Integrating Investment Policy with the Financial Plan

An Investment Policy Statement (IPS) translates financial plan objectives into actionable investment guidelines. Without this documented framework, investment decisions become reactive—driven by market conditions and emotions rather than systematic rules. This guide explains how to construct an IPS that integrates with your broader financial plan and provides the discipline necessary for long-term success.

Investment Policy Statement Components

Section 1: Investment Objectives

Investment objectives define what the portfolio must accomplish, expressed in specific, measurable terms.

Return Objective Formulation:

The required return depends on several factors from your financial plan:

• Current portfolio value
• Future contribution amounts
• Time horizon to goal
• Target ending value
• Inflation assumption

Calculation Example:

• Current portfolio: $450,000
• Annual contributions: $30,000
• Time horizon: 15 years
• Target ending value: $1,500,000 (inflation-adjusted retirement need)
• Required real return: 5.2% annually
• Required nominal return (assuming 2.5% inflation): 7.7% annually

This required return informs asset allocation decisions. A 7.7% nominal return target suggests a growth-oriented portfolio, while a 4% target could be achieved with more conservative allocations.

Goal Hierarchy:

Different goals may require different investment approaches based on their time horizons and priority levels.

Section 2: Risk Tolerance and Capacity

Risk tolerance reflects willingness to accept volatility, while risk capacity measures financial ability to withstand losses without compromising goals.

Risk Tolerance Questionnaire Factors:

Questionnaires typically assess:

• Reaction to hypothetical portfolio declines
• Investment experience and knowledge
• Time horizon perspective
• Recovery time available after losses
• Emotional response to volatility

Risk Capacity Analysis:

Risk capacity depends on objective financial factors:

Worked Example: Capacity Assessment

Thomas (age 55) and Rebecca (age 53):

• Portfolio: $1,200,000
• Retirement goal at 65: $1,800,000 needed
• Current savings rate: $50,000/year
• Income: Stable government positions
• Pension income at 65: $75,000/year combined

Capacity Indicators:

• 10–12 year horizon: Moderate capacity
• Stable income and pension: Increases capacity
• Pension covers 60% of retirement spending: Increases capacity
• Already 67% of goal achieved: Moderate capacity

Conclusion: Moderate-to-high risk capacity despite moderate time horizon due to pension backstop

Section 3: Investment Constraints

Constraints define boundaries within which the portfolio operates.

Liquidity Requirements:

• Emergency fund: 6 months expenses = $45,000 (held separately)
• Planned major purchases within 2 years
• Annual portfolio withdrawals in retirement

Time Horizon:

• Primary: Retirement in 15 years
• Secondary: Education funding in 8 and 12 years

Tax Considerations:

• Maximize tax-advantaged accounts before taxable
• Asset location: Bonds in tax-deferred, equities in taxable
• Tax-loss harvesting guidelines
• Roth conversion considerations

Legal and Regulatory:

• ERISA requirements for qualified plans
• Trust investment guidelines if applicable
• State-specific rules for certain assets

Unique Circumstances:

• Concentrated employer stock position requiring diversification
• ESG preferences or exclusions
• Illiquid assets (real estate, private investments)

Section 4: Asset Allocation Targets

Asset allocation determines the majority of portfolio returns and volatility. The IPS specifies target allocations with acceptable ranges.

Strategic Asset Allocation Example:

Glide Path Adjustments:

For goal-based planning, the IPS should specify how allocation shifts as the time horizon shortens.

Rebalancing Policy

Rebalancing Triggers

The IPS should specify clear rebalancing rules to remove emotion from the process.

