The investment policy statement (IPS) was originally intended as a tool to assist plan officials of defined benefit plans with making investment decisions in accordance with requirements under the Employee Retirement Income Security Act (ERISA) of 1974. Effectively, an IPS is the framework by which investments are analyzed and evaluated, and added or removed from a plan’s investment lineup. ERISA emphasizes the importance of having a prudent process. Note that an IPS is not required under ERISA per se; rather, it’s simply a very good idea to have one, as we will note¹, because the IPS assists in adherence to a prudent ERISA process.

"[ERISA's] test of prudence . . . is one of conduct, and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment, and not whether his investments succeeded or failed."

(Donovan v. Cunningham, 716 F.2d 1455, 1467 - 5th Cir. 1983)

ERISA litigation, generally, is focused on plan investments and costs. Therefore, in an attempt to mitigate risk, plan officials should take steps to ensure their investment selection and evaluation process is thorough, complete and well documented. The IPS is the first step in this process and having a well-crafted IPS that plan officials follow goes a long way to minimizing risk. An IPS is an effective tool in setting forth the process by which plan officials make investment-related decisions within the principles specified under ERISA.

Consider the fact that the defined contribution plan market did not even exist as we know it today when investment managers drafted the first IPSs. There was no such thing as participant self-direction of investments, ERISA Sec. 404(c) coverage or qualified default investment alternatives (QDIAs). As 401(k) plans increased in number, and participant self-direction became ubiquitous with the advent of ERISA 404(c) and the QDIA rules, plan officials became more concerned about compliance and liability in this new environment. During this time, the IPS was seen as an increasingly important tool to help plan officials control investment-related liability. Consequently, plan officials began incorporating IPSs into their plan governance processes more frequently. In fact, most (86 percent)² of defined contribution plans today have IPSs. Even among smaller plans (i.e., those with fewer than 50 participants), 72 percent have an IPS. An IPS has become so common in 401(k) plans that having an IPS is an adopted best practice, and a plan without an IPS would clearly be an outlier in terms of industry practice.

However, just having an IPS doesn’t absolve plan fiduciaries of their obligation to keep it fresh and current. As times change, so too do the prudently acceptable philosophies, investment option availability, vehicles, and processes change. As plans and investment options evolve, so too must IPSs. Recall the ERISA standard of best interest— all the actions of the plan fiduciaries must be in the best interests of the participants. The modern IPS should be a more robust and dynamic document than the simple, often vague, early IPS documents.

In working with plan committees and reviewing many IPSs we have noted consistent concerns with these documents that include:

Guidelines are too broad or narrow:
Some are too broadly written to be useful, while others are so detailed and narrow as to restrict the ability of plan officials to implement their beliefs, make changes or modify investment policies effectively. Other problems may crop up when plan committees do not follow the language within their IPSs. Such failures could exacerbate their liability with respect to plan investment selection, monitoring and replacement.³ Effectively, not following an IPS may be worse than not having an IPS.

Thus, what is the appropriate balance between too narrow and too broad of an IPS? An IPS should provide the framework and context for the investment decision-making process and, at the same time, allow plan committees the flexibility to make decisions based on the realities on the ground. As an example, we encountered a situation where an IPS had a complex formula to determine when an investment option should be replaced. The math was heavily weighted to replace the investment if the manager left. According to the formula, the investment should be replaced. However, in looking deeper into the situation, it appeared other factors ­albeit ones not noted in the IPS- should be considered. Yes, the manager of 30+ years was retiring; however, the new manager had been effectively co-managing the fund for two decades. Thus, an effective IPS gives committees discretion to act in circumstances where other factors contribute to a good decision-making process.

Benchmarking restrictions:
Benchmarks are another area of concern. Many IPSs mandate specific benchmarks for specific investments. Benchmarking is a dynamic process. In some respects, it’s an art – not science. Committees should have the ability to adapt and change benchmarks as prudence dictates. A well-written IPS should reflect this and provide the flexibility in allowing benchmark changes where appropriate.

Inconsistency with other documents:
An IPS does not exist in a vacuum; other documents must be considered when drafting an IPS to avoid inconsistencies and even contradictions. A couple of examples illustrate this concern. First, we have encountered IPSs calling for investment types not permitted in the plan document. Next, we have reviewed 3(38) Investment Manager agreements that are not consistent with the plan sponsor’s IPS.

We frequently hear the question, “Why do we need an IPS if we are using a 3(38) Investment Manager to oversee the investments?” It is a fair question. Plan officials must oversee the actions of all fiduciaries and service providers, and a properly drafted IPS is the appropriate document to memorialize the oversight process.

Selection and monitoring criteria:
Criteria for selecting and monitoring different types of investments should be indicative of what fiduciaries believe their participants should expect from those investment options.

• Passive funds, for example, should be expected to look like the market they are trying to replicate at all times – 1.0 Beta, 100% Upside Capture, 100% Downside Capture, 0.00% Fees – and they should be judged by how successfully they achieve those goals. 
• Active managers look to add value over long-term investment horizons by differing from their benchmark – being either more or less volatile, targeting higher or lower Upside and/or Downside Capture, accumulating more wealth after expenses. 
• QDIAs like Target Date Funds are blended portfolios that require different measurement criteria.
• Retirement Income solutions also need to have different measurement criteria outlined in the IPS since the goals and objectives for investors in these strategies are not the same as investors seeking to accumulate wealth.

