Does a DB plan need an Investment Policy Statement?

[Guest Grumpy456]

A colleague who does a lot of work on participant-directed DC plans told me earlier today that virtually all DB plans have adopted an investment policy statement. In my experience, I have not seen any DB plans with investment policy statements (granted, I work on smaller DBs--generally under 500 participants). I am just wondering whether other DB folks (1) see IPSs on their DBs and (2), if they do, how they go about defining the investment objectives. In the case of a DC plan, it is easy to see a disgruntled participant suing the plan for breach of fiduciary duty resulting in poor returns. In the case of a DB plan, the company simply puts more money in the plan if the assets underperform the actuarial assumptions. Anyone care to comment?

[WDIK]

The actuarial assumptions applicable for a plan are not selected arbitrarily. One of the factors in determining the plan's funding assumptions should probably be the investment strategy (policy) that will be utilized.

[AndyH]

The IPS should, among other things, specify the asset allocation guidelines and should set benchmarks for evaluation of performance. One of the ASPPA exams, probably C-4, from a few years ago included in it's study material a good outline on IPS's for DB plans. You might want to peruse their book store.

[Effen]

In the case of a DB plan, the company simply puts more money in the plan if the assets underperform the actuarial assumptions.

One of my pet peeves is investment consultants who look at the actuarial assumption as a "target". In a perfect world, the IPS should guide them on what sectors they should be investing in and how much risk the client wants to take. They should then be judged on how well they did against those indices during the time period. The actuarial assumption is simply a LONG TERM estimate, based on the IPS. If the actuary is assuming 7% and the fund earns 9% investing in entirely International Equity, the investment consultant should be fired, not applauded for out performing the assumption.

ERISA requires all plans (DB & DC) to have IPS. I assume most smaller plans ignore that requirement, but then again, I'm not the investment consultant.

FINAL-REG, ERISA-REG [¶14,746A], §2509.94-2 Interpretive Bulletin relating to written statements of investment policy, including proxy voting policy or guidelines

§2509.94-2

(2) Statements of Investment Policy

The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA §404(a)(1)(A) and (B). Since the fiduciary act of managing plan assets that are shares of corporate stock includes the voting of proxies appurtenant to those shares of stock, a statement of proxy voting policy would be an important part of any comprehensive statement of investment policy. For purposes of this document, the term "statement of investment policy" means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions, which may include proxy voting decisions. A statement of investment policy is distinguished from directions as to the purchase or sale of a specific investment at a specific time or as to voting specific plan proxies.

In plans where investment management responsibility is delegated to one or more investment managers appointed by the named fiduciary pursuant to ERISA §402©(3), inherent in the authority to appoint an investment manager, the named fiduciary responsible for appointment of investment managers has the authority to condition the appointment on acceptance of a statement of investment policy. Thus, such a named fiduciary may expressly require, as a condition of the investment management agreement, that an investment manager comply with the terms of a statement of investment policy which sets forth guidelines concerning investments and investment courses of action which the investment manager is authorized or is not authorized to make. Such investment policy may include a policy or guidelines on the voting of proxies on shares of stock for which the investment manager is responsible. In the absence of such an express requirement to comply with an investment policy, the authority to manage the plan assets placed under the control of the investment manager would lie exclusively with the investment manager. Although a trustee may be subject to the directions of a named fiduciary pursuant to ERISA §403(a)(1), an investment manager who has authority to make investment decisions, including proxy voting decisions, would never be relieved of its fiduciary responsibility if it followed directions as to specific investment decisions from the named fiduciary or any other person.

[QDROphile]

I don't see a requirement for an invesment policy, although one would be a good idea.

[Guest Grumpy456]

In the context of a DC plan, obviously the investment performance is critical since the accrued benefit in a DC plan is equal to the account balance which includes contributions adjusted for earnings/losses. In the context of a DB plan it is my understanding that the plan's actuary develops a "funding policy" which is held up to a standard of reasonableness. That funding policy is ultimately designed to match the plan's assets to its liabilities (of course, he know that that never happens). A plan is "properly funded" for a number of purposes: (1) FASB, (2) PBGC, (3) deduction, (4) funding, (5) plan termination, etc. If a DB plan needs an IPS, it would seem that its benchmarks should, at a minimum, reflect the actuary's funding policy assumptions (which, I suspect, relate to both return and liquidity--depending upon turnover, for example). It would seem odd to me if the plan's IPS benchmarks created tension between the plan's funding policy and its investment policy. Isn't the plan's funding policy really the key--e.g., the actuary might select an annual rate of return equal to 6.5% in order to develop the plan's cost as desired by the plan sponsor. If the benchmarks used in the IPS shoot for 8% and the plan's investment guy/gal actually achieves an 8% return, isn't there a conflict. Shouldn't the plan's IPS really leave the target earnings rate to the actuary and simply outline the procedures for selecting and changing plan investments when that benchmark isn't satisfied?

