Individual IPS formulation - Objectives constraints and retu...

Learning Outcomes

This article explains how to construct and assess individual investment policy statements (IPS) for the CFA Level 3 exam, including:

• Identifying and articulating appropriate investment objectives that reflect a client’s required lifestyle, wealth accumulation, legacy, and major expenditure goals in clear, exam-ready language.
• Translating qualitative objectives and cash-flow information into a quantified return requirement, distinguishing real versus nominal returns and incorporating inflation, taxes, and spending needs.
• Evaluating risk tolerance in the context of ability and willingness to take risk, and linking this assessment to suitable portfolio risk and return characteristics.
• Systematically classifying and describing the five major IPS constraint categories—time horizon, liquidity, tax, legal and regulatory, and unique circumstances—using precise exam terminology.
• Assessing how each constraint affects asset allocation, security selection, and implementation choices, and recognizing trade-offs when constraints conflict.
• Integrating client data to draft, review, and refine a coherent IPS that aligns objectives, return requirement, risk tolerance, and constraints in a format consistent with CFA Institute expectations.
• Practicing the structured, step-by-step reasoning required to justify IPS recommendations and to answer written-response (essay) questions under exam conditions.

CFA Level 3 Syllabus

For the CFA Level 3 exam, you are required to understand individual investment policy statement (IPS) formulation principles, with a focus on the following syllabus points:

• Distinguishing between investment objectives and return requirements in an IPS.
• Evaluating and formulating constraints (time horizon, liquidity, tax, legal and regulatory, 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.

1. Which of the following lists the five main constraint categories that must be addressed in an individual IPS?
   1. Inflation, time horizon, tax, leverage, behavioral
   2. Time horizon, liquidity, tax, legal and regulatory, unique circumstances
   3. Risk tolerance, liquidity, tax, leverage, behavioral
   4. Time horizon, inflation, tax, legal and regulatory, behavioral
2. How do higher ongoing liquidity needs most directly influence portfolio construction for an individual investor?
   1. They allow for a higher equity allocation because cash flows are predictable.
   2. They require a larger allocation to illiquid alternatives to earn higher returns.
   3. They increase the need for cash and high-quality bonds, reducing the share of illiquid and volatile assets.
   4. They have no impact if the investor’s risk tolerance is above average.
3. A client aged 57 plans to retire in eight years. From retirement, she expects to withdraw inflation-indexed income from the portfolio for life. Which combination best reflects key IPS elements for this client today?
   1. Short time horizon; high liquidity needs; capital preservation objective.
   2. Single-stage time horizon; low risk tolerance; pure income objective.
   3. Multi-stage time horizon; moderate-to-high return objective; explicit liquidity needs starting at retirement.
   4. Indefinite time horizon; no liquidity constraints; wealth maximization objective only.
4. What best describes the difference between an investment objective and a return requirement?
   1. The objective refers only to risk, while the return requirement refers only to taxes.
   2. The objective describes what the investor wants to achieve; the return requirement quantifies the portfolio return needed to achieve it.
   3. The objective is qualitative; the return requirement is the benchmark index chosen.
   4. The objective is short term; the return requirement is long term.

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.

At Level 3, you are often given several pages of case information and asked to distill it into a concise, logically consistent IPS. The challenge is not only to compute numbers correctly but also to justify them in words that clearly link client facts to portfolio decisions.

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.

For individuals, objectives are typically separated into:

• Required objectives: Outcomes that must be funded (e.g., maintaining a specified standard of living, ensuring sufficient retirement income, funding promised education expenses).
• Desired objectives: Outcomes the client would like to achieve but can forgo if necessary (e.g., leaving a bequest of a certain size, purchasing a vacation property).

On the exam, wording matters. A good objective statement:

• Identifies the purpose of the portfolio (e.g., fund retirement spending, preserve real wealth, support philanthropic giving).
• Indicates the priority of each goal (required vs desired).
• Is consistent with the client’s risk tolerance and constraints.

