Developing a 401(k) Investment Policy Statement

More companies are establishing a formal investment policy statement for their 401(k)-type defined contribution plans, as they have long done for defined benefit pension plans. The investment policy statement is designed to guide the sponsor's retirement plan committee as it decides, with the plan's financial services provider, on investment options to include in the plan, and to evaluate the performance of those investments over time.

The statement should be shared with plan participants to help them understand the reasoning behind the inclusion, and exclusion, of investment options in the plan—for example, to provide asset diversification, reduce risk and keep fees low. Spelling out these reasons can help participants to select appropriate investments for their own individual retirement portfolio from the plan's investment menu.

The Rationale

Having an up-to-date investment policy explained in a formal policy statement and, more importantly, following it, can go a long way to help plan sponsors show that they followed a prudent process for choosing and evaluating plan investment options.

For large plans, having an investment policy is accepted practice, but small plans often do not have an investment policy statement in place, according to Mark Lamoriello, the president and chief investment officer of LAMCO Advisory Services in Lake Mary, Fla. “Nothing in ERISA says having an investment policy is required,” he says. “But it is difficult to build an investment strategy for the plan without an investment policy.”

Unfortunately, the need for an investment policy statement is not getting through to all plan sponsors, particularly those with small plans. Although 83 percent of the 830 plan sponsors surveyed have an investment policy, that number drops significantly among small plans, according to the most recent 401(k) Benchmarking Survey conducted by Deloitte Consulting LLP with the International Foundation of Employee Benefit Plans and the International Society of Certified Employee Benefit Specialists. The survey found that just 68 percent of plans with $10 million or less in assets have an investment policy.

What To Cover

Overall, the investment policy statement should spell out:

• The plan’s overall investment philosophy and investment objectives.
• Who is responsible for choosing and monitoring the plan’s investments.
• How the plan will construct its investment menu and how it determines what investment options to offer, including what asset classes are included and why.
• How the plan will evaluate the investment funds offered, including the frequency and criteria to be used.
• Under what circumstances the plan will remove investment funds or managers and how that process will be managed.

The policy statement can be developed by the sponsor’s retirement plan committee with support from legal or investment counsel. Although plan service providers often supply investment policies with basic boilerplate language, it is a good idea to customize the policy as much as possible to match the circumstances and needs of the plan. Some plans have unique design elements and specific situations, such as offering company stock or a brokerage option, that must be addressed in the policy.

But no matter what it includes, an investment policy should be flexible enough to guide decision making, not to dictate it. “This is not a legal document,” says McPhail. “It has to be flexible enough to reflect the plan’s investment philosophy and to be meaningful for plan administration by including appropriate metrics for investments, the rules for manager selection and termination, and when investments should be put on a watch list.” The document should spell out what types of investments are not permitted in the plan, such as options, futures and derivatives, and why (unacceptably high risk, for example).

“Once the policy is in place, the committee must make sure the plan adheres to it and that the policy creates a process that is manageable,” says Lamoriello. “The biggest risk is that a policy will sound good on paper but not in action. And it is better to have no policy than a policy you won’t follow.”

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‘It's better to have no policy than a policy

you won’t follow.’

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For example, Lamoriello says that an investment policy that states that any fund that is in the bottom 50 percent of its peer group will be replaced could be unworkable in practice. “The policy should be designed to guide decisions, not to make decisions,” he says. A more-effective policy will state that the committee will look at series of rolling three-year periods and that funds that fall to a certain level will be reviewed immediately to determine if they should stay in the plan. This way, the committee is not locked into focusing on specific time frames of performance when making a decision.

Keep It Current

No matter how a plan sponsor develops its investment policy, “it shouldn’t sit on a shelf,” says Patrick Ross, a principal with accounting firm Haskell & White LLP in Irvine, Calif. “It should be revisited quarterly or at least annually. If you don’t look at it periodically, you may find that you are not following your own document.”

Update the investment policy statement periodically to reflect changes to the plan, the sponsor and the legislative environment. For example, if the plan changes service providers or alters the number of funds in its investment menu, or if the plan sponsor undergoes a merger or acquisition, the resulting changes should be reflected in the investment policy statement.

Even if there is no need to update the policy it should still be reviewed regularly. The key is to acknowledge that the committee—and especially any incoming members—have read the policy and remain comfortable with it.

Get the Word Out

Employee plan participants often gripe about the investment selections available in their defined contribution plan and wonder why out of the universe of available funds (or, certainly, all the funds offered by the financial service provider that manages their plan) only a small number are available to them.

That should be reason enough to ensure that the investment policy statement is distributed to new hires as part of their defined contribution plan package, and to current employees as well. By doing so, plan sponsors can increase participants' understanding of, and appreciation for, the plan and the investment options it provides, and they can help them to make better informed decisions regarding which mix of available funds might be appropriate for their retirement portfolio.

If the plan's financial service provider maintains a web site where participants can select and adjust their investment options, make sure that it contains a link to the policy statement.

Joanne Sammer is a New Jersey-based business and financial writer. Her articles have appeared in a number of publications, including Business Finance, Consulting, Compliance Week and Treasury & Risk Management.