Setting investment objectives for charities: a new way
Our recent study into investment services within the charity sector closely examined the investment fees that charitable foundations were paying. In that analysis, we concentrated on the implementation component of investing in a charitable endowment, and preliminary results showed that the sector could potentially save between £250 and £288 million in investment manager fees.
In part two of our study, we put advice under the spotlight by asking if there is a better way that advisors can work with trustees to set investment objectives and manage spending.
Summary of findings
We reviewed the annual reports of over 200 UK charities. Results show that:
- Of those in the study with listed assets, over half have the same investment target.1 This suggests that Charity objectives; a) may not be optimally aligned with their spending needs and b) that all of these charities have similar risk profiles. We challenge these assertions.
- Over a 5 year period, 62% of all charities in the study experienced a growth in the value of their listed assets that was not proportionally matched by a subsequent growth in spending. Meanwhile, 38% of all charities in the study overspent against their asset growth. This indicates that charities may benefit from better dynamic advice on how to align their growth targets with spending requirements in order to enhance their charitable missions.
Let’s look at the current landscape and our study results in more detail.
As reductions in public or government funding continue to hit the charitable sector, the demand for charitable services is growing. In a 2017 study from the Charities Aid Foundation, ‘generating income and achieving financial sustainability’ was cited as ‘the most pressing challenge for charity CEOs.’ Yet whilst many organisations said that ‘new technologies and more diverse ways of giving were being used to overcome challenges and reach goals’, finding ways to link spending and endowment growth optimally did not feature as a possible solution.
Meanwhile, the Charity Commission’s CC14 - which acts as a guide for trustees in investment related matters - states that when setting investment objectives, trustees may want to consider ‘longer term organisational objectives – for example, projects, initiatives, changes in strategy or other spending that the charity is planning and how they will be resourced.’
Against this landscape, are advisers doing enough work with trustees to understand their spending needs and align their objectives appropriately?
Our research team took a closer look at the charity sector, the investment objectives in place, and what this means for endowment spending. Specifically, we analysed the annual reports of over 2002 of the largest registered UK charities with investment endowments of £20mn and above. Here’s what we found.
Seemingly identical investment objectives
When looking at each charity’s individual investment objective, the majority (53%) of charities had the same objective in place, namely: Asset growth of RPI or CPI, plus a spending target of 3-4%.
Through one lens, this is understandable. Charities see themselves as long term investors; they look to preserve capital in real terms over the long term, and will often use either RPI or CPI as a benchmark for inflation. Meanwhile, a spending target of 3-4% can be seen as a sustainable long term objective in order to maintain spending on charitable activities, without taking excessive risk.
But can a seemingly ‘one size fits all’ target truly work optimally for charities, especially if we consider that each charity is unique and has risks that are bespoke to their own mission?
Consider a charity with multiple sources of income such as fundraising, government grants and real estate income, in addition to an investment portfolio. Compare this charity with a grant-giving organisation where the investment portfolio is the sole source of income, and one can already see how the risk profile and target returns may necessarily differ.
It is clear that each charity is unique and the starting point for assessing a charity’s investment target should begin with a robust analysis of their financial statements, taking into account all sources of income and expenditure.
So what happens when a charity with unique needs is guided by a presumably ‘standardised’ target?
The Spending Gap
In all of the 212 charities analysed – regardless of investment objectives – we assessed how spending had changed over a five-year period (2012-2016) in relation to how the value of listed assets had grown.
Investment income over the period broadly remained static. However, results showed that 62% of charities had underspent versus the growth of their listed assets and that on average for this group, spending growth had trailed the growth of income producing listed assets by 44%.
The implications of these findings is significant; if asset growth had moved at the same pace as spending growth over this five-year period, an extra £1.65bn could have been made available within the sector for charitable spending.
We believe that if charities are advised to think differently about returns and spending, a real opportunity exists to optimise spending within the sector without the need for them to take excessive risk.
