Looking through the lens of recent lawsuits the simple first step to a prudent decision forces us to answer difficult questions about how we made the decision as outlined in my last article “Taking the first step to a prudent decision”. Let us look at a common first step, the creation of an Investment Policy Statement (IPS).
An Investment Policy statement (IPS) is often used as a substitute for a written decision process statement, but how well does it measure up to the three pillars we discussed on our previous commentary?
- Have an auditable and repeatable sequence of steps
- Follow these steps
- Document the steps and how you followed them
An IPS usually outlines criteria that will be used to evaluate investment options. Typically however, the number of criteria is limited. The purpose is often specified as a method to filter out the majority of candidates rather than to identify the best candidate. One of the pros of this process is that it can take an overwhelming choice of investments and provide a nice short list for consideration. Are there drawbacks to this approach?
For example, an IPS will commonly state that, to be selected, an investment must have at least 3 years of performance and have returns in the top quartile of its peers over this 3-year time period. The first filter would exclude an investment that has 2 years and 360 days of history even if it delivered great performance on all other criteria. Or if the fund’s performance was excellent over the past 5 years during both a bull and bear market cycle but fell short of the top quartile in the last 3 years of a bull market only because it took less risk, preserving returns in down markets. It would have been excluded. Plus the order of filtering can impact the results thus making it difficult to repeat.
Plans that rely on simplistic filters run a real risk of failing to select the best candidate merely because that candidate marginally fails an arbitrary cutoff. Such an outcome would be even harder to defend if the primary purpose of using filters is to reduce the universe of all available funds down to a more manageable short list rather than objectively finding the best candidate for the plan.
Is filtering is an out-of-date method from the last century? Yes with the amount of cheap computing power at our fingertips today, fiduciaries can and should be evaluating all candidates using a comprehensive and consistent methodology that considers all relevant return, risk and operational criteria.
Recent lawsuits pointing to the failure to follow a plan’s IPS, such as Tussey V. ABB and Chevron, make clear that plan sponsors who use an IPS must be sure to follow its provisions and that the failure to have followed it exactly increased their liability.
In addition, many plans adopt an IPS that provides a generalized statement of criteria that will be used to evaluate candidates but does not provide a step-by-step description of the entire process. Perhaps fiduciaries believe that vagueness might give them more leeway to defend their decisions against a legal challenge. However, imprecise and incomplete process descriptions also provide plaintiffs with more opportunities to claim that certain expected steps were not followed by the plan’s fiduciaries. Warning an investment policy statement can increase liability if exceptions are made or a plan adds a new investment type that was not included in the IPS. Great care must be taken when using an IPS or it may not fulfill the three pillars and may not be the best 1st step.
Consider for your 1st step a well-written investment process statement or an Evaluation Process Statement (EPS) that describes a navigable path from the starting point clear through to the final solution, with no gaps and no dead-ends. It also explains the relationship between the inputs (assumptions, data, logical algorithms, subjective preferences) and results so that the process can be validated, successfully repeated and mistakes corrected. This will meet the three pillars!
Furthermore, modern software can ensure that fiduciaries follow the process to the letter and can easily produce written documentation that verifies this fact. Next we will discuss how to create an EPS.
Smart fiduciaries can reap the benefits of modern technology to implement a more prudent decision process that simultaneously improves decisions and reduces fiduciary risk and liability.
Make today a better decision-making day!
