Is Your Nonprofit Meeting its Investment Goals?\n\n Work with your investment manager or investment consultant to develop an appropriate investment policy statement- a key to nonprofit investing governance. \n Think about spending rate, return, and risk as pieces of the same puzzle. Arm directors with a sound understanding of how different levels of portfolio risk may affect the nonprofit’s ability to operate in the future.\n Use the golden rule (required annual return) to benchmark long-term investment success.\n\nServing on the board of a nonprofit is a fantastic way to contribute your skills to a cause you care about and have a positive impact on your community. \nGenerally, a nonprofit receives its funds from two major sources: benefactors and returns on its investment portfolio. The former, though critical, is relatively easy to wrap one’s head around: people who feel strongly about the nonprofit’s cause will (hopefully) be compelled to graciously donate to it. The latter, however, can often seem like a black box. \nWhat type of return can we expect and what impact does this have on our ability to spend? What is our organization’s risk tolerance? How do we know if we’re meeting our goals? This piece takes a look at best practices for nonprofit investing which will help better equip directors seated around the boardroom table in fulfilling their duties.\nRisk, Return, and Spending- a Chicken and Egg Problem\nThe risk and return of an investment portfolio are intrinsically linked. \nThere is “no free lunch” as is often said; higher return potential comes with higher volatility (risk), particularly over shorter periods. A nonprofit’s return and risk objectives should include meeting spending requirements while preserving its purchasing power and not taking undue risk. \nConstructing a portfolio to achieve these objectives should start with the question: what spending rate can we support given the expected returns on accessible asset classes within our risk tolerance? Or alternatively, if we have an established spending rate that we would not like to deviate from, what level of risk will we need to take to generate a return to sustain it?\nLet’s start with a common scenario. A foundation with a $10,000,000 initial portfolio has the intention to allocate 5 per cent of its assets per year to charitable giving. To keep things simple, let’s assume it will not be receiving any contributions of its own so its giving will come solely from the existing portfolio and its investment returns. \nThe foundation’s investment manager suggests two potential portfolios with different allocations to equity (higher risk) and fixed income (lower risk). She assumes long-term returns on a diversified global equity portfolio of 7 per cent and 3 per cent on a diversified global fixed income portfolio, returns that would more-or-less align with the current capital markets expectations of professional money management firms.\n\n\n\nThe investment manager runs a simulation, generating thousands of iterations of how the portfolio is likely to perform in the future with the following results:\n\nWe’ve projected portfolio balances 15 and 30 years into the future on an inflation-adjusted basis to assess how well the two options maintain their purchasing power. For example, a portfolio with $10,000,000 in inflation-adjusted value after 30 years would have maintained 100 per cent of the purchasing power it had initially. \nIn a real-world sense, fully maintaining purchasing power would mean the foundation could maintain the full “financial impact” it had initially. We’ve also projected expected maximum annual loss (the worst year a portfolio would have as per the simulation) and annual return and volatility. \nWe see here the tradeoff when choosing a level of portfolio risk as a nonprofit. The low risk portfolio, with an annual return of 3.8 per cent versus the 5 per cent spending rate, is projected to deteriorate significantly over 15 years. \nAs time passes, the higher spending eats into capital even further leaving the portfolio with only $3,271,736 after 30 years in inflation-adjusted terms, meaning the portfolio would have less than a third of the purchasing power it initially had. What about if more risk is added? The moderate risk portfolio is able to maintain $6,873,768 of capital after 15 years and $4,731,822 after 30 years. \nThis portfolio is able to maintain significantly more capital due to its higher annual rate of return (5.4 per cent). The tradeoff is evident though; along with higher returns for the moderate risk portfolio, the expected maximum annual loss of the portfolio is 35 per cent versus only 18 per cent for the low risk portfolio. Consider how a foundation board may react to a 35 per cent annual loss; is its willingness to accept risk sufficient to stomach this? This alludes to another crucial part of board governance beyond managing investments: managing emotions and expectations. The establishment of an investment policy statement (IPS) helps in this respect and is discussed in the final section of this piece. \nIt may seem strange that for the moderate risk portfolio, despite its 5.4 per cent return being higher than the 5 per cent spending rate, we see a rapidly decreasing balance over time. The reason for this is simple: inflation. For nonprofits seeking to continue their mission in perpetuity, the key performance indicator for investing success should be the required annual return. Inflation, spending, and expenses all play a part in this:\n\n\nRequired annual return = spending rate + inflation rate + expense rate\n \nThe spending rate would be the stated 5 per cent in this example. Our simulations use an inflation rate of 2.2 per cent based on historical levels. Expenses include any outgoing cash flows not related to donations (board compensation, investment management fees, etc.) funded by the foundation. \nLet’s assume in our case these are 0.5 per cent. These figures yield a required annual return of 7.7 for the portfolio to maintain its initial purchasing power. Given an expected return on diversified global equities of 7 per cent, the foundation won’t be able to maintain its spending power into the future using traditional asset classes. \nThe foundation has a few levers to pull that it can consider:\n\n Invest 100 per cent in equities to maintain as much purchasing power as it can. A simulation indicates this would yield a maximum annual loss of 56 per cent and 16 per cent annual volatility versus only 10.1 per cent volatility for the moderate risk portfolio. For a portfolio requiring flexibility for annual distributions this is not likely to be suitable.\n Reduce the spending rate. This is not typically the most enjoyable boardroom conversation to have for a foundation. Additionally, the CRA mandates a 3.5 per cent annual disbursement quota (subject to carryforward rules and other specifics), another constraint the foundation must operate within. \n Reduce expenses. At a modest 0.5 per cent, there may not be much wiggle room.\n\nIn practice, nonprofits will often receive contributions from their benefactors and an expected contribution rate can be netted against the spending rate to reduce the required return, though this is not always the case. \nAcross the universe of Canadian nonprofits, specifically endowments and foundations, two rules of thumb have historically been applied: a 5 per cent spending rate and a 60/40 allocation to equities and fixed income. Though this can provide a useful starting point for constructing a nonprofit investment portfolio, as we see in our above example, one size does not fit all and there is nuance required.\nGood Governance and the Investment Policy Statement\nAll nonprofits undertaking investment activities should have a formal investment policy statement (IPS). \nThis document serves to clearly define the roles and responsibilities of parties, permissible investments and restrictions, and serves as an enduring guide for nonprofit boards in the execution of their duties, a crucial point given that the turnover of directors is persistent. \nA competent investment manager should be able to guide a nonprofit through this process and have a strong idea of the required content. Below is a non-exhaustive list of common IPS sections and their purpose:\n\n\nSuccess in administering a nonprofit at the board level is a balancing act of making sure the organization’s affairs are in order while not overwhelming directors who are often volunteers or are humbly compensated for their service. \nA well-constructed IPS supported by a thorough analysis of how risk and return fit into the organization’s mandate is a great place to start. \nWorking with a competent investment consultant or investment manager can provide peace of mind during this process so that directors can focus on their organization’s core mission.