A number of charities that Brewin Dolphin works with have investments that are ‘permanently endowed’. Put simply, this means that the Trustees have the power to spend the income generated by the fund, but must preserve the capital value of the original gift. This can cause problems for charities in setting their investment objectives, as the temptation might be to opt for higher-yielding investments to maximise the income now. This may put the capital value at risk from investment loss or simply from inflation erosion as some investments providing a higher yield may be less productive on the capital growth front.
As part of the Trusts (Capital and Income) Act 2013, the Charity Commission introduced new guidance which allows permanently endowed charities to adopt a total return investment strategy without seeking individual approval from the Commission. Before this Act and the amendment it made to the Charities Act 2011, a charity was required to obtain an order from the Charity Commission in order to adopt a total return approach. These new regulations provide a set of rules for:
- The process of adopting a total return approach
- Allocating part of the total return for expenditure
- Reinvesting part of the total return into the fund to preserve its long-term value
- Releasing or borrowing part of the investment fund for expenditure, and the conditions for repaying it
- Reverting to the standard rules of investing for permanently endowed funds.
A total return approach allows the charity to use any increase in the value of its investment as income, provided it allows the permanent endowment, or ‘relevant fund’, to grow in line with inflation over the long term to protect the needs of future beneficiaries. All increases in value, both income and capital, form what is known as the ‘unapplied total return’. This can then be allocated to income or reinvested as capital subject to certain caps and restrictions.
The regulations also allow, in some circumstances, for charities to apply to lift the restriction on spending capital from within a permanent endowment. However this article will not discuss the provision, and will instead focus on some of the pros and cons of adopting a total return approach to investment. This will hopefully help trustees who are considering whether or not to adopt this new approach.
In this period of prolonged low interest rates, in which the income returns on so called “safer assets” have been suppressed, trustees may find themselves in a position of purchasing higher-risk assets just to get the yield they require.
A total return approach would allow trustees to invest in lower-yielding assets which are potentially less risky and more suitable for them because they can attribute part of the capital gain to the income fund which can then be spent. It is worth noting that a total return approach does not force charities into lower-yielding assets. Rather, it opens the door to a wider universe of assets from which to build their portfolio.
A total return approach to investing respects the original permanent endowment, often bestowed on that basis by a philanthropic founder. Whilst permanent endowments are not as common as they once were, charities that do not respect the wishes of their historic donors may risk alienating future donors, particularly those donating large sums or leaving large legacies which may not be very common for some charities but can make a substantial contribution to the work of the organisations when they are gifted.
The new rules allow trustees to be flexible with how they use the capital whilst respecting and preserving the value of the endowment. For example, they may draw upon capital from the endowment for a specific project to repay or replace at a later date.
It is vital that trustees with a permanent endowment balance the needs of beneficiaries now and in the future. This is often an issue for trustees who are trying to get as much income as possible out of an endowment now, thus sacrificing capital growth potential and therefore disadvantaging future beneficiaries. A total return policy allows more emphasis to be given to sustained capital growth, given that part of it can be extracted to supplement the natural income from the investments.
Adopting a total return policy is time consuming and should not be entered into lightly. There can be a considerable amount of work involved in identifying the date of formation and the relevant fund which represents the original endowment. These aspects will influence the investment fund from which the income can be taken and must be done correctly. On an ongoing basis, trustees must ensure they are accounting correctly for the income, capital and unapplied total return.
These different “pots” must be accounted for separately and the trustees must know where they stand at all times, as this will influence their decisions around how they spend their funds. In times of a shortfall in income, capital can be used to top it up which may result in assets being sold to fund this shortfall.
Trustees need to plan this as far in advance as possible in order to avoid the risk associated with selling investments at a time when markets are depressed.
Trustees will be required to demonstrate that a total return approach is suitable and appropriate for their charity and that they have acted according to their duty of care to beneficiaries - both current and future. Furthermore, it has the potential to burden trustees with other decisions, such as how much of the unapplied total return to spend in a given year or how much to reinvest in a good year. These additional decisions can also increase the cost of administration and accountancy services, all of which must be taken into account when deciding what is in the best interest of the charity.
Regulations surrounding coming out of a total return approach and reverting back to the standard rules of spending only income are complicated, and a decision to revert to the standard rules should be carefully considered. If the trustee board is planning on adopting the total return approach for only a short time, they should probably think again.
Should your charity adopt a total return approach? Whilst the new regulations provide greater flexibility, adopting the new approach is a big decision and may not be suitable for every charity. The points raised in this article, along with the Charity Commission guidance, should help you in making your decision; however it is wise to consult your specialist advisers, namely your investment managers, lawyers and accountants, prior to making any changes to your policy.
By Kelly Harkins Associate Investment Manager
The value of investments can fall and you may get back less than you invested.The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Ltd.