IPS as a job avoidance shield:
Another problem with IPSs is they can be used by plan officials and their advisors to hide behind, whitewash their responsibilities and not take appropriate action.

Unfortunately, we have seen numerous situations where the IPS has been used as an excuse for not making changes or modifying the investment menu. Comments to the effect of “that’s not permitted under the IPS” are often used to maintain the status quo and provide the advisor or consultant with an excuse for not exploring new approaches or products.

If the plan fiduciaries believe there are investment options that can improve outcomes for plan participants, the question that needs to be asked is: “Why does the IPS restrict our ability to do what we believe is the right thing to do?” Meeting notes should be recorded that describe why the particular action is appropriate and action should be taken. Updating the IPS to allow what the fiduciaries believe is prudent is tantamount.

Fees, expenses, and revenue sharing:
IPSs have other potential shortcomings. Frequently, we note IPSs do not address revenue sharing and the processes by which such amounts are offset, allocated and accounted for. Based on previous litigation, having such language is prudent (Ronald Tussey, et al. v. ABB, Inc., et al., U.S. District Court, W.D. Missouri, No. 2:06 CV-04305-NKL, March 31, 2012.).

Also, it has been noted in certain cases that fee and expense calculations are inconsistent with contracts and prospectuses. Plan officials, being tasked with operating the plan in the best interests of the participants, need to recognize the potential for these errors, and create review and audit mechanisms designed to identify these situations. The IPS is the ideal document to record such processes.

Obsolete language
Many IPSs are out of date and have not been amended to reflect modern investment options, plan philosophies and economic trends. To illustrate this point, it is common for an older IPS to reference mutual funds as the available investment options, while in operation the plan uses more modern investment choices such as exchange traded funds (ETF), collective investment trusts (CITs), managed accounts or retirement income options. The IPS should reflect the actuality of what the fiduciaries believe as well as what the plan is doing.

Macroeconomic issues can and do impact plan investment decision making, and a well drafted IPS should consider such issues. To illustrate, consider inflation. We are experiencing the first inflationary cycle since the onset of the self-directed 401(k). Inflation has significant implications on retirement-related investment decision making. Arguably, factors as impactful as inflation should be considered in the construction and make-up of the investment line-up and, thus, should have a place in the IPS.

The IPS is a living document and plan officials should routinely review and amend it as circumstances dictate. Plan officials periodically amend plan documents for legislative and regulatory changes, as well as when participants’ needs change. The IPS is a useful tool for educating plan committee members and should be regularly reviewed and periodically amended.⁴

An important consideration in IPS language is the overall philosophy of the plan. Originally, the industry considered 401(k) plans as ancillary retirement savings arrangement after pensions and personal savings. 401(k)s were considered an accumulation vehicle a participant could use for extra income at retirement. This theory does not hold true today.

For many participants, their 401(k) plans are their primary retirement vehicle for providing assets to drive a retirement income plan. This distinction, while subtle, is important because if the 401(k) is the primary retirement vehicle, in effect, it becomes a pension. Today’s 401(k) plan, therefore, demands more than a simple investment lineup, which necessitates an appropriate IPS.

If the 401(k) plan is the primary retirement plan, or the 21st century pension, the investment focus should change from accumulation of assets at an unspecified future date, to setting retirement income goals at a specified date and investment strategies focused on attaining that goal. If the 401(k) plan is, effectively, the pension for most individuals then a goals-driven approach and investment selection philosophy similar to defined benefit investment strategies would seem to be warranted.

It is important to recall the duties imposed upon plan officials by ERISA. Plan officials are obligated under ERISA to operate the plan in the best interest of the participants and beneficiaries while keeping fees reasonable. IPS language should meet that standard. For example, if the bulk of the participants are using the 401(k) as a primary retirement income vehicle, not as an ancillary arrangement, then, arguably, ERISA would require the investment focus be more pension-like, supporting retirement income and investment products that deliver on that goal.

It may be time to re-evaluate not only a plan’s IPS, but the entire philosophy behind maintaining a 401(k) plan. If most workers are using their 401(k) plans to drive their retirement income plan under an inflationary cycle, those circumstances require novel investment options and an updated IPS.

In summation, plan officials should incorporate an IPS into an overall good governance process. Specifically, plan officials should review the IPS language periodically to help ensure its adequacy based on economic conditions, available investment and retirement income products, and the needs of the participants. This document can be a valuable tool in meeting the duties prescribed by ERISA. It can and should be a living document that is an active part of good plan governance practices.

1. Retirement Learning Center, IPS Checklist
2. Plan Sponsor Council of America, 64th Annual Survey, 2022
3. PLANSPONSOR, "Having an IPS Doesn't Necessarily Increase Plan Sponsor Liability, " February 2021
4. Defined Contribution Insights, "Best Practices for 401(k) Investment Policy Statements," 2021