Examples of concise, exam-appropriate investment objectives:

• “Primary objective: Provide inflation-adjusted spending of USD 120,000 per year in retirement while preserving the real value of capital over the long term.”
• “Primary objective: Achieve long-term capital growth to fully fund university costs for two children beginning in 10 and 13 years.”
• “Secondary objective: Maintain a legacy of at least USD 2 million (in today’s dollars) for the client’s heirs.”

The IPS should clearly distinguish between broad objectives (“fund retirement lifestyle”) and the return requirement (“achieve a 4% real after-tax return per year”) that is necessary to satisfy those objectives, based on the client’s circumstances.

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 relevant factors.

Evaluating Risk Tolerance

Before quantifying the return requirement, you must judge whether the implied risk is acceptable. Level 3 questions often ask you to assess or justify the client’s risk tolerance.

Key Term: Risk Tolerance
The overall degree of risk an investor can accept, combining both their financial ability to bear risk and their psychological willingness to accept portfolio volatility and potential losses.

Key Term: Ability to Take Risk
The extent to which an investor’s financial situation (wealth, income, time horizon, flexibility) can support volatility and potential losses without jeopardizing key goals.

Key Term: Willingness to Take Risk
The investor’s psychological comfort with uncertainty and loss, based on attitudes, past experience, and expressed preferences.

Key factors affecting ability to take risk:

• Size of the portfolio relative to required spending (larger surplus → higher ability).
• Stability, level, and diversification of income sources.
• Length of investment time horizon (longer horizon → higher ability).
• Flexibility of goals (discretionary vs non-discretionary spending).
• Remaining human capital (age, career stage, earning prospects).

Key indicators of willingness to take risk:

• Explicit statements about loss aversion (e.g., “cannot accept more than 10% loss in any year” → low willingness).
• Past investment experiences and reactions to market downturns.
• Preferences for “guarantees” or capital preservation versus growth.
• Behavioral traits (e.g., anxiety about markets, focus on short-term results).

On the exam:

• Assess ability and willingness separately, giving brief support from case facts.
• State an overall risk tolerance (below average, average, or above average).
• When ability and willingness conflict, the recommended approach is to adopt the lower of the two, provided the goals remain feasible. If the lower tolerance makes goals infeasible, this tension should be highlighted and may require revising goals or funding.

The risk objective in an IPS should therefore say something like:

• “Risk tolerance: Ability is above average given substantial financial assets relative to spending needs and a long time horizon; willingness is average based on moderate concern about losses. Overall risk tolerance: average to above average.”

This qualitative risk objective must be consistent with the portfolio’s implied volatility (e.g., equity allocation, use of leverage).

Calculating Return Requirement

You must translate objectives and planned cash flows into a required portfolio return. This involves integrating information from the client’s projected spending, time horizon, taxes, 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.

The typical exam framework for a single-period nominal required return is:

1. Determine the investable asset base at the start of the period (exclude personal-use assets such as primary residence unless clearly part of the investment portfolio).
2. Estimate net cash outflow from the portfolio during the period:
   • Net outflow = spending needs – external income earmarked for that spending.
   • If savings are added to the portfolio (net inflow), this reduces the required return.
3. Express the cash-flow requirement as a percentage of beginning assets: $$\text{Spending rate} = \frac{\text{Net cash outflow}}{\text{Investable assets at start of period}}$$
4. Add expected inflation to obtain a nominal return, using either an additive approximation or exact compounding:
   • Approximate: $$r_{\text{nominal}} \approx \text{Spending rate} + \text{Inflation}$$
   • Exact: $$1 + r_{\text{nominal}} = (1 + \text{Spending rate})(1 + \text{Inflation})$$
5. Adjust for taxes if required. For a flat tax rate $t$ on investment income: $$r_{\text{pre-tax}} = \frac{r_{\text{after-tax required}}}{1 - t}$$

Key Term: Nominal Return
A return expressed in current money terms, including the effect of inflation.

Key Term: Real Return
A return adjusted for inflation, representing growth in purchasing power.

Key Term: After-Tax Return
The return on a portfolio net of all applicable taxes on income and capital gains.

