Key Takeaways
- An IPS documents two key elements: investment objectives (return requirements, risk tolerance) and constraints (time horizon, liquidity, taxes, legal, unique circumstances)
- Risk tolerance has two components: ability (financial capacity) and willingness (psychological comfort)--the more restrictive determines appropriate risk level
- Return requirements should be stated as specific, measurable goals (e.g., 'real return of 5% annually to fund retirement') not vague aspirations
- The CFP exam uses the mnemonic RR TTLLU: Risk, Return, Time, Taxes, Liquidity, Legal, Unique circumstances
- An IPS should be reviewed at least annually and whenever major life events occur (marriage, job change, inheritance, etc.)
- The IPS does NOT include specific investment selections--it establishes the framework for making those decisions
Investment Policy Statement
The Investment Policy Statement (IPS) is a written document that serves as a roadmap for investment decision-making. It establishes the guidelines and framework that govern how a client's portfolio should be managed. Think of it as a contract between the client and the investment manager that ensures everyone understands the goals, constraints, and expectations.
Why the IPS Matters
An IPS is not just paperwork--it serves critical functions:
- Provides clarity: Forces clients and advisors to articulate goals and constraints explicitly
- Sets expectations: Establishes benchmarks for evaluating portfolio performance
- Guides decisions: Creates a framework for making investment choices during market volatility
- Ensures consistency: Prevents emotional decision-making by documenting the agreed-upon strategy
- Demonstrates fiduciary duty: Shows the advisor has considered the client's complete financial picture
CFP Exam Tip: The IPS establishes the framework for investment decisions but does NOT include specific investment selections. It tells you what to achieve and the rules to follow--not which specific stocks or funds to buy.
IPS Structure: Objectives and Constraints
Every IPS contains two major components: investment objectives and investment constraints. The CFP exam frequently tests your ability to identify and apply these elements.
Investment Objectives
Investment objectives define what the client wants to achieve. The two primary objectives are return requirements and risk tolerance.
Return Requirements
Return requirements specify the rate of return needed to meet the client's financial goals. Effective return objectives are:
- Specific and measurable: "6% nominal return" or "4% real return after inflation"
- Goal-oriented: Tied to specific needs like retirement income, education funding, or wealth preservation
- Realistic: Based on historical asset class returns and current market conditions
- Time-appropriate: Adjusted for the client's investment horizon
| Return Type | Definition | Example |
|---|---|---|
| Nominal Return | Return before adjusting for inflation | "8% annual return" |
| Real Return | Return after adjusting for inflation | "5% real return (8% - 3% inflation)" |
| Required Return | Minimum needed to meet goals | "6.5% to fund $50,000 annual retirement" |
| Desired Return | What client hopes to achieve | "10% to accelerate wealth building" |
Common return requirement scenarios:
Example 1 - Retirement: A 55-year-old client has $2 million and needs $100,000 annually for 30 years of retirement. The required return can be calculated using present value of annuity formulas.
Example 2 - Education: A client needs $200,000 in 10 years for college. With $100,000 currently invested, they need approximately 7.2% annual return.
CFP Exam Tip: When calculating required returns, consider whether the goal is stated in nominal or real terms. Real return requirements must account for inflation.
Risk Tolerance
Risk tolerance determines the appropriate level of investment risk for a client. It has two distinct components that must both be evaluated:
1. Ability to Take Risk (Financial Capacity)
Ability is an objective measure based on the client's financial circumstances:
- Time horizon: Longer horizons increase ability to take risk
- Portfolio size relative to needs: Larger portfolios relative to goals increase ability
- Income stability: Stable, high income increases ability
- Insurance coverage: Adequate insurance increases ability
- Emergency reserves: Sufficient liquidity increases ability
2. Willingness to Take Risk (Psychological Comfort)
Willingness is subjective and based on the client's emotional comfort with volatility:
- Investment experience: More experience often increases willingness
- Reaction to past losses: How did they respond to market downturns?
- Sleep test: Can they sleep at night with this level of volatility?
- Risk tolerance questionnaires: Standardized assessments help quantify willingness
| Ability | Willingness | Appropriate Approach |
|---|---|---|
| High | High | Can invest aggressively |
| High | Low | Use willingness (more conservative) |
| Low | High | Use ability (more conservative) |
| Low | Low | Must invest conservatively |
CFP Exam Tip: When ability and willingness conflict, use the more restrictive measure. A client with high ability but low willingness should be invested conservatively until their willingness increases through education.
Investment Constraints
Constraints are factors that limit or influence how the portfolio can be managed. The CFP exam uses the mnemonic RR TTLLU (Risk, Return, Time, Taxes, Liquidity, Legal, Unique) to remember all components.
Time Horizon
Time horizon is the expected length of time the portfolio will be invested before funds are needed.
| Horizon Length | Typical Range | Risk Implications |
|---|---|---|
| Short-term | Less than 3 years | Lower risk tolerance; emphasize capital preservation |
| Intermediate | 3-10 years | Moderate risk; balanced approach |
| Long-term | Over 10 years | Higher risk tolerance; growth-oriented |
Multiple time horizons: Many clients have multiple goals with different horizons (e.g., college in 5 years, retirement in 20 years). The IPS should address each separately.
