Charity Investment

Adopting a total return approach for permanent endowments

Sarah Cotton, Assistant Portfolio Manager


From the beginning of this year permanently endowed charities have been able to adopt a total return approach without needing to seek approval from the charity commission.  We ran a series of workshops on the change, aimed at giving trustees a clearer picture of the principles and practicalities of a total return approach for permanent endowments . The sessions were led by Kate Rogers, Head of Policy at Cazenove Capital Management, and Ann Phillips, partner at Stone King. 

Total return is  the ability to use capital, as well as income, to meet expenditure requirements and fulfil charitable aims. 

Traditionally, a permanent endowment is a gift to a charity that cannot be spent, but must be held to produce an income for the charity into perpetuity. Permanent endowments aim to balance the needs of the current and future beneficiaries, which is often expressed as maintaining the real value of the endowment whilst generating sustainable income to fund current spending.

The change in the law now affords permanently endowed charities greater flexibility in achieving this balance. Under a total return approach, the form in which investment return is received (for example, income, dividend or capital growth) does not matter. Instead, investments are managed to make the most of the total investment return that they generate. This enables charities to focus on investments that are expected to give the best performance in terms of their overall return, rather than on investments which will give the ‘right’ balance between capital growth and income.  The trustees can allocate whatever portion of the total return they consider appropriate as income, which is then spent furthering the aims of the charity. The balance remaining is carried forward as ‘unapplied total return’.

The importance of maintaining the original value of the endowment is still paramount, although interestingly, on a nominal basis rather than adjusted for inflation.  A key challenge to any charities  that wish to adopt this approach is the identification of this original value.  This ‘core capital’ is untouchable, and everything in excess of this value considered as ‘unapplied total return’ and theoretically available for expenditure.  Thankfully the charity does not necessarily need to go back to the original gift value, but can base their ‘core capital’ on a valuation at a reasonable point in the history of the endowment. Crucially, when choosing this value, the charity must ensure that there is an adequate safety buffer to ensure that spending can continue in times of market stress, when the value of the endowment may fall.  If this value falls below the core capital there can be no spending at all, not even income.  That is a pretty big risk for permanent endowments, and one that needs to be appraised carefully.  The ‘right’ level of the buffer might take into account your asset allocation and the projected volatility of your investments and might look back in history to see ‘worst case’ market falls.  For the average charity portfolio, this might mean that roughly half of the permanent endowment should be made up of unapplied total return at the outset. 

Whilst the changes do allow more freedom, it places further burden on the trustees who must decide the proportion of capital to be drawn down to complement income for spending when balancing the needs of the current and future beneficiaries.  It is also a requirement for trustees to identify the original value of the endowment, or indeed choose a historical level at which they feel most comfortable, which may be difficult to evaluate.  While the total return approach allows a broader asset mix, as you no longer have to choose assets with a bias towards higher income yield, the charity must be able to fund commitments without needing to sell volatile or illiquid assets. In this respect cash flow is still an important consideration when contemplating moving to total return. In addition the total return approach may not be appropriate for all of the permanent endowment, as investment in direct property does not provide the opportunity from which to spend capital.

Whilst the change in law is welcomed for the flexibility and new power in decision making it allows permanently endowed charities, it should be carefully weighed against the risks and considerations for the individual charity when judging if appropriate.

Please contact us for a copy of the presentation or if you would be interested in attending a further session on this subject

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