Investment Policy Statements for Trusts
Foundations, trusts and retirement plans are required to
have an investment policy statement. Wealthy individuals, as well as
anyone with money earmarked for goals such as retirement or college
education, should have an investment policy statement. Often referred to
as an IPS, the investment policy statement is the basic building block in
an intentional investment process, according to Creating an Investment
Policy Statement by Norman M. Boone, M.B.A., CFP®, and Linda S.
Lubitz, CFP®.
With an IPS, an adviser and a client agree upon all the
essential issues surrounding how and why the money is to be managed. This
step usually is handled after the adviser has assessed the current
situation of the trust by reviewing the applicable trust documents, tax
returns, and other financial documents. The adviser must manage the trust
portfolio such that it complies with the purposes, terms, distribution
requirements and other circumstances of the trust, according to The New
Fiduciary Standard, by Tim Hatton, CFP®, CIMA, AIF, written in
conjunction with the Foundation for Fiduciary Studies.
In addition, The New Fiduciary Standard says it’s
important that advisers determine whether the trust documents identify
trustees and named fiduciaries in writing; if there is sufficient detail
identifying selection criteria, duties, and responsibilities of investment
committee members; if the trust documents allow for fiduciaries to
delegate prudently investment decisions to others.
In many cases, the process for creating an IPS for a trust
is the same as it is for a retirement plan or a foundation. An adviser
must:
 | identify a client’s goals |
| identify a target rate of return |
| understand the time horizon |
| understand the client’s risk tolerance |
| identify acceptable investment categories and vehicles |
| establish an acceptable allocation of asset categories |
| write an IPS |
| select the specific investments that fit the allocation model |
| monitor and adjust the portfolio as appropriate. |
On the surface, this process seems simple enough. The
tricky part, however, comes when you have to adjust the IPS to meet the
requirements of the trust document. For example, the beneficiaries might
be minors (typically 18, but 21 in some states), or the beneficiaries may
be adult children receiving regular distributions for college funding, or
the trust may call for distributions to beneficiaries at preset ages, such
as 25, 30, and 35. Each of these scenarios might call for a different
asset allocation to assure the appropriate liquidity at the appropriate
time.
When advisers create an
IPS for a trust, special attention must be paid to the timing of planned
cash inflows and outflows, and that an investment time horizon has been
identified. Knowing the investment time horizon determines which asset
classes will be considered, what the mix among asset classes will be, what
sub-asset classes will be considered, and which mangers or funds will be
selected.
With respect to timing, an adviser must make sure there
are enough liquid assets to meet distributions when due. The trust may
call for distributions to pay specific expenses of the beneficiary, like
college tuition. Likewise, there must be enough liquid assets to meet
distributions tied to specified ages such as when a trust beneficiary
turns age 25 or 30. These distributions are known well in advance and cash
can be set aside for them. The adviser must also make sure there are
enough liquid assets to pay other liabilities of the trust such as
advisory fees or taxes when they come due.
To do this, the adviser should prepare a schedule of the
portfolio’s anticipated cash inflows and outflows for at least the
coming five-year period. A time horizon in which a distribution must be
made within five years would be considered short-term and a time horizon
in which a distribution must be made after five years would be considered
long-term. If short-term distributions exceed the inflow of cash over a
given period, assets will have to be earmarked to cover the shortfall.
Generally, though not always, assets earmarked for short-term time
horizons would be invested in cash and short-term fixed-income securities
with liquidity and preservation of capital often being the primary
investment objective. And assets earmarked for long-term time horizons
could be placed in a wider variety of asset classes, including stocks,
bonds and cash or even real estate and alternative investments. The cash
flow schedule also helps the adviser rebalance a portfolio, by using
deposits to add to under-represented asset categories and by liquidating
holdings that have grown too large in order to fund planned withdrawals.
Advisers often will take one of two approaches to
allocating assets within a trust. In one case, the adviser might separate
the money that must be distributed within five years from the money that
must be distributed after five years, maybe even using separate accounts
for each time horizon. The shorter-term money would likely be allocated to
investments that provide safety of principal – cash and short-term
fixed-income securities, for instance. The adviser would then invest the
remaining portion of funds in assets typical of a portfolio with a
long-term time horizon, stocks and bonds, for instance.
Alternatively, the adviser might invest all of the assets
together, allocating assets among stocks, bonds and cash in one account,
and use strategic or annual rebalancing of the portfolio to produce the
funds for required distributions.
Along with preparing for partial distributions of the
trust corpus, the IPS and the investments must also align with the
eventual liquidation of the trust. Trusts have a finite life and must be
liquidated at some point. Depending on the terms of the trust, this
liquidation may be a short-term distribution (within five years) or a
long-term distribution (five years or longer). The IPS and the investments
must reflect that time period in the asset allocation.
The Investment Policy Statement is a lot like a blueprint
for the management of a portfolio. It should spell out all the roles of
the various parties related to the trust, including the adviser, client,
and other parties, and especially the process by which the account is to
be managed and monitored. A good IPS helps foster communication between
adviser and client, and helps everyone to understand their
responsibilities and duties as they work together to administer and manage
the trust to carry out its purposes in the lives of the trust’s
beneficiaries.
August 2005 —This column is produced by the Financial
Planning Association, the membership organization for the financial planning
community, and is provided by McGuire & Co, LLC , a local member of the
FPA.
