Total Return for Permanently Endowed Charities

It means charities can take some of their income from capital gains, rather than just organic income. It can be a more flexible solution, but can also bring administrative complexities for permanent endowments on which this article is especially focused. Trustees should weigh the pros and cons carefully.

The past decade has been challenging for income investors: until recently the response of central banks to the Global Financial Crisis and pandemic has been to push interest rates lower. Charity trustees have found themselves with an uncomfortable dilemma: take more risk to achieve the same level of income or resign themselves to lower income levels and – potentially – compromise their charitable goals.

Following a change in the law in 2013, charity trustees can pass a resolution to adopt the ‘total return’ approach for their permanent endowment funds – a focus on overall return rather than just income yield. This provides a mechanism whereby trustees can take income from accumulated capital gains as well as organic income, such as dividends from shares or interest from bonds. (Before 2013, the total return approach could only be adopted by applying it to the Charity Commission).

The move was necessary because the assets such as cash and fixed interest that for a long time had generated the safe income for spending had stopped doing so. A charity with a permanent endowment needs to balance the needs of current beneficiaries with that of future beneficiaries. Current beneficiaries need to be provided with sufficient income, while future beneficiaries need to be able to rely on receiving similar levels of benefit in future.
The problem became acute once central bank action on interest rates caused yields on cash and fixed income to fall to historic lows. Under the old rules, where income could not be taken from capital, portfolios needed to be focused on higher-yielding assets to support the existing beneficiaries. This often led to chasing after investments that appeared to generate the required income, but in fact delivered falls in both capital value and income because the focus wasn’t on the overall long-term return.

In addition, not only are ‘safe’ income-generative assets increasingly scarce, this approach potentially neglected assets that deliver most of their return as capital growth, such as some of the alternative asset classes (commodities, hedge funds) and index-linked gilts. This risked negatively influencing returns for future beneficiaries.
2022 has proved to be a watershed year as inflationary pressures built and central banks raced to remove monetary stimulus by raising interest rates and moving to quantitative tightening. The transition caused both fixed interest and equities to fall at the same time, an extremely rare event, but it does mean that nominal returns on fixed interest have risen markedly, albeit still a long way below current inflation. We have also seen a shift away from equity growth investment styles and a higher preference for equities that can generate both growth and dividend income – a trend that we think might persist.

While a change in market emphasis probably reduced the immediate pressure on those charities that have not already switched to a total return basis, we think the additional flexibility of a total return approach still makes sense and provides the optimal way to treat both sets of beneficiaries fairly, but ultimately the decision is one that has to suit each charity and the preferences of their trustees.

Under the total return rules, both the income and the capital gains can be treated as incoming resources for the endowment fund. The trustees then have discretion over how much of the total is transferred to the income funds of the charity. Any incoming resources not transferred in an individual year can be carried forward and transferred to the income funds in future years. These carried forward amounts are referred to as the ‘total unapplied return’.

Previously, a charity could only spend money that was generated as income. In other words, they could spend dividends from shares, or interest from bonds, but couldn’t use profits from investment gains. This gave it much less freedom for distributions to beneficiaries. Today, the charity may spend some of the capital gains, as long as the original capital rises in line with inflation over the long term.

The shift may sound straightforward in principle, but it may be a tricky balance in practice. There are advantages and disadvantages. On the plus side, a total return approach gives the investment manager more flexibility. Rather than focusing on a diminishing range of income investments, the investment manager can select the investments to maximise the overall return, consistent with the investment policy and the approach to risk.

As such, they can bring a greater focus on quality and sustainable growth investments that generate a reasonable and growing income. These types of assets tend to perform in line with inflation or better.
Equally, a focus on ‘income at all costs’ can force charities to take on more risk than is prudent for their long-term goals. Rather than investment grade bonds, for example, they move to high-yield bonds, or equities. Within equities, high yield can be an indicator of distress (the market expects the dividend to be cut). The portfolio can become skewed to assets that pay the right level of income but may be significantly more volatile.

In contrast, a total return approach allows the investment manager to buy assets with a lower yield but stronger growth prospects and greater chance of dividend growth in the future. This more flexible investment approach increases diversification in both asset and sector selection.

Equally, the amount transferred to the income funds each year can be budgeted for with confidence – in setting the budget, the trustees do not need to worry that a downturn in dividends or interest payments will result in the income being reduced for the year. Any reduction in income (or capital losses) can be covered from the unapplied total return mentioned earlier. The level of income fund reserves held can be reduced, as the charity will be able to make withdrawals from the unapplied total return to cover the costs of any unforeseen events.
In extreme circumstances, such as the unapplied total return falling to zero, it is possible to use the original capital to provide income – although there are strict limits on the amounts that can be withdrawn and any amounts that are withdrawn must be repaid.

Nevertheless, there are risks inherent in the adoption of a total return approach. In its early stages, it can add to the burden of administration, imposing greater responsibilities for the trustees and, potentially, increasing the need for professional support – and therefore raising costs. Initially, it can require a significant amount of work to ensure the information related to the formation of the endowment and the original funds is correctly identified.

Equally, trustees will need to be able to demonstrate that this approach is suitable for their charity and meets the needs of all beneficiaries (current and future). Trustees will also need to be willing to take decisions on how much of the unapplied total return to spend each year and how much to save. While this doesn’t have to be complex, it can add to the decision-making burden. In general, the move to a total return approach should be thought of as a long-term decision.

Once the policy is adopted, it is imperative that the trustees are correctly identifying and accounting for income, capital and unapplied return. The trustees must know how much is in each pot as this will impact decisions on spending. This requires judgement and if wrong, the charity could end up back where it started, spending too much, to the detriment of future beneficiaries. Or, if the transfer is insufficient, the charity may spend too little and accumulate capital to the detriment of the current beneficiaries.

If the unapplied total return is insufficient, capital losses could deplete it. This in turn could prevent the charity from making a transfer to the income funds until such time as the unapplied total return was replenished (i.e. by future capital gains and income). If this happened, the charity may have very limited income available for a number of years and may have to curtail its operations. It is also possible that capital assets become subject to ‘distressed’ sales at low points in the market.

Nevertheless, there are ways around these problems with appropriate advice, careful planning and suitable decision-making. For example, good organisation and strong visibility on cash requirements should help manage the risk of short-term cash calls during unfavourable market conditions.

The change in the interest rate environment since 2022 reduces the immediate pressure on charities that have not already adopted a total return approach. However, overall we see the greater flexibility that a total return approach affords as welcome for investment managers. It gives us greater ability to protect the capital on the downside, while also allowing us to find value flexibly. Nevertheless, this approach can bring additional complexity for charity trustees and should be considered carefully. It does not suit all charities and their trustees.

This article was originally published in STEP Journal - Nick Murphy, Flexibility vs Complexity, (Issue 1, 2021), and has been updated to reflect the changes to the interest rate environment since 2022.