Learning Outcomes
After reading this article, you will be able to construct and assess investment policy statements for individuals by identifying appropriate investment objectives, formulating return requirements, and evaluating constraints including time horizon, liquidity, tax, legal, and unique circumstances. You will be prepared to distinguish between types of constraints and interpret how they combine to shape an investor’s IPS, a core CFA Level 3 exam skill.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand and apply individual investment policy statement (IPS) formulation principles. You should focus your revision on:
- Distinguishing between investment objectives and return requirements in an IPS
- Evaluating and formulating constraints (time horizon, liquidity, tax, legal, unique circumstances)
- Calculating explicit and implicit return requirements for private clients
- Integrating qualitative and quantitative data into the IPS construction process
- Identifying common pitfalls in IPS drafting and interpretation
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are the five main constraint categories that must be addressed in an individual IPS?
- How does an investor’s liquidity need influence portfolio construction and asset allocation?
- A client wishes to retire in eight years and requires annual portfolio withdrawals increasing with inflation thereafter. What key investment objective(s) and constraint(s) would you note in her IPS?
- What is the difference between an investment objective and a return requirement?
Introduction
An individual investment policy statement (IPS) sets out the goals and limitations that guide investment decisions for a private client’s portfolio. The IPS is the fundamental reference for portfolio construction, management, and review. It aligns the investment strategy with the unique requirements of the investor. For CFA exam candidates, gaining proficiency in IPS formulation is essential—incorrect objectives, misunderstood constraints, or poor calculation of return requirements can result in incorrect portfolio recommendations or analysis.
Key Term: Investment Policy Statement (IPS)
A formal, written document outlining a client’s investment goals, risk tolerance, return requirement, and all relevant constraints to guide portfolio management.
INDIVIDUAL IPS FORMULATION: OBJECTIVES, CONSTRAINTS, AND RETURN REQUIREMENT
Setting Investment Objectives
The investment objective in an IPS articulates the investor’s primary financial goals and any secondary priorities. It should be clear, precise, and quantified where possible.
Key Term: Investment Objective
A statement describing the investor’s desired outcomes, typically in terms of required income, wealth accumulation, legacy goals, or major expenses.
The IPS should clearly distinguish between objectives ("fund retirement lifestyle") and the return requirement ("achieve a 4% real return per year") that is necessary to satisfy those objectives, based on the client’s circumstances.
Calculating Return Requirement
You must translate objectives and planned cash flows into a required portfolio return. This involves synthesizing information from the client’s projected spending, time horizon, and existing assets. Both explicit needs (annual withdrawals) and implicit erosion of capital through inflation must be considered in setting a real—or nominal—return requirement.
Key Term: Return Requirement
The minimum return necessary for a portfolio to meet the investor’s spending needs and objectives, accounting for inflation, taxes, and other factors.
Identifying Constraints
Five broad categories of constraints must be systematically addressed in every individual IPS:
- Time Horizon: The length and phase(s) over which portfolio assets will be used. Multiple time horizons may exist for different objectives.
- Liquidity Needs: The necessity for cash withdrawals or the need to hold assets that can readily be sold without significant loss.
- Tax Considerations: Any tax regimes, account types, or investment structures affecting after-tax returns or preferred investment vehicles.
- Legal and Regulatory: Restrictions or requirements arising from the law, regulation, or the investor’s status (e.g., trust provisions, jurisdictional rules).
- Unique Circumstances: Any specific preferences, values, or prohibitions (e.g., ESG focus, restricted securities, or personal values).
Each constraint affects asset allocation, security selection, or implementation choices.
Key Term: Constraint
Any condition (time horizon, liquidity, tax, legal, unique) limiting how a portfolio can be managed or constructed.Key Term: Liquidity Need
The expected or potential need to withdraw cash from the portfolio, or to maintain easily saleable assets.
Worked Example 1.1
A 50-year-old client wants to retire in 10 years with annual after-tax withdrawals of $100,000 (in today's dollars) for 30 years. Her portfolio is currently $1,200,000. Inflation is 2%. Estimate her required nominal return in retirement, assuming no legacy objective.
Answer:
First, project real withdrawals: $100,000 per year, increasing with inflation. Portfolio must support 30 years of inflation-adjusted withdrawals. Use a financial calculator or annuity formula. Assuming a 0% real return, $100,000 × 30 = $3,000,000, which exceeds her assets. To find the required return, set up a present value of an increasing annuity formula to solve for the nominal return. The required return will be between 4–6% nominal (depending on assumptions), higher than inflation, to avoid portfolio depletion.
Worked Example 1.2
A client plans a major spending event ($400,000) in 5 years for a child's education. How would you reflect this in the IPS?
Answer:
Under constraints, specify a significant liquidity need in year five. Asset allocation may need to hold a substantial portion in cash equivalents or short-term bonds as the expenditure approaches, to avoid forced sales of risky assets during adverse market conditions.
Exam Warning
Do not confuse “investment objectives” with “return requirement.” Objectives state what the client wants to achieve (“maintain lifestyle; preserve capital”), while return requirement is the quantified portfolio return needed to achieve those aims.
Revision Tip
When constructing or critiquing an IPS, always list all five major constraint categories—even if for one the answer is "none." This approach is required in the CFA exam to demonstrate completeness.
Summary
A well-formulated IPS for individuals clearly states objectives, return requirements, and all constraints. Objectives specify the purpose of the investment, return requirements translate these goals into measured targets, and constraints define the portfolio’s boundaries. IPS drafting and assessment skills are core CFA Level 3 competencies and frequently tested.
Key Point Checklist
This article has covered the following key knowledge points:
- Differentiate between investment objectives and quantitative return requirements in an IPS
- Calculate required return based on cash flows, inflation, and assets
- Identify and describe all five constraint categories in an individual IPS
- Understand how each constraint affects portfolio construction and asset allocation
- Recognize the importance of explicit, quantified objectives and appropriately structured return calculations
Key Terms and Concepts
- Investment Policy Statement (IPS)
- Investment Objective
- Return Requirement
- Constraint
- Liquidity Need