Calendar-Based Rebalancing:

• Review allocations quarterly
• Rebalance annually (specify month)
• Advantage: Simple, predictable
• Disadvantage: May miss significant drift between reviews

Threshold-Based Rebalancing:

• Rebalance when any asset class deviates beyond specified band
• Common thresholds: 5% absolute deviation or 25% relative deviation
• Advantage: Responds to market movements
• Disadvantage: Requires ongoing monitoring

Hybrid Approach (Recommended):

• Monitor monthly for threshold breaches
• Rebalance immediately if any class exceeds maximum range
• Conduct full review and rebalance annually regardless of thresholds

Example Threshold Calculation:

• US Large Cap target: 35%
• 5% absolute band: Rebalance below 30% or above 40%
• 25% relative band: Rebalance below 26.25% (35% × 0.75) or above 43.75% (35% × 1.25)

Rebalancing Implementation

Tax-Efficient Rebalancing Methods:

1. Direct new contributions: Allocate deposits to underweight classes
2. Dividend reallocation: Direct dividends to underweight positions
3. Tax-advantaged account trades: Execute trades in IRAs/401(k)s first
4. Tax-loss harvesting: Sell overweight positions with losses
5. Taxable account trades: Last resort, consider tax impact

Worked Example: 60/40 Portfolio for Couple Retiring in 15 Years

Client Profile:

• Richard (52) and Sandra (50)
• Combined income: $195,000
• Current portfolio: $680,000 (401k, IRA, taxable brokerage)
• Annual savings: $45,000
• Retirement goal at 67: Maintain $110,000 annual spending
• Social Security (combined at 67): $52,000
• Required portfolio income: $58,000/year (adjusted for inflation)

IPS Development:

Return Objective:

• Target portfolio at retirement (15 years): $1,450,000
• Current value: $680,000
• Annual contributions: $45,000
• Required return: 6.1% nominal (3.6% real)

A 60/40 portfolio has historically delivered 7–8% nominal returns, providing margin above the required return.

Risk Assessment:

• Risk tolerance questionnaire score: Moderate (score 58/100)
• Risk capacity: Moderate-to-high (stable income, 15-year horizon, Social Security backstop)
• Maximum acceptable single-year decline: 25%
• Historical 60/40 maximum drawdown: 32% (2008–2009)

Asset Allocation:

Rebalancing Rules:

• Review allocations monthly
• Rebalance when any asset class exceeds range bounds
• Annual comprehensive rebalance in December
• Use new contributions to rebalance when possible
• Execute trades in tax-advantaged accounts first

Glide Path:

• Current (age 52/50): 57% equity
• Age 57/55: Reduce to 52% equity
• Age 62/60: Reduce to 47% equity
• Retirement (67/65): Target 42% equity

Review Schedule:

Sample Review Cadence

Monthly Tasks (15 minutes)

• Check portfolio allocation vs. targets
• Note any asset class outside acceptable range
• Direct contributions to underweight classes

Quarterly Review (1 hour)

• Calculate portfolio return vs. benchmark
• Review individual fund performance
• Assess any threshold breaches requiring action
• Document market conditions and outlook

Annual Review (2–3 hours)

• Complete rebalancing if not triggered during year
• Update return assumptions if market conditions warrant
• Recalculate required return based on progress toward goals
• Review and update constraints section
• Adjust glide path if time horizon changed
• Document all changes in IPS revision history

IPS Integration Checklist

Initial Development

• Calculate required return from financial plan goals
• Complete risk tolerance questionnaire
• Assess risk capacity based on objective factors
• Document all investment constraints
• Select target asset allocation aligned with required return and risk profile
• Define rebalancing triggers and procedures
• Specify glide path for allocation adjustments over time

Investment Selection

• Choose investment vehicles for each asset class
• Evaluate expense ratios (target under 0.20% for index funds)
• Confirm tax efficiency of holdings by account type
• Document rationale for each investment selection

Rebalancing Discipline

• Set calendar reminders for monitoring schedule
• Create allocation tracking spreadsheet or use software
• Document rebalancing transactions and rationale
• Review tax implications before taxable account trades

Ongoing Maintenance

• Update IPS when major life changes occur
• Revise return assumptions after significant market shifts
• Reassess risk tolerance every 3 years or after major events
• Adjust glide path as time horizon shortens
• Maintain IPS revision history

Behavioral Discipline

• Review IPS before making any investment changes
• Document emotional state during market volatility
• Resist allocation changes based on short-term performance
• Stick to rebalancing rules regardless of market predictions
• Use IPS as commitment device during market stress