Creating an Investment Policy Statement
One of the insights from behavioural finance is that we all benefit from systematizing and automating our financial behaviour. Set up your bill payments to come out of your bank account automatically, and you will never worry about missing your payments again. Sign up for a pre-authorized contribution plan to your RRSP that will come out of your bank account on the day you get paid; you will never again have to scramble to your bank on the last day of the contribution deadline. An Investment Policy Statement (IPS) helps you accomplish a similar task with your investments.
A Household’s Finances
A young couple has two children. The husband, Alex, is 38 years old and the wife, Sarah, is 36. Their two children are a daughter, Sophia, age 8, and a son, Jackson, age 6. A decade ago, they bought a house in a medium-sized city for $250,000. They have about $140,000 remaining on their mortgage and their payments are a little over $1,000 per month.
Defined Contribution Pension Plans
Alex and Sarah each earn gross employment incomes of about $60,000 per year. Each are participants in defined contribution pension plans with their respective employers. Their plans provide for each employee to contribute 4% which is matched by a 4% contribution by their employers. As a consequence, their T4 slips show pension adjustments of $4,800, the amount that is contributed to their plans. Alex and Sarah have a wide range of investment funds to choose from through their employers’ pension administrators. They are each using the default choice, a target date fund that gradually grows more conservative as their retirement date gets closer.
Registered Retirement Savings Plans
That leaves them each with RRSP contribution room of ($60,000 x 18% = $10,800 – $4,800 =) $6,000. Although they fell behind on contributing while Sarah was on her maternity leaves, their frugal ways have allowed them to catch up. They contribute the maximum to their RRSPs each year, using the mutual funds available through the advisor at their credit union.
Registered Education Savings Plans
Sarah and Alex are big believers in education. So, even though they were stretched thin financially while Sarah was staying home with her babies, they decided to begin contributing to a family RESP for their children soon after each of them were born. It helped that Sophia’s and Jackson’s grandparents supported their efforts by providing annual birthday presents totalling $1,000 for each child. This reduced the amount that the parents had to come up with to $1,500 for each of Sophia and Jackson. Given the Canadian Education Savings Grant (CESG), which provides an extra 20% on top of what they contribute, Alex and Sarah felt that this was a program to which they could not say no. Their credit union advisor recommended the mutual funds for this account, too.
Although Alex and Sarah would like to contribute to Tax-Free Savings Accounts for themselves, too, they realize that they won’t be able to accomplish that until their mortgage is paid off. They set a target year of 2030. In that year, they plan to: 1. Become mortgage-free, and with their mortgage up for renewal this year, the new lower rates and a slightly higher monthly payment make that possible; 2. Finish contributing to Sophia’s RESP, since she will be 17 that year and will no longer be eligible to receive the CESG after that; and 3. Begin contributing to TFSAs, increasing the amount two years later after Jackson turns 17.
Creating an Investment Policy Statement
Alex and Sarah feel pretty good about their financial situation, but they wonder if they can make any improvements. They have been reading about the costs of mutual funds offered by the banks and credit unions and they wonder if they can do any better by investing their money themselves. Without any direct investment experience on their own, however, they wonder how they can manage it. A search of the internet turns up various solutions. They finally settle on a few ideas: simple is better than complex; automating the investment process is better than frequent intervention; costs matter. Deciding they need to set rules for themselves, they begin with these three items as the foundation of what becomes their Investment Policy Statement.
Defined Contribution Pension Plans
Alex and Sarah agree that they will leave their pension plans alone. The investment process is as simple as can be, it’s all done automatically, and the investment fees are much lower than their current investments in their RRSPs and the RESP.
Simple is Better than Complex
The advisor at their credit union recommended that they use five different mutual funds in their accounts. Alex and Sarah understand that the different funds were used in order to properly diversify, but they wonder if they could get the same result with fewer moving parts. Based on this criterion, they know that they do not want to invest in individual stocks and bonds because that would be very difficult. Therefore:
- No individual stocks or bonds will be purchased.
- To the extent possible, only one or two funds will be used per account.
Automating the Investment Process is Better than Frequent Intervention
Alex and Sarah want to make the process as seamless as possible, like it is now. When they first set up their RRSPs and RESP, their advisor had them complete forms so that a regular amount would be drawn from the accounts on the day their pay was directed-deposited and contributed directly to their registered plans. They also knew that once contributed, the money would be invested directly into their mutual funds. About once a year, their advisor would call them to recommend that they adjust the proportion invested in each of their funds, a process called rebalancing. That doesn’t seem too onerous. They decide on two more rules:
- Set up a Pre-Authorized Contribution Plan and Systematic Investment Plan.
- Rebalance annually, if necessary.
One of the main reasons Alex and Sarah wanted to try DIY investing was in order to lower their investments costs and therefore, they hoped, boost growth in their accounts. They had read that about 2.5% of the value of their funds was taken in costs called a Management Expense Ratio or MER, charged by the fund company, which reduced their annual investment returns from about 6.6% to 4.1%. If they could cut those costs by even 1% that could make a big difference over the long run. Below is a table of where their RRSPs stand as of the end of 2020 compared to where they project they might have been if their return had been 1% greater over the same period:
If they carried on at the same pace, each of them working until age 65, Alex and Sarah estimate that the lower fee would allow them to earn an extra $200,000 each in their RRSPs. As a result of these calculations, the next rule for their Investment Policy Statement is:
- Seek the lower cost option.
