The U.S. retirement system over the past five decades has transformed in several ways for the public and private sectors. Among the most significant change was the trend that continues toward replacing the defined benefit (DB) plans or pensions either completely or partially with defined contribution (DC) plans.
Congress passed the Revenue Act of 1978 which allowed highly paid employees to avoid being taxed on deferred compensation. It referenced an Internal Revenue Code Section 401(k).
Ted Benna, a benefits consultant, used Section 401(k) as a precedent to allow highly compensated employees to save pre-tax money in a company’s retirement plan.
In 1981, the IRS issued new rules allowing employees to fund their 401(k) plans through payroll deductions while receiving an employer match. Almost half of the major corporations within two years offered 401(k) plans according to the Employee Benefits Research Institute.
Today, federal employees and members of the armed services today have seen their traditional pension plans reduced with the equivalent of a 401(k) plan, the Thrift Savings Plan.
What is an Investment Policy Statement (IPS)?
Employees are now investors. Yet many investors do not have an investment plan. The first step every investor should take is creating an Investment Policy Statement (IPS).
Defined benefit plans do not require an IPS. But Defined contribution plans do. A good financial planner should provide you with a written IPS tailored to your needs. Such a document is essential to attaining your long-term financial goals because it defines your specific situation with regard to your expectations for risk and is reflective of your overall financial plan.
But what if you are your financial planner? What is your desired asset allocation? Do you have an ideal target allocation for each class in the portfolio and rebalancing targets? Are there some investments you would never want to own?
How to Create an Investment Policy Statement (IPS)
If you are your financial planner, you can create your own IPS. Here is advice from Investopedia, Morningstar, and Bogleheads on how to proceed. Harold Pollack, a University of Chicago social scientist, even designed his IPS to fit on an index card.
A written IPS serves the same purpose as a business plan. It is a dynamic document that should be altered to react to underlying conditions changing your future. Marriage, children, retirement goals, etc. for example may modify your asset allocation decisions.
The process of putting the IPS in writing is it can save you from making a bad decision. “Writing things down doesn’t just help you remember, it makes your mind more efficient by helping you focus on the truly important stuff according to Mark Murphy.
The discipline in creating your own IPS is that it is a contract to keep you on your path to achieving your goals. If you are serious about your long-term goals, it requires focus. Allocating funds randomly within the Thrift Savings Plan or a 401(k) plan without an IPS is akin to wildly throwing darts hoping they will land to optimize your financial future.
An IPS can be particularly useful in explaining to your family what your intentions were for owning or not owing certain equities or fixed-income instruments. You may want to even offer instructions on suggestions in your ISP as to how they may consider changing the asset allocations of investments for different needs and situations.
Providing details to others about their future role with the investments is another benefit of such a plan. In the event of your cognitive decline, your planning advice will be welcomed.
In the event of your death, the asset allocation for your retirement income needs may change for your spouse. Think about the income needs for him or her will change. The IPS can address those contingencies as part of your estate plan.
Perhaps the focus of the time horizon will be different for the remaining assets. The financial strategy may shift toward grandchildren’s higher education. Providing guidance for your loved ones will be appreciated.