In more complex cases, you may need multi-stage return requirements:

• Pre-retirement: Accumulation phase (no withdrawals, possibly contributions).
• Post-retirement: Decumulation phase (withdrawals; often higher required return).

In such cases, the exam may ask for:

• A single long-term return requirement consistent with the main goal; or
• Separate return requirements for each stage.

Read the question carefully; answer exactly what is requested and state any simplifying assumptions (e.g., “assume a constant annual nominal return over the full horizon”).

Worked Example 1.1

A 50-year-old client wants to retire in 10 years with annual after-tax withdrawals of USD 100,000 (in today's dollars) for 30 years. Her portfolio is currently USD 1,200,000. Inflation is 2%. Estimate her required nominal return in retirement, assuming no legacy objective and taxes already accounted for in the USD 100,000 figure.

Answer:
First, treat the USD 100,000 as a real annual withdrawal, increasing with inflation over 30 years. The portfolio today (USD 1.2 million) is in today’s purchasing power as well, so we solve for a constant real return that allows a 30-year real annuity of USD 100,000.

Conceptually:

• Let $r_{\text{real}}$ be the constant real return in retirement.
• The present value of a real, inflation-indexed annuity is: $$\text{PV} = 100{,}000 \times \frac{1 - (1 + r_{\text{real}})^{-30}}{r_{\text{real}}}$$
• Set PV equal to USD 1,200,000 and solve for $r_{\text{real}}$ using a financial calculator or spreadsheet.

Solving this equation gives a real return of roughly 7–8% per year. To convert to a nominal return (given 2% inflation):

$$1 + r_{\text{nominal}} = (1 + r_{\text{real}})(1 + 0.02)$$

For a 7.4% real return:

1 + r_{\text{nominal}} \approx 1.074 \times 1.02 \approx 1.095 \Rightarrow r_{\text{nominal}} \approx 9.5\% $ Thus, the client’s required nominal return in retirement is in the **high single digits** (around 9%–10% per year). On the exam, you would: - Show the **structure** of the calculation (annuity PV and inflation adjustment). - State that the required nominal return is high, implying an aggressive post-retirement asset allocation or the need to revise spending expectations.

Note how this calculation feeds back into the risk objective: a 9–10% nominal target usually implies high equity exposure and thus high risk, which may be inconsistent with a low stated risk tolerance.

Worked Example 1.2

A client plans a major spending event (USD 400,000) in 5 years for a child's education. How would you reflect this in the IPS?

Answer:
Under constraints, specify:

-Time horizon: Multi-stage. The first stage runs from now until the tuition payment in year 5; subsequent stages cover later goals (e.g., retirement). -Liquidity needs: A significant, known liquidity requirement of USD 400,000 in year 5.

In terms of portfolio implications:

-A portion of the portfolio earmarked for this payment should be invested in low-volatility, liquid assets (short-duration bonds, cash equivalents), especially as year 5 approaches. -The remaining assets (not needed for year-5 spending) can be invested according to the longer-term risk and return objectives.

In the IPS, you might write: “Liquidity: The client has a known requirement of USD 400,000 in year 5 to fund a child’s education; assets sufficient to meet this need will be invested in short-term, low-risk securities as the date approaches.”

Worked Example 1.3

A retired client has a portfolio of USD 1,500,000. She needs USD 60,000 per year (nominal) from the portfolio, expects inflation of 2%, and pays a flat 25% tax on portfolio income and gains. Compute the approximate pre-tax nominal required return for the coming year.

Answer:
Step 1: Compute the after-tax spending rate as a percentage of beginning assets:

$$\text{Spending rate} = \frac{60{,}000}{1{,}500{,}000} = 4\%$$

Step 2: Add expected inflation (approximate method) to maintain real capital:

$$r_{\text{after-tax nominal}} \approx 4\% + 2\% = 6\%$$

Step 3: Convert to pre-tax required return given a 25% tax rate:

r_{\text{pre-tax nominal}} = \frac{r_{\text{after-tax required}}}{1 - t} = \frac{6\%}{0.75} = 8\% $ So the portfolio must earn approximately **8% pre-tax nominal** in the coming year to fund the required spending while maintaining real capital. In the IPS, you would state: “Return requirement: Approximately 8% pre-tax nominal, based on a 4% spending rate, 2% inflation, and a 25% tax rate.”

