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A Matter of Policy

An investment policy statement is a critical part of 401(k) plan.

1Aug

In the movie Gladiator, things really heat up when the Roman soldier Maximus utters the battle cry, "At my signal, unleash hell!" When Chris Jones, the CFO of S.W. Rodgers Co., found out that his company's 401(k) plan was underperforming in a raging bull market, he uttered a similar cry.


The results were a little less bloody, but just as decisive: He ultimately fired the vendor after hiring a consultant to help design a stronger plan. And he learned an important lesson about the value of an investment policy statement (IPS). "Until that moment, we didn't even know we needed one," admits Jones. "We knew the investments weren't performing well, but we had no criteria to determine just how badly they were doing."


That was over a year ago. Today, with a well-crafted IPS at the ready, Jones and the plan's investment committee have a clear blueprint of how to select and monitor investments, including appropriate benchmarks. "We make sure that the investments meet the standards that we've set," says Jones. Those targets are determined jointly by the client, the consultant, and the vendor.


Like many small companies, S.W. Rodgers, a Gainesville, Virginia-based construction business with 820 employees, initially put all its eggs in one basket, relying on an investment product vendor to put together an investment package for the 401(k) plan and to monitor the investments. Such reliance on a single firm may be unwise, says Fred Reish, an Employee Retirement Income Security Act (ERISA) attorney and partner at the Los Angeles law firm Reish & Luftman. "Clients need to be familiar with the processes that the financial institutions are using, and they need to make sure that they agree with what they are doing," he says.


That's where investment policy statements come in handy. Such documents not only spell out performance measurements, they also protect against the short-term "noise" of passing investment fads, says David Wray, president of the Profit Sharing/401(k) Council of America, a Chicago-based trade association of plan sponsors. Employee satisfaction with 401(k)s is generally high, he explains, except for one thing: everyone knows one additional fund that would make his or her plan perfect. Some employees can be extremely aggressive in lobbying for new funds to be added to the plan. "If you don't have an investment policy that outlines a strategic vision for your investments, it's difficult to say no to those individual requests," Wray says. And if the company itself decides a change is in order, he adds, an IPS can provide valuable focus for choosing new funds.


Moreover, an IPS also serves as an incontrovertible piece of documentation if plan performance or administration is ever questioned — by lawyers, that is. Wray stresses this with an evangelist's zeal. "We need to demonstrate that investment policy statements add value," he says. "Plan sponsors are responsible for acting in a prudent and deliberate way, and if they are challenged, they need to have evidence of a prudent decision-making process. If you don't have a paper trail of what you've done and why, you can't prove that you've had a diligent policy in place."


Yet, even given an IPS's many uses, recent surveys reveal a surprising complacency among 401(k) plan sponsors, despite perpetual anxiety over fiduciary responsibility. A 1999 BARRA RogersCasey/IOMA defined contribution survey, for example, revealed that 44 percent of 401(k) plan sponsors don't have a formal investment policy. While that's an improvement over the 52 percent of 1998, the findings — which were based on responses from nearly 500 plans representing $218 billion in assets and 5.2 million participants — reveal that larger plans are more likely to have such policies than smaller plans. For example, 61 percent of plans with more than 10,000 participants have a formal investment policy, compared with 49 percent of plans with fewer than 250 participants. "That's probably because large plans have greater resources," says David Katz, managing director at BARRA RogersCasey.


Indeed, 31 percent of surveyed plan sponsors cited lack of sufficient resources as a reason for not having an investment policy, while 34 percent said it was because they believed an IPS adds little or no value. But if you ask Steff Chalk, president of Chalk 401(k) Advisory Board, a Cincinnati-based consulting firm, the real reason that companies fail to secure an IPS is that they don't understand all the things such a statement can do for them. He creates one for every client he works with, and says there's no reason other companies should put it off. "It's like balancing your checkbook," he says. "It's something that's not hard, but many people never get around to it."



Fiduciary Fulfillment

Ever since Congress passed ERISA in 1974, CFOs and other high-ranking financial executives have heard the term "plan fiduciary" batted around ad nauseam. But according to Doff Meyer, senior vice president of Delaware Investments, a Philadelphia-based investment management firm, many still don't appreciate just how responsible they may be. Plan sponsors, explains Meyer, are sometimes under the mistaken impression that participant-directed 401(k) plans remove the fiduciary obligations traditionally found under defined benefit plans. "As fiduciaries," Meyer says, "plan sponsors incur a certain amount of fiduciary liability with respect to the investments in the plan, regardless of who directs the participant accounts."


Neil E. Wolfson, national partner in charge at KPMG Investment Consulting Group, based in New York, agrees: "At the end of the day, the ultimate fiduciary responsibility rests with the plan sponsor, and there's no way to get around it." But what if plan sponsors appoint a consultant or outside investment managers? "They haven't removed their responsibility to select and monitor the investments in a prudent fashion," says Wolfson.


