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Investment strategy for charities
Chris Watts from the London office talks about a recent investment review he completed for a charity.
A new client recently asked us to review their investment strategy. Nothing unusual there. However, in this case, the client was a charity rather than a pension plan, and the assets in question were the charitable funds.
The main purpose of the project was to judge the appropriateness of the current asset allocation and to make recommendations as to ways in which the allocation could be made more appropriate in future, in view of the likely liability profile.
In this case we based our analysis on a cashflow study, rather than a more sophisticated stochastic economic analysis of the possible relationship between the assets and the liabilities. The two different approaches have their particular uses, and it was decided that at least in the first instance the specific circumstances of this particular client made the simpler analysis more appropriate.
To conduct a cashflow study we first need details of projected outgo. This is an area where input from the client is required and in this case our client produced a projection of both future donations and grants. As well as helping determine investment strategy, this type of projection can also help a client plan the pattern of their finances both now and in the future.
The cashflows then need to be analysed, with a view to producing an investment strategy which will aim to match expected outgo, maximise long-term investment returns (subject to certain risk considerations) and allow sufficient flexibility in unexpected situations.
In the case of a charity it is the client's projected outgo, and not the projected net cashflows, which are most important in determining the matching investment strategy for existing funds. It is, therefore, important to distinguish between those of the future liabilities that might be thought of as relating to the existing funds and those that might be thought of as being met by future income through donations. If the fund did become "paid up" then the outgo would be gradually reduced so that the fund would not be used up too quickly.
We then considered which assets should be used to back the various cashflows. To help us, we conducted some analysis on the historical outperformance of equities over gilts (called the equity risk premium or ERP). (Click here for more information on ERPs.)
It might not be prudent to look at only the average equity outperformance, and we think it is more appropriate to consider that performance that has historically been exceeded 9 times out of 10, or else 3 times out of 4 (the 90th and 75th percentiles respectively). This offers a risk-adjusted measure of the outperformance.
The first conclusion was that equities have shown a high level of risk over short-term periods. Although this in itself is intuitive, our analysis suggests that "short term" could be defined as up to perhaps 7 or 10 years for this purpose, depending on how conservative a line is taken. Longer periods may also be appropriate depending on the needs of a particular client.
Arguably, therefore, it is the payments for the next 7 or 10 years which represent those liabilities that should be backed by cash or bonds rather than equities. Payments due after that can be backed by assets expected to deliver higher long-term returns such as equities. The longer time frame means that there is a relatively low chance of equities under-performing cash or bonds.
In order to test the sensitivity of our analysis, we also projected the client's finances forward 5 years (allowing for expected income over the next 5 years only) and reworked our analysis. This gives us an indication as to how the suggested strategy may need to change over time.
For further information on how actuarial asset-liability matching techniques can be applied to charitable funds please speak to Chris Watts in our London office.
Chris Watts, February 2003.