A customised objective for bespoke needs
An investment objective that is customised to the unique risk and return requirements of any given charity has the potential to unlock additional spending. When we also consider that 38% of charities overspent against their endowment growth, a customised dynamic objective which takes a more holistic view of a charity’s financials could also safeguard against potentially unsustainable overspending.
We know that setting a risk profile and creating the right asset allocation are key primary objectives. We have long lead with this philosophy; in-fact, in the mid-1980s we sponsored a landmark study which concluded that asset allocation – not market timing or stock selection – is the primary factor in determining why different portfolios experience different rates of return. The diversification of managers is equally important, as is setting a spending target.
But it’s in further enhancing this entire process that we believe a window of opportunity can be found – specifically, using technology to monitor a charity’s specific spending goals over the medium and long term, with their unique risk and return requirements firmly in view.
Our Outsourced Chief Investment Officer (OCIO) solution has proprietary technology in place that monitors the specific spending goals of each client over the medium and long term, with their unique risk and return requirements firmly in view.
For each charitable endowment that partners with us, this means:
- A portfolio that is continuously monitored and under review; supporting our strategic advice and analysis, and leading to the recommendation of asset allocation changes
- Pre-defined triggers in place that signal when an endowment appreciates or depreciates above or below an agreed level
- Reporting that examines the effect this has on the charities ability to spend
When triggers are hit, trustees are encouraged to revisit their original objectives, identify any special projects for which spending could be released, or renegotiate their risk tolerance as they see fit.
In practice: An example case study
A £30mn charity has an investment objective of inflation plus 4% and currently spends £800k a year on average on charitable activities.
The required capital to support £800k per annum into perpetuity is £20mn (£800k/4%), meaning that the ‘coverage ratio’ of the portfolio is 150% (£30mn/£20mn).
In our OCIO model, we introduce the concept of a coverage ratio which takes into account a charity’s current portfolio value and sets out a framework to consider how a charity can ensure that sufficient resources exist over time to meet the required planned levels of spending. It looks to answer specific questions such as:
- Can the charity afford to meet its current spending?
- Can the trust afford to spend more?
- How will the charity (and SEI) monitor the ability to meet/change these payments?
Let’s say our £30mn example endowment experiences positive investment performance and the portfolio value rises to £40mn. The endowment now has a coverage ratio of 200% (£40mn/£20mn), if it wished to continue to maintain annual payments of £800k per annum.
The daily monitoring of spending coverage levels
At this stage, the endowment can now choose to release an extra £270k to support its charitable activities or work on a special project and still maintain its original coverage ratio of 150%.
This process can be repeated across various scenarios of required spending and target returns, enabling charities to quantify the link between endowment values and required spending. It takes into account the changes in risk via an increase or decrease in spending for a given portfolio return. In other words, the model can go beyond a static inflation + 4% target, delivering the dynamism that could help charities further their mission.
The opportunity for charities
The potential for releasing greater spending into the charitable sector exists.
Part one of our research into the charity sector showed how meaningful fee savings could be made. Our latest analysis now shows how the advice process could be enhanced by using our OCIO model and leading technology to optimise the interaction between investment targets and spending.
We work with over 175* charities globally, totalling £18bn* in assets under management. Our vast experience means we can tailor our solution to charities of any size, allowing all clients to operate with the efficiency, sophistication and cost structure of a multi-billion pound fund.
By partnering with an OCIO with significant scale, focus and the open architecture of a manager of manager platform, charities can access a holistic solution that looks not only to access fee leverage, but can unlock access to a vast array of specialist managers.
Our dedicated charities advice team is committed to understanding your unique needs and will help you:
- Align endowment assets with organisational spending/liquidity needs
- Improve stability and predictability through active diversification and portfolio modelling
- Refine focus to the issues that impact the long-term mission of your charity
- Monitor your progress using leading techniques and technology
Find out more
To find out more about our OCIO solution for charities, please don’t hesitate to contact me at 0203 810 7602 or or email me directly.
1. Of 212 charities analysed, 90% had listed assets. Of this subgroup, 53% had an investment objective of inflation + 3-4%.
2. 212 charity accounts were analysed in total between June-September 2018.
*As at 30 Sept 2018
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