These five policies are only the bare bones of an Investment Policy Statement and they do not address timelines and risk tolerance. In particular, the RESP for Sophia and Jackson has a much shorter timeline so it will need to be shifted to a more conservative mix of investments much sooner than Alex and Sarah’s RRSPs. In the following, I will put some flesh on the bones of this Investment Policy Statement for our hypothetical household.
Investment Policy Statement
The purpose of this Investment Policy Statement (IPS) is to assist us in effectively monitoring our investments.
Statement of Objectives
The investments covered by this IPS total approximately $239,000.
The objective for our RRSPs is long-term growth.
The objective of our RESP is long-term growth now, gradually becoming more conservative and tilting toward preservation of capital as post-secondary education approaches.
The investment guidelines for our accounts are based on investment horizons as follows, after which the assets in the accounts will begin to be withdrawn:
- Alex’s RRSP: 27 years, to age 65
- Sarah’s RRSP: 29 years, to age 65
- Sophia’s interest in the RESP: 10 years, to age 18
- Jackson’s interest in the RESP: 12 years, to age 18
We do not expect to withdraw from our RRSPs before reaching age 65. Similarly, we do not expect to withdraw from the RESP until Sophia, and then Jackson, respectively, enter post-secondary education.
We understand that investments have some risks involved. In particular, we are concerned that although investments in the stock market tend to go up more often than not, they also tend to vary quite dramatically in value. Losses in the stock market can also persist for an extended period of time.
On the other hand, investments in fixed income products like bonds and GICs produce much more stable returns but they may not perform as well and sometimes do not even match the rate of inflation.
For our RRSPs, based on risk tolerance surveys that we have taken online, we are comfortable with a mix of assets with 70% in equities and 30% in fixed income. We realize that this mix will prevent us from receiving the highest returns compared to a portfolio that is 100% in the stock market, but it will also protect us against a serious loss. We are prepared to give up some return in exchange for somewhat greater stability.
For the RESP, we realize that we must make adjustments regularly as our children get older. Taking into account their current ages, we have reduced Sophia’s asset mix to 60% equities and 40% fixed income, while we have a more aggressive 80% equity / 20% fixed income portfolio for Jackson. These are technically “notional” asset mixes as we have only one family RESP with both Sophia and Jackson as beneficiaries, and all the assets are held together. The true asset mix is about 68% equity and 32% fixed income.
Based on a 70/30 asset mix in our RRSPs, we expect long-term returns of about 5.1%.
For the RESP, this year we are expecting about a 5% return. We have invested for higher returns earlier in the history of the account and plan to become more conservative over time. As a result, we think that the long-term return of the portfolio will continue to be approximately 5%.
Asset Allocation Guidelines
We have learned that individual stock picking seldom rewards the risk that investors take on. We believe that our asset allocation is more important. For that reason, we will continue to invest in mutual funds for now. We think that a global balanced mutual fund that covers the entire world of the stock market is the best choice for our RRSPs. On the equity side of the fund, we want about 30% of the stocks to be from Canada, about 40% from the U.S., 20% from developed international markets like western Europe, Japan, and Australia, and the remaining 10% from emerging markets. The remaining 30% of the account will go into Canadian bonds.
We picked the percentages for the various stock positions in proportion to their weighting in the world’s stock markets. Although having Canada at 30% is disproportionate to our country’s weight, we believe it makes sense since we live in Canada. We also read that having about 25 to 30% invested in Canadian stocks tends to mix well with stocks from the other countries by reducing volatility, which we like.
For the RESP, we are taking a slightly different approach. We will use two funds. One will be a global equity fund and the other a Canadian bond fund.
Rebalancing of Asset Allocation
Since we plan on using a single fund for our RRSPs, we will not need to do any rebalancing ourselves. That will be taken care of regularly by the fund manager.
However, because we are using two funds in the RESP, we will have to regularly make adjustments. Each year we will direct a greater proportion of our monthly contributions to be automatically invested in the bond fund. When the Canadian Education Savings Grants (CESG) come in, we have to manually invest those, so we will fine tune the balance to maintain our target allocation for that particular year.
We will monitor our funds’ performance against a benchmark using Exchange-Traded Funds that track relevant indices.
We will conduct performance reviews annually at the beginning of the year following the publication of results for each of above-mentioned ETFs.
Investment Policy Statement (IPS) Review
We will review our IPS at least annually to assess the following:
- Continuing relevance of our stated objectives
- Availability of opportunities to simplify our investment process
- Availability of lower cost investment options
- Availability of low-cost alternatives to DIY investing
The above is just one example of a possible IPS. You may think that this level of detail hardly seems necessary. However, working through this kind of process and writing it down helps investors to continue with their long-term plan when short-term market gyrations tend to threaten one’s ability to follow the course. To a great extent, Alex and Sarah have already taken care of that problem by automating their investment process and selecting one- or two-fund solutions for their accounts.
I invite readers to do an internet search for “Investment Policy Statement.” You will find statements that are not intended for the self-directed DIY investor, but they can be adapted for your own purposes. If you have never planned out your investment approach until now, you now have an excellent opportunity to take your first step.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.