Charity Investment

Technical briefing – Total Return

The Charity Commission has published its review of the Charities (Total Return) Regulations 2013. Although there are no major changes, we thought a quick reminder might be useful for trustees of permanent endowments who may be considering adopting a total return approach

05/02/2019

Kate Rogers

Kate Rogers

Head of Policy

At the end of last year the Charity Commission published its review of the Charities (Total Return) Regulations 2013. They concluded that the regulations achieve the policy aims which were threefold; to facilitate the adoption of total return investment by charities; to decrease the regulatory burden - as permanently endowed charities don’t need the Commission’s authority to adopt this approach; and to introduce safeguards to ensure the permanent endowment is not misused.

For some, this is a missed opportunity for simplification as the regulations are perceived as over engineered in parts. This is noted in the Commission’s response but has not been prioritised ‘given the small number of charities that would benefit, the ability of those charities to access professional advice and pressure on our resources.’

So it seems that the regulations are staying as they are. Time for a quick reminder?

Permanent Endowment

Some charities have assets that are ‘permanently endowed’. That means trustees are legally obliged to hold these assets permanently - either to further the purposes of the Charity, or to generate an income. The income can be spent, but the capital cannot.

Most charities are not permanently endowed; although many wish to exist in perpetuity. Investing charities without permanent endowment restrictions can choose to spend income or capital to further their charitable purpose and will therefore invest to maximise their ‘total return’ irrespective of whether the return is from capital appreciation or income. Conversely, invested permanent endowments are only able to spend income which tends to bias investments towards income producing assets.

This difference has become particularly pronounced over the last decade; with interest rates and bond yields falling significantly. Permanent endowments seeking income have needed to focus their investment assets in higher yielding areas; restricting their investment universe and hampering diversification.

Total Return Investment

The Trusts (Capital and Income) Act 2013 added a new power to the Charities Act 2011. This power allowed trustees of permanently endowed charities to adopt a total return approach to investment, without having to seek the Charity Commission’s authority. The Regulations set out the rules that trustees must follow in adopting a total return approach and focuses on safeguarding the original permanent endowment.

Adopting a total return approach gives permanently endowed charities greater flexibility. Under a total return approach, the form in which investment return is received 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, 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’.

1. Identifying the ‘original endowment’

Trustees wishing to adopt a total return approach must first identify the permanent endowment assets and their ‘original value’. This is likely to be the most important step, and may determine the tolerance of the endowment investment approach to volatility of capital value. For a permanent endowment, invested in long term assets, trustees will want to make sure the ‘original endowment’ value is significantly less than the current value, to provide a buffer for any short term equity market falls and to enable spending to continue in times of market stress.

This identification exercise can also be an administrative headache; particularly if multiple endowments exists. The regulations do talk about a ‘reasonable estimate’ and the fact that ‘trustees won’t be expected to carry out an elaborate tracing exercise’. In practise trustees adopt a range of approaches, and many take advice from their accountant, lawyer and investment manager. This original endowment value is referred to as the ‘investment fund’.

2. Passing a resolution

Once trustees have identified the original endowment, and therefore the current balance of ‘unapplied total return’, they must pass a resolution. They do not need to notify the Charity Commission, and the regulations don’t contain any specific instructions on its wording.

3. Allocating unapplied total return

The unapplied total return balance will vary according to the market value of the endowment. This should be invested in the same way as the ‘investment fund’. In order to spend unapplied total return, the trustees will need to allocate a portion of these assets to the ‘income fund’. Trustees can also allocate unapplied total return to the investment fund – to increase the value of the permanent endowment, and reduce the unapplied total return balance. This is less frequently used in practise. The regulations do also allow for the reverse; up to 10% of the investment fund can be released to the income fund for spending, although this is subject to recoupment.

Whilst the regulations do allow more freedom for permanent endowments and have undoubtedly increased the uptake without adding to the Charity Commission’s work, they do place further burden on trustees who must decide how to balance the needs of the current and future beneficiaries. These spending decisions can have a significant impact on the long term value and spending power of the endowment and trustees are encouraged to take professional advice.

A version of this article appears in the March 2019 edition of Charity Finance

Author

Kate Rogers

Kate Rogers

Head of Policy

Kate specialises in investment on behalf of charities, endowments and foundations and joined Schroders Charities in 2005 after four years with Kleinwort Benson Private Bank Charity team.

Kate is chair of the Charity Investors' Group, which is a membership organisation providing a forum for investment debate. In this role she has collaborated with CFG to launch a guide to written investment policies and 'For Good and Not For Keeps' published by the Association of Charitable Foundations in 2013. Kate also regularly writes on charity investment in the charity sector press.

Kate is also Portfolio Director at Cazenove Charities. She is a CFA charterholder and has a BSc (Hons) in natural sciences from the University of Durham, is Chair of her local community foundation, and governor of her local primary school.

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Limited 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

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