In 2013 the Trustees of a Charity asked us to use modelling to illustrate possible future investment returns and volatility resulting from the Charity’s current asset allocation, and then to suggest possible alternative asset allocations. We undertook stochastic (or statistical) analysis on the current and potential alternative asset allocations using our in-house asset-liability model, BWARM.
- Is the investment objective in line with the Charity’s return objectives, and what are the implications in terms of risk?
- Could the same expected return be achieved but with lower anticipated asset value volatility, and what are the implications in terms of governance burden?
“The fund must be able to produce sufficient resources over a projected 10 year period to permit the current level of annual expenditure to continue in real terms and to maintain the capital value of the fund in real terms over that 10 year period.”
Is maintaining an investment objective of RPI + 2.6% pa, which is expected to provide around £700,000 pa for expenditure, while still maintaining the real value of the underlying fund, sufficient?
- If a higher expected return is required, a greater proportion of the assets would need to be allocated to more volatile asset classes.
- If a lower expected return could be tolerated, less investment risk could be incurred by allocating to less volatile assets.
The following charts illustrate the results of our modelling, showing the anticipated range of real returns after 10 years under a range of possible investment strategies, expenditure plans and return targets.
A projected real return of 0% pa on the underlying funds, after allowing the withdrawal of funds for spending would indicate projected performance in line with the objective of paying the annual target expenditure (increasing with inflation) and maintaining the value of the Fund in line with inflation.
Reducing risk and the impact on governance
We considered the option of replacing some or the entire existing equity holding with an investment in a DGF. Below are the results of the modelling we conducted, based on the assumption that the current target of RPI + 2.6% pa remains appropriate, under two scenarios: one where half of the equity allocation is replaced and the other where the whole allocation is replaced. The greater the allocation to DGF, the greater the reduction in the anticipated range of outcomes after ten years:
Allocating to a DGF would be expected to have the benefit of less volatile asset returns, but with broadly the same expected return. Also, with an active manager looking at the markets on a daily basis, this would provide the Trustees with a level of support that they do not receive under a passive approach. However, adopting this strategy would incur extra costs in terms of both Trustee time and financial resources, due to the selection and monitoring of a new investment manager. The Trustees should therefore consider whether this additional governance is manageable, and whether the level of volatility anticipated within the current approach is acceptable. For example, if the Trustees consider that the Charity has sufficient flexibility to control year-to-year spending in the event that the assets underperform, reducing volatility may not be a key priority.