Investment policy statements manage trusts' financial goals

With an investment policy statement, an adviser and a client agree upon all the essential issues surrounding how the money is to be managed and why. This step is usually handled after the adviser has assessed the current situation of the client's trust by reviewing the applicable trust documents, tax returns and other financial documents. The adviser must also manage the trust portfolio so that it complies with the purposes, terms and distribution requirements of the trust, according to “The New Fiduciary Standard” by Tim Hatton, CFP, CIMA, AIF.

Written in collaboration with the Foundation for Fiduciary Studies, “The New Fiduciary Standard” says that it's important for advisers to determine whether trust documents identify trustees and the named fiduciaries in writing; if there is sufficient detail identifying selection criteria, duties and responsibilities of investment committee members; and if the trust documents allow fiduciaries to prudently delegate investment decisions to others.

In many cases, the process for creating an investment policy statement is the same as it is for a retirement plan or a foundation. Advisers must identify client goals and a target rate of return, and understand the time horizon and the client's risk tolerance. Also, advisers must identify acceptable investment categories and vehicles, establish an acceptable allocation of asset categories, write an investment policy statement, select specific investments that fit the allocation model, and monitor and adjust the portfolio as appropriate.

On the surface, the process seems simple enough. The tricky part, however, comes when the investment policy statement must be adjusted to meet the requirements of the trust document. For example, the beneficiaries might be minors (typically 18, but 21 in some states), or they may be adult children receiving regular distributions for college funding. Or, the trust may call for distributions to beneficiaries at preset ages, such as 25, 30 and 35. Each of these scenarios might call for a different asset allocation to appropriate liquidity at the appropriate time.

When advisers create an investment policy statement for a trust, special attention must be paid to the timing of planned cash inflows and outflows, and to an identified investment time horizon. The investment time horizon determines which asset classes will be considered, what the mix among asset classes will be, what sub-asset classes will be considered and which managers or funds will be selected.

With respect to timing, an adviser must make sure that there are enough liquid assets to meet distributions when they are due. The trust may call for distributions to pay specific expenses of the beneficiary, such as college tuition. Likewise, there must be enough liquid assets to meet distributions tied to specified ages, such as when a trust beneficiary turns 25 or 30 years old. These distributions are known well in advance, and cash can be set aside for them. The adviser also must make sure there are enough liquid assets to pay other liabilities of the trust, such as advisory fees or taxes when they are due.

Advisers should prepare a schedule of the portfolio's anticipated cash inflows and outflows for at least the coming five-year period. A time horizon in which a distribution must be made within five years would be considered short-term; longer than that is considered long-term. If short-term distributions exceed the inflow of cash over a given period, assets will have to be earmarked to cover the shortfall. Generally, though not always, assets earmarked for short-term time horizons would be invested in cash and short-term fixed income securities with liquidity and preservation of capital often being the primary investment objective. Assets earmarked for long-term time horizons could be placed in a wider variety of asset classes, including stocks, bonds and cash, or even real estate and alternative investments. The cash flow schedule also helps the adviser rebalance a portfolio by using deposits to add to under-represented asset categories and by liquidating holdings that have grown too large in order to fund planned withdrawals.

Advisers often will take one of two approaches to allocating assets within a trust. In one case, the adviser might separate the money that must be distributed within five years from the money that must be distributed after five years, maybe even using separate accounts for each time horizon. The shorter-term money would likely be allocated to investments that provide safety of principal - cash and short-term, fixed-income securities, for instance. The adviser would then invest the remaining portion of funds in assets typical of a portfolio with a long-term time horizon, such as stocks and bonds.

Alternatively, the adviser might invest all of the assets together, allocating assets among stocks, bonds and cash in one account, using strategic or annual rebalancing of the portfolio to produce funds for required distributions.

Along with preparing for partial distributions of the trust corpus, the investment policy statement and the investments also must align with the eventual liquidation of the trust. Trusts have a finite life and must be liquidated at some point.

The investment policy statement is a lot like a blueprint for the management of a portfolio. It should spell out all the roles of the various parties related to the trust, including the adviser, client and other parties, and especially the process by which the account is to be managed and monitored.

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates. Woody can be reached at william.woody@axa-advisors.com.