be able to quickly apply the agreements to specific recommendations and trades. What specific securities you will recommend is an implementation issue, not a policy issue, and therefore should not be part of an investment policy statement. The criteria you follow in choosing which securities to recommend is a policy issue and therefore could properly be included, if the decision-making process you use will be consistently applied. As investment recommendations are developed, the policies outlined in the IPS should guide the decision-making, so the client will get what was expected, not necessarily in terms of results, but in the process used.
- Ongoing communication. Our regular meetings, phone calls, emails and periodic reports are conducted as called for in the IPS. This also helps to set appropriate expectations.
- Monitor & adjust. No portfolio stays as originally structured. So, as laid out in the IPS, we monitor the portfolio for poor performers, rebalancing opportunities, new ideas, and tax-loss harvesting opportunities. As these things change, the IPS should be treated as a “living document” and periodically should be updated to align with the actual experience.
Since the IPS reflects the policy agreements between you and your client, if you should change something in your advisory investment process, you will need to keep your clients informed about the change and document that discussion. Why not also change the IPS to keep it up to date?
Similarly, changes for the client should be reflected in the IPS. If a client needs to withdraw funds from a portfolio rather than making steady contributions, or if a client’s risk tolerance has substantially changed, it’s important to document that, so why not do so in the IPS? Keeping your IPS current establishes a record of openness and transparency that will inevitably raise the client’s level of trust in you.
A history of updated IPSs is also the best possible way to protect yourself against litigation with a client. Imagine going into court with documents signed by the client acknowledging changes in approach made by the advisor, and showing the advisor’s acknowledgement and adaptation to changes in the client’s needs and circumstances.
Court decisions regarding fiduciary litigation have unfailingly held that when a reasonable investment process and standards are documented and used, the advisor should not be held responsible for the actual investment results.
Managing client expectations is the holy grail of effective client relations, and the IPS directly lets you clarify what you will be doing with your clients’ money and document that your clients know about it.
Including IPSs as a key part of your investment process is now an industry best practice. If you’re not already consistently using IPSs in your practice, today’s turbulent markets make now an excellent time to start.
Norm Boone and Linda Lubitz Boone are co-founders of IPS AdvisorPro, an online software solution. Norm is the president of Mosaic Financial Partners in San Francisco, and Linda is the president of The Lubitz Financial Group in Miami.
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