Investment Policies for Defined Benefit Plans

Investment policies for defined benefit plans, including pensions and other postemployment benefits (OPEB),[1]  govern the ways in which plans will carry out their investment programs, to strengthen both the financial condition of the plan and the promise to deliver benefits to plan participants. Investment policies:

• Define fiduciaries’ due diligence standards and compliance with applicable federal, state, provincial, and local investment laws;[2],[3]
• Document and provide transparency regarding investment goals, priorities, and performance review and measurement;
• Define the internal controls of the system and aid in identifying and mitigating risks such as market and environmental risks; and
• Formally articulate the system’s asset allocation strategy and provide benchmark index targets for evaluating investment manager performance.

An investment policy is a governing document in which the governing board formally sets broad policy parameters. Detailed guidance about implementation and oversight of the investment program may be contained in the investment policy or other documents, such as investment procedure manuals and agreements with third parties. GFOA’s Best Practice, Investment Policy, recommends that all governments establish a comprehensive written investment policy, which should be adopted by the governing body.

An investment policy must reflect the legal restrictions set forth in federal, state, provincial and local laws as well as those established by common law and fiduciary standards. Fiduciaries, such as members of governing bodies and other key decision makers, have the responsibility to invest the system’s assets for the exclusive benefit of the participants. GFOA’s Best Practice on Governance of Public Employee Postretirement Benefits Systems should also be used as a guide in developing investment policies for defined benefit plans.

GFOA recommends that the investment policy address the elements outlined in GFOA’s Best Practice, Investment Policy. In addition, the policy should address the following elements:

• Statement of goal, purpose, or mission: Articulate the rationale for having the policy, as well as the investment goals (e.g., to meet or exceed a certain benchmark for the overall portfolio while taking into consideration the appropriate level of risk).
• Statement on managing risks of investments: Identify investment guidelines for investment professionals to follow (e.g., limits on holdings of individual securities and credit ratings).[4]
• Asset allocation strategy: Identify the factors that fiduciaries should continuously monitor and review in assessing whether they are adhering to the plan’s long-term asset allocation strategy, as well as specifying the plan’s rebalancing policy;[5]
• Liquidity of investments: Identify the process the system will take to identify its liquidity requirements, balancing the need to maintain cash flow with maximizing returns.;[6]
• Guidelines for other investment-related service providers: Define guidelines for selection and periodic performance evaluation of professionals, such as investment consultants and custodians. Measures of evaluation may include service quality, cost, and communications.[7]
• Investment management guidelines: Define selection criteria and manager watch list/termination guidelines, which may include criteria and procedures related to specific benchmarks for placing an investment on a watch list or terminating an investment.[8]
• Cost management: Define expectations for evaluation of total cost and fee transparency (e.g., transaction cost, investment management fees, custodial fees, performance-based fees, and other investment-related expenses).[9]
• Performance measurement (benchmarking) and reporting: Define measurement and reporting criteria such as the frequency of reporting and monitoring, the way external and internal parties report investment results, the evaluation process (with clear definitions of strategies); and the performance benchmarks for permissible asset classes, expectations, and criteria for investment manager performance measurement.[10]

In addition:

• If the plan has foreign assets, identify parameters for establishing foreign currency positions and how they will be managed (e.g., a position of no more than a certain amount hedged in foreign currency).
• If the plan has alternative investments, review GFOA’s Alternative Investment Checklist.
• Outline the guidelines for transaction or brokerage trade transactions to avoid any real or perceived conflicts of interests and to avoid all revenue or expense sharing (soft dollar) arrangements between the plan and its service providers.