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Returns to Form - Allocating Investment Returns for Charities
Chris Watts and Glenda Ashison explore the difficulties faced by charities when allocating the investment returns of permanent endowments.
This article first appeared in the February edition of Charity Finance magazine.
Some charities receive donations in the form of permanent endowments, which are subject to a prohibition on expenditure of capital and in many cases are associated with older charitable trusts. Charities would usually have to hold these permanent endowments on a permanent basis with only the income from the donation being available for the charity to spend.
Before reforms by the Charity Commission came into effect in June 2001, many charities were left with soaring permanent endowment values, thanks mainly to stock market growth but also because of declining income. This was brought about by a trend for many companies to reduce or even stop paying dividends - an effect of market trends and the abolition of advance corporation tax credit for pension funds.
The existence of permanent endowment investments can force charities to follow investments can force charities to follow investment strategies that may not provide the best overall return. In particular, charities with permanent endowments may be under pressure to determine their investment strategy by considering the income rather than the total returns that a particular strategy would offer.
According to 2002 JP Morgan Charity Investment Industry Survey, 48 per cent of charities surveyed adopted a total return approach to investment to ease pressure on income. Total return investment describes an approach where all forms of return on investments are added together to produce a total return. Some of this total return is then used to meet the needs of present beneficiaries, while the remainder is added to capital to help meet the needs of future beneficiaries. The policy requires trustees to be even-handed between present and future beneficiaries but frees them from the distinction between returns in the form of capital growth and income.
Following approval from the Charity Commission in 2001, charities that have permanent endowment investments can make use of this alternative strategy. There are three ways for trustees to adopt the total return approach depending on the individual circumstances of each charity. If the governing document of a charity does not allow the use of a total return investment strategy then it is necessary to obtain authority form the founders, if they are still living, or other supporters of the charity, before applying to the commission for an order. Alternatively if the charity's governing document allows the power of amendment, then it is possible to exercise this power in order to pursue a total return strategy. But because of the way this strategy is administered there are legal issues that can arise regarding the accumulation of too much income. In order to overcome this the commission recommends that trustees follow the third option which is to request an order from the commission which will grant the power to pursue a total return strategy.
Before an order is granted, the commission requires a reasonable estimate from the trustees of the unapplied return from the investment of gifts, and the gifts themselves.
Also the provision of the power must be, in the eyes of the commission, in the best interests of the charity.
The total return approach does not mean that trustees are given unrestricted powers to spend the capital, but it does allow them to invest in a way that generates the best overall return regardless of whether that is income or capital. This allows flexibility in distributing permanent endowments for the charity.
But it is not clear whether any allowance should be made for the impact of inflation in the value of the original gift when made. Traditionally, the impact of inflation on permanent endowed, capital would be ignored. It could be argued that any uplift in asset values, caused by inflation or otherwise, represents unapplied return. But the commission's reference to "resources which represent the value of the gifts when made" suggest a different view.
The total return approach of maintaining the real value of the permanent endowments arguably fulfils the trustees' duty of even-handedness between present and future beneficiaries. Some of the total return obtained in this way would be used to meet the needs of present beneficiaries while the rest would be added to the existing capital to help meet the needs of future beneficiaries.
One of the directions governing the use of power under the commission's model order is "to use such care and skill as is reasonable". This duty of care and skill mirrors that of the Trustee Act 2000, and applied when initially identifying the unapplied total return; when balancing present and future interests; and when taking and considering advice. The commission advises trustees to "seek specific professional advice from the person who provides the charity with investment/actuarial advice" directed towards ensuring that the expenditure and investment scheme is sustainable.
Factors to be considered include fluctuations in investment values, the likely effect of inflation and any anticipated changes in need or service provision over time. The suggestion is that the real value of past permanent endowments (PPEs) should be maintained, rolled up with price inflation, but that any excess could be regarded as distributable.
One such formula for a distributions reserve which is not yet allocated as distributable and where future positive real returns are not guaranteed, for example where investment is in equities or property, is:
Effectively this is what might be expected to happen in the long term.
But in the short term for volatile assets the actual value of a PPE investment may not increase in line with expectations.
Suppose that a PPE investment is held in a particular share with an arbitrary real value of £100. There are then three scenarios for the future movement in the value of that investment; it could either increase in value, decrease in value or remain unchanged. The graph illustrates, in broad terms, how the value of such a PPE investment might vary if held over 10 years in equities compared to the expected long term returns (split into returns in excess of inflation and dividend payments - in this case assumed to be reinvested).
First suppose that, a year later, the total value of £108, which includes £2 of real capital growth, £3 maintaining the real level of the investment and a £3 dividend. The approach above would give you the option of spending the total income from the real capital growth to match inflation. So £5 in this case.
Next consider the case where, in a year's time, the total value of the investment only rises with inflation to a value of £103, provides no capital growth - in effect leaving the real value of the investment unchanged and a £3 dividend. Again you could argue that any returns in excess of inflation could be expendable, only the £3 dividend in this case.
Finally, the equity might depreciate in value to £95, say. In this case there is a £8 real capital loss. It could be argued that in this case it would be sensible to hold back the dividends to recoup some of the real loss. But it might be justifiable to spend the income if you thought that the equity value would rebound over time.
For volatile assets the fluctuation of the real value of the PPE could justify retaining some returns in excess of inflation in order to protect against the value of the asset going down in the future. This particular issue is difficult to quantify in general as individual charities finances and risk tolerances will be important. The life insurance industry offers a resilience test to check that the capital value is maintained at set intervals.
This test is a standard requirement that allows for the effects of possible future changes in asset value and also on the adequacy of these assets to meet payments in the future.
Broadly speaking, firms must consider how a fall of 25 per cent in the market value of equities and a subsequent 10 per cent fall in companies' earnings will affect the fund. Other types of investment are also considered under the test. Such a test is a useful starting point when thinking about appropriate risk management associated with the investment of PPEs.
This article first appeared in the February edition of Charity Finance magazine.
Chris Watts & Glenda Ashison, March 2004.