Case 1: Mary Middendorf Mary Middendorf, 43, is marketing director for MCTECH, a

Question

Case 1: Mary Middendorf

Mary Middendorf, 43, is marketing director for MCTECH, a multinational supplier of computer and telecommunications equipment. Due to the recent acquisition of her firm by a larger organization, Middendorf has been informed that her position will be terminated in six months. Middendorf is visiting with Michelle Mightman, CFA, to discuss her financial situation. During the meeting, Middendorf makes the following statements:

1. “My investment portfolio is currently valued at $700,000. MCTECH has had a fantastic profit sharing and incentive program, so my current holding of MCTECH stock is $500,000 of that. The rest of my portfolio is in a broad market stock index fund. I have a money market checking account, in which I maintain a relatively constant balance of $10,000, and a 401(k) plan worth approximately $300,000. My house, which I received debt-free as part of my divorce settlement, is valued at $350,000. My total after-tax monthly income just meets our living expenses.”

2.   “I am not married, but I have two children, ages 14 and 16, and I receive $1,000 a month in child support. That will end as each child reaches 18, and my ex-husband is not required to help with college expenses. The 16-year-old currently has no desire to go to college, as he is a rock musician and wants to follow his heart. Of course, that might not work out for him. The 14-year-old wants to go to a prestigious university and become a surgeon. I want to be able to pay most of her college expenses, so that she doesn’t graduate with student loans. Assuming she gets into her college of choice, her undergraduate education could cost $50,000 a year.”

3. “When my position is terminated with MCTECH in six months, I will receive a lump-sum after-tax cash payment of $200,000, which is twice my current salary. The acquisition is all stock so my MCTECH position will be replaced by the stock of the acquiring firm.”

4. “The all stock transaction means that my portfolio will contain a much more stable security. The previous two years were substantially rocky for my investments, so I am happy the MCTECH stock will be replaced. My investment portfolio exhibited a substantial improvement with the news of the acquisition, and I look forward to the continued appreciation of my portfolio with the favorable performance of the acquiring company’s stock. I want to avoid overly risky individual investments and would like my portfolio to be relatively stable and not experience any significant losses. I do not expect any unusual expenses in the short-run, but I want to maintain a comfortable cushion of emergency funds.

5. “Although various firms have given me employment offers commencing in six months, I would like to travel and generally rest during the six months following my separation from MCTECH. Most employment offers I received are for amounts slightly higher than what I am currently making at MCTECH. I am confident I will be able to get other equivalent offers in a year’s time.”

Instructions:

To properly assist clients, a financial advisor must know the clients’ current situation and plans for the future. To accomplish this, the advisor must meet with the client to develop an Investment Policy Statement, IPS. The Objectives and Constraints portion of the IPS (as defined by CFA® Institute) is extremely important. On the following pages, you will see questions related to Investment Policy Statements in general as well as tables containing the objectives and constraints section of an IPS.

Part 1: Answer the following questions from the perspective of a financial advisor.

1. What is an Investment Policy Statement, IPS, and what should it contain? Why is it important to develop an IPS before determining the appropriate asset mix for your client?

2.   How often should you meet with or contact your client to determine whether the client’s situation has changed and whether the client’s IPS should be updated? What sorts of things would require an update to a client’s IPS?

3.   After reading an article, your client is very excited about a new stock and wants you to add it to her portfolio. Considering your client’s objectives and constraints, what must you do before adding the stock to her portfolio?

Explanation / Answer

An investment policy statement (IPS) is a document drafted between a portfolio manager and a client that outlines general rules for the manager. This statement provides the general investment goals and objectives of a client and describes the strategies that the manager should employ to meet these objectives. Specific information on matters such as asset allocation, risk tolerance and liquidity requirements are included in an investment policy statement.

The IPS should include monitoring and control procedures to be followed by everyone involved in the investment process. This includes establishing the frequency of monitoring, specifying benchmarks for comparison of portfolio returns and concrete procedures for making any future changes to the IPS. Serious investors think through the possible reasons for changing their IPS, such as financial or lifestyle changes. More important, they specify the reasons not to change their IPS (i.e., short-terThe IPS should include monitoring and control procedures to be followed by everyone involved in the investment process. This includes establishing the frequency of monitoring,

specifying benchmarks for comparison of portfolio returns and concrete procedures for making any future changes to the IPS of the client. Serious investors think through the possible reasons for changing their IPS, such as financial or lifestyle changes. More important, they specify the reasons not to change their IPS (i.e., short-term market performance).

An IPS lists the investor’s investment objectives, along with his time horizon. For the better layout making while preparing IPS. Special attention should be given to describing the investor's risk/return profile, including naming asset classes that should be avoided as well as naming preferred asset classes. For example, an individual may have an IPS stating that by the time he is 55 years old, his job will become optional, and his investments will annually return $55,000 in today's dollars given a certain rate of inflation. This would be only one of many points included in an IPS portal.