Under ERISA, plan sponsors are responsible for monitoring plan investment options and the underlying portfolios on an ongoing basis. "It is not sufficient for fiduciaries to merely choose a mutual-fund menu for the 401(k) plan and then wash their hands of their ERISA mandates," says Robert Rafter, senior vice president and director of institutional sales for Salomon Smith Barney's Corporate Retirement Services Department, in New York. In order to fulfill their obligations, Rafter says, companies need to create a comprehensive, prudent investment and monitoring process that meets ERISA's standards; an investment policy statement is a perfect starting point.


While Rafter notes that a written investment policy statement is an important element in establishing the necessary fiduciary risk management controls, he also stresses it is equally important that the investment committee act in accordance with that document.


"If you get very specific in your document but the investment committee doesn't act in accordance with those requirements," he warns, "you may create an additional liability for the fiduciaries."



Getting Started
Because an IPS creates a framework for all aspects of the plan, it seems only logical to draft one before rolling out a 401(k) to employees, but where does that leave established plans that lack an IPS? "A company can create one anytime," says Jody Strakosch, national director at MetLife's Retirement and Savings Group in Minneapolis. "But often the addition of new investment options creates an excellent situation for finally spelling out goals."


Large companies usually have the resources to create an investment policy statement in-house, but many companies choose to hire outside consultants to draft or at least review their policy statements. Some take advantage of the help offered by product and service providers.


Although plan providers will do the job, Chalk recommends using an independent consultant — someone who isn't involved in managing the 401(k) funds — to prevent conflict of interest. " We want the vendor of the investments to agree to the policy, but we don't want them to write it," he says. "I have yet to see the vendor who will say, 'We've done a poor job; it's time to fire us.' "


Michael Miller, vice president of global compensation and benefits at Lear Corp., a $12.4 billion auto-parts maker, agrees. "Our outside consultant gives us a quarterly review of the plan's performance, and our benefits committee reviews it," he says. "We also use them to help us make decisions about the plan, such as which funds to offer."


Outside advisers can play another important role as well: helping plan sponsors keep up with various regulatory requirements spelled out in ERISA. Miller was stunned, for example, when his adviser notified him that the Southfield, Michigan-based company is required to provide information to older employees that explains their options for drawing on funds in retirement and managing their accounts during their last years of employment. "I've been in this business for 37 years, and this particular requirement was news to me," says Miller, emphasizing that the burden of fiduciary responsibility is not just media hype or a consultant's sales ploy.


How specific, then, should an IPS get? "It's a function of what type of investment vehicle you're dealing with," says Wolfson. "For a separate account, you can be much more restrictive about how the funds are managed than you can with a mutual fund." Indeed, at Lear, a newly offered self-directed brokerage account limits the percentage of retirement funds an employee can invest in this way to 50 percent. "We may be a bit paternalistic," Miller says, "but we need to balance an employee's desire for investment return with an acceptable level of risk."


A similar sense of balance may characterize the best policy statements. Wolfson says the more specific a statement is, the better, both in spelling out what forms of investments will be offered and in stating the control procedures for monitoring adherence to those guidelines. But, he cautions, "you don't want to draft an elaborate, 100-page document that no one will read and follow in its entirety."


Once an investment policy is in place, don't tuck it away in a drawer, advises Meyer of Delaware Investments. She recommends that the statement be revisited at least quarterly or during each investment review, even though it doesn't need to be rewritten that often. "It's a dynamic document," says Katz of BARRA RogersCasey. "As there are changes in the plan, the investment lineup, or the investment committee, you should refresh it."



A Safeguard Against Litigation?
So far, fiduciary liability lawsuits against 401(k) plan sponsors by disgruntled participants have been rare. That's because "we've been in a bull market since the early 1990s, and the booming stock market has covered up a lot of mistakes in plan management," says attorney Reish. "However, if the country enters a recession and the stock market is down, and it becomes obvious that an employer and its plan committee didn't diligently select and monitor the investments, there will be lawsuits."


And, since it's impossible to predict whether a particular investment will go up or down in value, rather than looking at results, the court will look at the steps plan sponsors went through selecting the investments, explains Reish.


Even though it's not a panacea, a correctly written statement can help in two ways. "First, having an IPS shows that the employer was earnest in its desire to prudently select and monitor investments," he says. "Second, ERISA measures compliance in terms of the process. Did you go through the right process in selecting and monitoring those investments? An investment policy statement outlines the process and the criteria that are going to be used to satisfy ERISA's fiduciary requirements. So, if you draft it and you do it knowledgeably, and then you implement the procedures as they are described in the document, you've satisfied your fiduciary duties under ERISA."


In theory, at least, which is as much as can be hoped for, and well worth the effort. An investment policy statement doesn't safeguard against litigation, but it can provide a first line of defense in court. But don't just write it, Reish says, use it. "Putting something down in writing and then not following it," he cautions, "is often more dangerous than not having put it down in the first place."

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