Time horizon considerations:
- Shorter horizons require more liquidity and less volatility
- Longer horizons allow for recovery from market downturns
- Time horizon should be reassessed as circumstances change
Liquidity Needs
Liquidity refers to the ability to convert investments to cash quickly without significant loss of value.
Factors affecting liquidity needs:
- Known upcoming expenses (home purchase, college tuition)
- Emergency fund requirements (typically 3-6 months of expenses)
- Income stability (unstable income requires more liquidity)
- Insurance deductibles and potential claims
- Business or personal obligations
Liquidity planning:
- Match investment liquidity to the timing of cash needs
- Maintain adequate emergency reserves outside the investment portfolio
- Consider lines of credit as backup liquidity sources
Tax Considerations
Tax status affects investment selection and strategy:
| Account Type | Tax Treatment | Strategy Implications |
|---|---|---|
| Taxable | Gains and income taxed annually | Tax-efficient investments; tax-loss harvesting |
| Tax-Deferred (Traditional IRA, 401k) | Taxes paid on withdrawal | Less tax-efficient assets can be held here |
| Tax-Exempt (Roth IRA, 529) | No taxes on qualified withdrawals | High-growth investments appropriate |
Tax efficiency strategies:
- Asset location: Place tax-inefficient investments in tax-advantaged accounts
- Tax-loss harvesting: Realize losses to offset gains
- Municipal bonds: Tax-exempt interest for high-bracket investors
- Long-term holding: Qualify for lower long-term capital gains rates
Legal and Regulatory Constraints
Legal constraints include regulations and legal restrictions that affect investment choices:
- Trust provisions: Investment restrictions specified in trust documents
- ERISA requirements: Fiduciary rules for retirement plans
- Foundation rules: Minimum distribution requirements for private foundations
- Regulatory restrictions: Insider trading rules, blackout periods
- Jurisdictional rules: State-specific investment regulations
Unique Circumstances
Unique circumstances are client-specific factors that don't fit other categories:
- Socially responsible investing (SRI): Ethical or religious restrictions on certain investments
- Concentrated positions: Large holdings in employer stock or inherited shares
- Business ownership: Illiquid assets that affect overall portfolio risk
- Family considerations: Supporting dependents, planned bequests
- Health issues: May affect time horizon or liquidity needs
- Behavioral factors: Past experiences that influence investment preferences
When to Revise the IPS
The IPS is a living document that should be reviewed regularly and updated when circumstances change.
Regular Review Schedule
- Annual review: At minimum, review the IPS annually to ensure it remains appropriate
- Performance review: Evaluate whether the portfolio is meeting IPS objectives
- Assumption check: Verify that return and risk assumptions remain valid
Triggering Events for IPS Revision
| Life Event | Potential IPS Impact |
|---|---|
| Marriage/Divorce | Changes to goals, risk tolerance, time horizon |
| Birth of child | New education funding goals, increased liquidity needs |
| Job change | Income stability, time horizon, employer stock considerations |
| Inheritance | Portfolio size, return requirements, tax implications |
| Health changes | Time horizon, liquidity needs, insurance considerations |
| Retirement | Shift from accumulation to distribution phase |
| Market events | May require reassessment of risk tolerance (willingness) |
| Tax law changes | Strategy adjustments for tax efficiency |
CFP Exam Tip: The IPS should be reviewed whenever there are significant changes in the client's life circumstances, financial situation, or investment goals--not just when markets are volatile.
Selecting Appropriate Benchmarks
An IPS should specify benchmarks against which portfolio performance will be measured.
Benchmark selection criteria:
- Representative: Reflects the asset classes in the portfolio
- Investable: Can actually be purchased (index funds exist)
- Measurable: Data is readily available
- Specified in advance: Chosen before performance period, not after
| Portfolio Type | Common Benchmark |
|---|---|
| U.S. Large Cap | S&P 500 Index |
| U.S. Total Market | Russell 3000 Index |
| International | MSCI EAFE Index |
| Fixed Income | Bloomberg U.S. Aggregate Bond Index |
| Balanced (60/40) | 60% S&P 500 / 40% Bloomberg Agg |
Sample IPS Components
A complete IPS typically includes these elements:
- Client overview: Description of family situation, employment, and financial background
- Investment objectives: Return requirements and risk tolerance assessment
- Investment constraints: Time horizon, liquidity, taxes, legal, and unique circumstances
- Asset allocation: Strategic allocation targets and acceptable ranges
- Rebalancing policy: When and how the portfolio will be rebalanced
- Benchmark selection: Indices used to measure performance
- Review schedule: Frequency of IPS review and updates
- Roles and responsibilities: Duties of client, advisor, and other parties
A 62-year-old client has a high ability to take risk due to substantial assets but expresses significant anxiety about market volatility. What risk tolerance should be reflected in the IPS?
Which of the following would trigger a review and potential revision of a client's Investment Policy Statement?
According to the CFP Board guidelines, which element is NOT typically included in an Investment Policy Statement?