In general terms, an update is needed when something about the original agreement has or needs to change. While we have full discretion with our advisory firm clients’ assets, we also have an agreement with our clients that if we would like to change anything that is documented in the IPS, then we need to check with them first, before making that change. That makes the IPS a meaningful document, to our clients and to us, and it gives an important degree of control to clients about their important issues as they are asking us to manage their investments on their behalf.

In the IPSs we have, the most frequent change is a change in the asset allocation. Rather than update the whole IPS, we simply send our client a single sheet that acts as an amendment to the IPS, reviews their current target allocation, highlights what changes we want to make, and it provides a simple explanation regarding why we want to make the change (in all cases, we’ve talked to the client beforehand to explain our reasoning and get their input). Their signature is evidence of their approval and amends the IPS so that it is kept up to date.

EVENT-BASED UPDATES

Because an important element of the IPS is documenting who the client is, what their mindset was when they approved the investment process, and what their goals and tolerance for risk were, we believe it is important to renew the IPS periodically. It helps to have the IPS as part of the discussion every time you talk with the client, reinforcing that it is a living and vital document that you take seriously. That said, the IPS needs to be updated when and if the following events occur:

You want to change something about your investment procedures or policies that is different from what is in the IPS.

You want to further clarify a procedure or policy that is less than clear in your IPS.

You want to change how you are managing this particular client’s investments (e.g., change in asset allocation or change in types of securities or asset classes to be utilized).

When there are meaningful changes to the client’s circumstances.

SET A REGULAR UPDATE SCHEDULE

Beyond updating the IPS when circumstances require it, we also recommend keeping a regular schedule of review and update. Individual clauses can be reviewed and updated on a schedule that corresponds with normal portfolio monitoring procedures.

In addition, we think the IPS should be reviewed in full on an annual basis to review for any outdated information. Once the IPS is sufficiently old, you and the client (or the courts!) might consider it stale and no longer valid. Just on principle, we believe every IPS ought to be rewritten every 3-5 years, just to remind the client this is an active and important document and because it needs to accurately reflect the client’s current thinking and circumstances.

An IPS for an individual client should be an extension of their financial plan. The reason for their portfolio should be reflected such as saving for college and retirement and should reflect the client’s goals in terms their time horizon, as well as the level of returns that need to be targeted to achieve those goals. Their risk tolerance and the amount already saved for those goals. This will lead to the establishment of a target asset allocation and the types of investment vehicles to be used.

Generally, the target allocation will include a range. For example, large-capstocks might have a target allocation of 20% with an acceptable range of 15% to 25%. In other words if the actual percentage of large-cap stocks is within the range there is no need to rebalance that part of the portfolio. Criteria is to select, monitor and replace the investment vehicles should be outlined. These might include performance relative to their peer group, costs, changes in management (for ETFs and funds) and other relevant criteria. These criteria should be the basis of period portfolio reviews with the client. There should be a benchmark to enable the client and financial advisor to track the portfolio’s returns.

401(k) plans

In the context of a 401(k) plan, an IPS serves a similar but slightly different purpose. Financial advisors working with 401(k) plan sponsors should draft an IPS for the plan as one the first things they do. An existing plan may have an IPS in place and if so the advisor should review this document and make revisions (or start from scratch) as needed. The overriding reason that a 401(k) plan sponsor needs an IPS is for fiduciary protection. The IPS should document an investment process that will be followed by the sponsor in conjunction with their financial advisor to manage the plan. The periodic investment committee meetings should document what transpired and how decisions made reflect the IPS process. In light of recent 401(k) court cases this is even more important than ever.

The IPS should state the purpose of the plan, which will be along the lines of providing a retirement savings vehicle for the organization’s employees. The types of investment vehicles that will be used should be outlined. These could include mutual funds, collective trusts , stable value funds and managed accounts, such as target- date funds or risk-based options. The asset classes to be offered should be spelled out as well.

The IPS should discuss how often the investment committee will meet to review the plan and who the plan’s service providers are. It should indicate that these service providers will be reviewed periodically. The IPS should also specify the criteria that will be used to select, monitor and to replace the investment options used in the plan. These might include relative performance of the mutual funds as compared to their peers, a change in fund management, a pronounced increase or decrease in assets under management or a change in the fund’s investment style. Investment expenses should also be noted as a major factor here as well.

While it may sound like a 401(k) IPS is for the benefit of the plan sponsor and mitigating their fiduciary liability, a 401(k) plan that follows a well-conceived IPS will invariably provide a better retirement savings vehicle for the plan’s participants then one that doesn’t have an IPS.

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