Should your charity take a barbell approach to reserves?
How separating short-term liquidity needs from long-term reserves could help charities balance immediate funding requirements with longer-term investment growth.
Increasingly, charities experiencing shortfalls in voluntary income are looking to their long-term reserves to supplement their operating budget. However, increased drawdowns or changing investment objectives specifically to target income may have unintended consequences. For example, selling in a downturn or allocating an overweight to income generating assets might negatively impact the longer-term growth of an investment portfolio. So how can charities plan to meet their shorter-term liabilities while benefitting from longer term compounding?
Balancing today’s funding needs with tomorrow’s growth
When constructing a portfolio, a charity’s liquidity needs should be considered. Instead of looking at reserves as one pot, charities can take a barbell approach, effectively splitting their reserves in two. One pot holds the short-term reserves and is designed to liability match over the near term, for example, the next 1-5 years. The second pot holds longer term reserves which would be a more growth-oriented portfolio, subject to the charity’s objectives and risk budget.
How could a barbell approach work in practice?
Take, for example, a charity with £4m in reserves. The charity is concerned that part of these reserves may be called upon to help cover salaries, grants and other operating costs. The charity does a cashflow analysis and wants to provide around £1m to ensure against a shortfall from voluntary income for the next 4 years. This amount can form the ‘short term’ pot, leaving the remaining £3m to be allocated to the ‘long term’ pot.
The shorter-term reserve can adopt cash management with short-dated low risk instruments. These should be highly liquid, readily tradeable instruments so that cash is available within a couple of business days after a trading instruction. Known liabilities can be matched with UK gilts maturing at the time the cash is needed.
So, if the £1m in the example consists of £250k requirements every year for the next four years, a gilt maturing each year can be selected to provide the streams of cash needed. If some or all of this cash is ultimately not needed upon maturity, these gilt proceeds can be rolled up into another gilt or moved into the long-term pot. By adopting a gilt ladder, yields can be locked in to provide protection from falling interest rates if held to maturity.
The charity may feel comfortable taking more risk with funds they do not expect to need for many years. Any income accumulated can be reinvested, and the effects of compounding mean that the income returns left untouched can grow meaningfully. For example, for a portfolio yielding 2.5%, reinvesting this income stream over 5 years achieves a cumulative 13.1% return over the period solely from income. If the income was withdrawn over this period, the charity would not benefit from compounding and the future value of the portfolio could be lower. This level of income return, combined with any capital growth achieved on the portfolio, can help maintain the purchasing power of the reserves whilst also adding real investment returns. Ethical exclusions, if appropriate for the charity, can be applied to this pot given there would be a wider range of assets than the short-term pot. But remember, the value of investments, and any income from them, can go down and investors may get back less than invested.
By taking a barbell approach, and planning for shorter term liabilities and longer-term growth, charities can take a proactive approach to managing risk, allowing reserves not needed in the near term to grow unconstrained while still matching their short-term liabilities in a low-risk manner.
Evelyn Partners works with over 1,100 charities and manages £3.4 billion charity assets under management. To learn how we might help your charity please get in touch.
Evelyn Partners Investment Management LLP is authorised and regulated by the Financial Conduct Authority.
