Most advisors are familiar with the investment policy statements used by pension plans and other types of institutional investors. You may also know that the Employee Retirement Income Security Act of 1974 requires pension plans to have IPS.
The law states the investment of pension assets is too important to rely on verbal instructions. In other words, the pension manager needs to make a written promise that makes explicit the implied promise of operating under strict pension laws.
This compact outlines investment goals and objectives of a client and tells how the manager will go about getting it done. Asset allocation, risk tolerance, and liquidity requirements are typically included in an IPS.
In the case of pension plans, there is also a substantial amount of fiduciary liability for trustees, advisors and money managers. The same is true for individual advisors so then why would a financial advisory firm to individuals want to — in essence — issue a set of instructions for a lawyer to go by in the future about how to assess errors and omissions?
The truth is that it’s good for both sides and here I’ll explain just what I mean by that.
1. Why is verbal communication dangerous?
It may sound like a joke, but verbal communications are subject to selective amnesia. That is, trustees, investors, advisors and money managers tend to remember information that benefits them and forget information that damages them.
Verbal communications are also subject to interpretation. Risk tolerance is a perfect illustration. There is no science that creates a specific measurement for future risk. In fact, most advisors and investors use a vague definition of risk that is based on allocation to common stock investments. So what happens when an investor says no material down years? Advisors are going to have various definitions of the word material (-10%, -20% or -30%) and so are investors. What are the odds the two definitions are identical? Not very short. This is why this investment requirement should be documented in an IPS. See: No eff-ing way: Goldman professionals can’t email profanely?.
The clarity of verbal communications erodes over time. For example, how are you supposed to recall the details of a conversation that took place three years ago? See: We’re better than this: The 10 words and expressions that should be expunged from the RIA business.
2. Investment policy statements for individuals
Institutional IPS run 25 to 40 pages, depending on the service provider. A number of topics must be covered that are based on ERISA, Department of Labor, trustee and participant requirements. However, a high percentage of this content is not required for IPS that apply to individual investors. Consequently, the IPS for individuals should only be five to 10 pages long and cover only issues that are important to you and a client: Return objective, risk tolerance, liquidity requirements, restrictions, income requirements, taxation and other topics. Get right to the point and make the statement as direct as possible. Nothing should be subject to interpretation in the IPS. See: Now, the SEC wants you to be a writer, too?.
3. Advisor liability
Some advisors believe they are increasing their liability if they countersign an IPS that documents investor requirements. I believe you are increasing your accountability, but not your liability — for three reasons. You control the provisions in the IPS, you have the opportunity to develop realistic expectations and you should not sign an IPS that contains unrealistic provisions. See: Proposed DOL regs expose more advisors to fiduciary liability.
4. Does account size matter?
You could charge a fee for an IPS. In that case account size matters, because large accounts pay bigger fees than small accounts. Asset amounts also matter if you roll the cost of an IPS into an asset-based fee. So you have a minimum asset requirement for an IPS. See: 7 things a financial advisor needs to know to succeed in the 401(k) business.. On the other hand, if you believe IPS’ protect you from unrealistic expectations, you may want to provide one for all of your clients. In this case, you use a questionnaire to obtain data from clients and software to produce the IPS. For a small time commitment, you could provide an IPS to anyone.
5. Multiple professionals
A high percentage of investors, in particular those with larger asset amounts, have multiple money managers investing their assets. Therefore, one IPS will have to cover multiple managers by giving them specific assignments in the document. For example, a money manager is instructed to invest in large-cap value stocks and to not deviate from this investment strategy without investor approval in advance.
This works if the money manager is a separate-account manager. It does not work if the money manager is a mutual fund or hedge fund. Consequently, you have to execute the provisions of the IPS when you recommend pooled account managers. For example, you determine the amount of money that is invested in a large-cap-value mutual fund? See: Dynasty Financial turns two, picks a new long-term goal and shows off $2 billion of SMA assets.
6. Dual signature
The IPS is not effective until both parties sign the document. In the case of a couple, the husband and wife should both sign off on the IPS to eliminate any risk that they are not on the same page. You should not sign the document if you cannot execute all of the requirements that pertain to you. Any questionable provisions should be negotiated with the client. You should sign the document when you strongly believe you can provide all of the required services and produce results that are consistent with the provisions in the IPS. See: Joe Duran tries out novel financial planning strategy on himself and his wife.
Do not sign documents that have unachievable requirements. For example, the client wants a 15% return with low risk that is described as no more than a 10% loss in any down year. The client must have realistic expectations.
7. Creating value
Do not assume individual investors know how IPS benefit them. Very few have even heard of an IPS. You have to be prepared to introduce the document to them and explain its importance. Keep it simple. Create a one-page marketing piece that describes the key features of the IPS, why investors should have one and the primary benefits. For example, verbal instructions are subject to misinterpretation and selective amnesia. Verbal instructions benefit advisors and not investors. Documentation protects vital investor interests. And, advisors are more accountable when there is an IPS.
8. Fiduciary advisor vs. sales representative
Are your clients better off with an IPS? The answer is absolutely yes. Any time they can replace verbal communications with documentation they are better off. Why? Sales reps rely on verbal communications to win new clients. Verbal gives maximum effect to their personalities and sales skills. And, they do not want a written record of what they tell investors in order to gain control of their assets. On the other hand, fiduciary advisors provide documentation because that is in the investors’ best interests.
9. Competitive advantage
You win when investors agree they should have an IPS and they will not select advisors who do not provide this service. You just eliminated 90% of your competitors. Why? Only high-quality advisors can afford to provide this service. Low-quality advisors prefer verbal instructions that are subject to interpretation, and sales reps cannot provide this service.
Note: Most advisors will not develop their own investment policy statements. Instead, they will use a service such as my friend Norm Boone’s IPS AdvisorPro for $5 per statement. See: Norm Boone builds software company around investment policy statements.
Jack Waymire spent 28 years in the financial services industry. For 21 years he was president of an RIA that provided wealth management services to more than 50,000 individual and institutional investors. He is the author of “Who’s Watching Your Money?” and the founder of PaladinRegistry.com, a website that provides free advisor research, ratings and reports to investors. He is a columnist for Worth magazine and a contributor to major financial websites, and is frequently quoted by the media.