On exam questions, you should clearly indicate whether your return is pre-tax or after-tax, real or nominal, and ensure that your assumptions match the wording of the question.

Identifying Constraints

Five broad categories of constraints must be systematically addressed in every individual IPS:

1. Time Horizon
2. Liquidity Needs
3. Tax Considerations
4. Legal and Regulatory Factors
5. Unique Circumstances

Key Term: Constraint
Any condition (time horizon, liquidity, tax, legal and regulatory, unique circumstances) limiting how a portfolio can be managed or constructed.

Time Horizon

Key Term: Time Horizon
The period over which the portfolio will be invested before major cash flows or goals significantly change the risk and return profile.

Key points for individuals:

• Many individuals have multi-stage horizons (e.g., working years, early retirement, late retirement, estate).
• The effective horizon often extends beyond the client’s life expectancy if there are explicit legacy goals or dependent beneficiaries.
• Longer horizons generally support higher risk capacity, subject to liquidity needs and other constraints.

Example IPS phrasing:

• “Time horizon: Multi-stage. First stage: 10 years to retirement; second stage: 25-year retirement period; overall horizon long term.”

In the exam, avoid simply repeating what the client says (e.g., “my horizon is 10 years until retirement”) if the facts imply a longer economic horizon. Show that you recognize the post-retirement stage.

Liquidity Needs

Key Term: Liquidity Need
The expected or potential need to withdraw cash from the portfolio or to maintain easily saleable assets to meet spending or contingencies.

Liquidity constraints include:

• Regular withdrawals to fund living expenses (especially when they exceed income from other sources).
• Known large expenditures (education, property purchase, tax payments).
• Emergency reserves if the client has unstable income or concentrated risks.
• Requirements to hold cash or near-cash if the client wants the portfolio to be readily liquid (e.g., in case of potential business opportunities).

High liquidity needs typically imply:

• Larger allocations to cash and short-duration, high-quality fixed income.
• Reduced allocations to illiquid assets (private equity, real estate, certain hedge funds).
• More conservative rebalancing and drawdown policies.

Tax Considerations

Key Term: Tax Constraint
Any feature of the investor’s tax situation that affects portfolio structure, asset location, realization policy, or the required return.

Tax issues for individuals often include:

• Different tax treatment of interest, dividends, and capital gains.
• Tax-advantaged versus taxable accounts (e.g., retirement accounts vs brokerage).
• Jurisdiction-specific rules (e.g., withholding taxes on foreign income, wealth taxes).
• Large unrealized capital gains that make immediate liquidation costly.

Within the IPS, tax considerations influence:

• Asset location: placing tax-inefficient assets (e.g., high-turnover strategies, taxable bonds) into tax-deferred accounts when possible.
• Realization policy: deferring realization of gains to benefit from compounding and lower effective tax rates.
• Return requirement: high tax rates increase the pre-tax return needed to meet after-tax goals.

Legal and Regulatory Factors

Key Term: Legal and Regulatory Constraint
Any law, regulation, or legal structure affecting how a portfolio may be managed, which securities may be held, or how assets are transferred.

Examples for individual investors:

• Restrictions from trust documents (e.g., income-only distributions, spending rules).
• Divorce settlements or prenuptial agreements affecting access to assets.
• Cross-border issues (e.g., residency, citizenship) affecting permissible investments.
• Regulatory constraints on insiders (e.g., blackout periods for trading employer stock).

These constraints often limit asset selection or trading flexibility and must be explicitly noted.

Unique Circumstances

Key Term: Unique Circumstances
Any investor-specific factors not captured in other constraint categories, such as ESG preferences, prohibited investments, or concentrated positions.

Examples:

• ESG or values-based exclusions (e.g., no tobacco, weapons, or fossil fuel stocks).
• Desire to retain a “legacy” asset (e.g., family business, inherited stock) despite concentration risk.
• Illiquid holdings that cannot be sold for a period (e.g., lockups in private funds).
• A required minimum cash balance in the portfolio beyond what is justified by normal liquidity needs.

