A funding policy addresses the level and timing of contributions necessary to fund benefit obligations throughout the life of a retirement plan.

In a defined contribution plan establishing the level and timing of contributions is relatively simple.  Plan sponsors must establish what percentage of employee contributions they will match, the timing of these flows within the coming year, and policies for contributing discretionary cash in the case of profit-sharing plans.

In a defined benefit plan the plan sponsor estimates the costs of accrued liabilities (benefits that are already owed to employees) and projected liabilities (benefits that will be owed, but are currently of uncertain value), as well as return on invested assets, in order to project required contribution levels and formulate the funding policy.   The Employee Retirement Income Security Act of 1974 (ERISA) requires that every plan have a procedure for establishing and implementing a funding policy.

How does a plan sponsor create a funding policy?

Most sponsors of defined contribution plans contribute a certain fixed percentage of employee contributions, or in the case of profit-sharing plans, an amount that depends partly on profitability and partly on the employer's discretion.  So, in a defined contribution plan, funding costs are the percentage of employee contributions that the sponsor has promised.

Funding policies for defined benefit plans are more complex because they must address the issue of liability (both accumulated and projected) in the form of benefit payments, and determine how these liabilities will be funded through contributions and the return on the investment of these funds.

Under the ERISA guidelines, plan sponsors must hire an enrolled actuary to perform these calculations.  The actuary ensures that the funding needs of the plan are met and also assists the plan sponsor in determining the appropriate actuarial cost method (funding method) and actuarial assumptions.  Different cost methods or actuarial assumptions can change the minimum required contribution for funding purposes and the maximum contribution allowable for tax purposes, thus providing plan sponsors some flexibility.

An investment policy is narrower in scope than a funding policy in that it applies specifically to the governance of plan assets.  For instance, a given policy might establish general investments guidelines and restrictions, allocations among assets and managers, benchmarks, and performance goals, among other things.  The investment policy is formally communicated through the investment policy statement.

How are the funding policy and the investment policy related?

A funding policy helps to shape a plan's investment policy by determining the short-and-long term financial needs of the plan.  When these needs are known to the plan sponsor, the sponsor can select appropriate investment objectives and specific investments policies to meet these needs.  The investment policy has an impact on the funding policy in that the investment approach chosen will affect the actuarial assumptions of return on assets.

Are pension plans required by ERISA to produce an investment policy statement?

Although ERISA does not explicitly require a pension plan sponsor to draft an investment policy statement (IPS), one of the first documents that will be requested for examination in any type of compliance audit conducted by the Department of Labor is the IPS.

Why is it important for a plan to have a written investment policy?

A written investment policy is essential for several reasons, among which are the following:

1. The monitoring of invested assets and documentation of that monitoring are crucial to the fulfillment of a plan sponsor's fiduciary responsibility under ERISA.
2. The funding and investment policies help in the selection of appropriate investment managers.
3. Written policies serve as a yardstick for evaluating and monitoring future performance.

The Department of Labor has made this explicit by stating that investment monitoring is a two-step process:

1. Funding and investment policies have to be determined and set down in written investment objectives.
2. The right managers to do the investing must be found.

A written policy statement is advisable because the appropriateness of a particular investment policy or of a subsequent investment decision may, from time to time, come in question, but these decisions will be legally defensible as long as they are properly documented.

Alpha & Omega, Inc. Financial Management Consultants
8580 La Mesa Blvd, Suite 100
La Mesa, CA 91941
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