Also, for DB's subject to FASB, what do the accountants say, if anything, about the plan's investment performance relative to the IPSs benchmarks?

This is an interesting subject.

[Effen]

I guess the question is what you mean by "funding policy". If it has anything to do with the investments, then I think you have the process backwards. The client and their financial advisor decide on what to invest in and the actuary should set their assumptions based on that. If the investments are going to be 100% CD's, the assumed interest rate will be lower than if it will 100% equities. In the small plan word when a plan is first started the actuary may tell the client they are using 5% for funding, because they have nothing else to go on. That doesn't mean the client should then set their investment strategy around making 5%. If they invest very conservatively and simply shoot for 5%, they will be keeping their costs high and benefits low. If developed a strategy that would produce 8% over time, their cost could be lower or their benefits higher.

I once heard great 412(i) analogy... you go to a restaurant and the waiter brings out 2 identical looking steaks. One costs $20, the other $400. What is the difference between the two you ask.... the waiter replies, "a $380 deduction". In other words, at the end of the plan you get the same benefit, so why pay more if you don't need too. The more you can make on the asset side, the less cash you need to spend for the same benefit. One reason a 412(i) generates such high contributions is they use a very low interest assumption (2%). Due to 415 limits they can't pay out any more at the end, they just give you crappy investments and your deductions are higher because your investment performance is expected to be so bad.

Most pension actuaries are not financial consultants and have very little to do with the actual investing. We generally work on the liability side of the funding, not the asset side.

There is also a big difference between large plans and small plans. Small plans are usually funded using lower assumptions not only to be conservative, but also to generate higher contributions / deductions. Large plans tend to set assumptions a little more scientifically, looking closer at the actual investment strategy. Most companies don't want to contribute any more than they need to. In big plans, the pre & post retirement assumptions are almost always the same, but they can be different.

An oversimplification for a small plan would be to say the pre-retirement assumption reflects the assumed long term rate of return on the assets and the post-retirement assumption reflects the interest rate used to pay-out the benefits. For example, a typical small plan will pay a lump sum. Since lump sum rates are relatively low, the actuary may assume a post-retirement rate of 5% on the assumption that a 5% lump sum will be paid at retirement. If the client is investing 70% in equity and 30% in bonds, the pre-retirement rate may be 7% reflecting an assumed long term bond return of 5% and assumed long term equity return of 8%. In practice however, most small plan actuaries would just use 5% pre and post to be conservative and to keep life simple. (This may change in 08 when PPA kicks in.)

You are also correct that there are different assumptions for different purposes. FASB provides guidance on how they want assumptions selected for financial purposes. This process is not necessarily the same process used to set the funding assumptions. RPA current liability & PBGC are based on mandated assumptions, so the actuary has little to no discretion.

If you are really interested, the American Academy of Actuaries has published guidance on the setting of actuarial assumptions for various purposes. It should be on their web site.

[Guest Grumpy456]

Awesome response! Thanks! I'll take a look at the website.

It sounds as if large plans likely need an IPS more than medium or small plans. Let me put that differently. Even medium and small plans likely have investment policies, those policies just tend to be less formal and unwritten while large plans may need to have a written, clearly-articulated investment policy statement. Is that about right?

Say a DB plan has adopted a written IPS that establishes 8% as the annual target return on plan assets. Let's also assume that the plan's actuary has selected 6.75% as the annual interest rate used in the plan's funding assumptions. Should there necessarily be a tie between the two? Assume that the investment folks regularly hit their 8% target. At some point should the actuary change his/her funding assumption from 6.75% to 8% (or something closer to 8% than 6.75%)?

[AndyH]

How does PPA affect this? Is the assumed investment return soon to become 6%? 5.5%? Is the investment policy supposed to be geared towards that, or is an equity gain an implicit assumption or expectation?

[Effen]

Let's also assume that the plan's actuary has selected 6.75% as the annual interest rate used in the plan's funding assumptions. Should there necessarily be a tie between the two? Assume that the investment folks regularly hit their 8% target. At some point should the actuary change his/her funding assumption from 6.75% to 8% (or something closer to 8% than 6.75%)?

Yes, there should be some relationship between the investment policy and the actuarial assumption, but the assumption should be on the conservative side. If they have a good investment manager who performs well against the indices, that will produce actuarial gains and lower the cost. The actuary will generally not assume the manager will always do better than the index since in general, all things will eventually come back to the average.

How does PPA affect this?

My comment had to do with the fact that the interest "assumption" for Post PPA funding will be tied to the yield curve produced by the specific plan's participants. The days of 5% pre/post for small plans are over starting in 2008. As far as determining the minimum required contribution, the ability for the actuary to set the interest assumption has been removed from our quiver starting in 2008.