Each constraint affects asset allocation, security selection, or implementation choices. Good exam answers not only list the constraints but also briefly explain the investment implications (e.g., “High liquidity needs limit allocation to illiquid alternatives”).

Key Term: Liquidity Need
The expected or potential need to withdraw cash from the portfolio, or to maintain easily saleable assets.

Worked Example 1.4

A 40-year-old entrepreneur has net worth of USD 15 million, of which USD 10 million is the illiquid value of her privately held company. The remaining USD 5 million is in a diversified, liquid portfolio. She plans to retire in 20 years, has modest current spending relative to her liquid assets, but strongly prefers not to see annual portfolio losses greater than 5%. Assess her risk tolerance and identify two key constraints.

Answer:

-Ability to take risk: Above average. Total wealth is high, human capital remains significant (age 40), and required spending from the liquid portfolio is modest relative to its size. The long time horizon (20 years to retirement plus retirement years) further supports high ability. -Willingness to take risk: Below average. She explicitly states discomfort with losses greater than 5% annually, indicating high loss aversion and low tolerance for volatility. -Overall risk tolerance: Below average, because willingness is lower than ability and behavioral constraints must be respected. The IPS should recommend a relatively conservative allocation in the liquid portfolio.

Key constraints:

-Liquidity: Current liquidity needs are modest (living expenses easily supported by liquid assets), but the illiquid business holding represents a large portion of net worth; the investable portfolio must be sufficiently liquid to cover personal spending and business contingencies. -Unique circumstances: Highly concentrated exposure to her own company (USD 10 million vs USD 5 million in liquid assets) and a preference to retain control. This concentration and her strong aversion to loss support a conservative allocation within the liquid portfolio, potentially tilted toward low-volatility, income-generating assets.

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, given the client’s financial situation, inflation, taxes, and spending.

Revision Tip

When constructing or evaluating 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 and structured thinking.

Summary

A well-formulated IPS for individuals clearly states:

• Investment objectives: What the portfolio is meant to accomplish (e.g., fund retirement, preserve real wealth, support bequests) and the priority of each goal.
• Risk tolerance: A reasoned judgment of the investor’s ability and willingness to take risk, leading to an overall risk tolerance classification consistent with the proposed asset allocation.
• Return requirement: A quantified, real or nominal, pre-tax or after-tax return consistent with the objectives, based on explicit cash-flow analysis and assumptions about inflation and taxes.
• Constraints: Time horizon, liquidity needs, tax situation, legal and regulatory factors, and unique circumstances, each with clear portfolio implications.

At Level 3, you are expected not only to compute numbers correctly but also to justify them by linking client facts to IPS elements. Coherence is critical: return requirements must be consistent with risk tolerance and constraints; constraints must be reflected in asset allocation and implementation choices. Practicing this structured reasoning will significantly improve your performance on written-response IPS questions.

Key Point Checklist

This article has covered the following key knowledge points:

• Differentiate clearly between investment objectives (qualitative goals) and quantitative return requirements in an IPS.
• Assess ability and willingness to take risk, and combine them into an overall risk tolerance classification with supporting rationale.
• Calculate required return based on cash flows, inflation, taxes, and investable assets, distinguishing real versus nominal and pre-tax versus after-tax returns.
• Identify and describe all five constraint categories in an individual IPS: time horizon, liquidity, tax, legal and regulatory, and unique circumstances.
• Explain how each constraint affects portfolio construction, asset allocation, and security selection, especially when constraints conflict with one another.
• Draft concise, exam-ready IPS statements that align objectives, risk tolerance, return requirements, and constraints, and that can be defended under essay exam conditions.

Key Terms and Concepts

• Investment Policy Statement (IPS)
• Investment Objective
• Return Requirement
• Risk Tolerance
• Ability to Take Risk
• Willingness to Take Risk
• Nominal Return
• Real Return
• After-Tax Return
• Constraint
• Time Horizon
• Liquidity Need
• Tax Constraint
• Legal and Regulatory Constraint
• Unique Circumstances