Investments - Strategy

Managing in a Low Interest Rate Environment

A survey conducted by Fiduciary Trust Company and Associated Grant Makers highlighted that while many endowments and foundations increased fundraising or reduced charitable activities as a result of the low interest rate environment, a significant number may have overlooked important, additional considerations.

Introduction

There is little doubt that the sustained low interest rate environment of the past several years has impacted endowments and foundations (E&Fs) throughout the country. From fundraising and investing to spending and grant-making, the effect of historically low interest rates has been felt across all activities, including board governance. What’s more, the perceived relief stemming from recent Federal Reserve interest rate hikes was fleeting and misunderstood by many E&Fs.

In a 2017 survey conducted by Boston-based Fiduciary Trust Company and Associated Grant Makers, nearly all the E&Fs polled expressed awareness and growing concern about “required” spending levels in excess of both realized or expected investment returns. The respondents, however, were far more divided when it came to the remedial actions necessary to address the disconnect.

Exhibit A- Actions Taken or Considered in the Prior Two Years

Among the key findings from the survey:

  • Fundraising: Of the fundraising institutions, an overwhelming majority either increased fundraising efforts or were in the process of considering such actions. Of course, this is easier said than done during a period in which peer organizations are pursuing similar strategies.
  • Investing: Nearly all respondents recognized asset allocation as one of
    the most important considerations in achieving their investment objectives. However, a significant number have not reviewed their asset allocation or, conversely, have taken aggressive action, potentially without proper regard for the downside risks.
  • Grant-making or Spending: Of the grant-making institutions polled, more than two out of every five said they either reduced grant-making activities or were considering such a difficult decision. Meanwhile, among public charities, nearly half reviewed and potentially reduced spending. These tactics can obviously help bridge the gap, but at what expense to the charitable or grant-making mission of the organization?
  • Board Governance: Finally, fewer than half of the respondents have employed solutions that suggest they have a comprehensive understanding of the rules and regulations that govern their respective organizations. In some cases, respondents may be overlooking related actions that can afford nonprofits greater flexibility; in others, certain activities of a high-functioning governance model – one capable of enabling superior risk-adjusted returns – were not pursued. Maintaining a sophisticated governance function may even be considered the most effective and important relief lever considering it encompasses the three other potential actions discussed above and instills the flexibility necessary to help organizations avoid more drastic options during periods of stress.

The sections that follow outline in greater detail some of the findings from the aforementioned survey, as well as related important considerations and best practices that can effectively and efficiently help institutions confront this era of low interest rates while also preparing them for future challenges that may arise.

Research Approach

Fiduciary Trust and Associated Grant Makers initiated this research to better understand how foundations, endowments and other nonprofits have been impacted by the low rate environment. We also sought to understand how well board members or trustees within these institutions understand their fiduciary duties and responsibilities. The survey and accompanying viewpoints should drive awareness around areas that organizations should consider in addressing the complexities and risks of a low rate environment.

The online survey was conducted during the months of December 2016 and January 2017. A total of 236 respondents participated in the survey, representing a pool of nonprofit institutions comprised of corporate, family, public and private independent foundations, as well as other nonprofit organizations and endowments, including hospitals, schools, religious institutions, and charitable organizations.

Fundraising

The low rate environment has triggered several actions from endowments and foundations to increase revenue and reduce expenses. Among survey respondents, one action stood out above all others: Increase fundraising efforts (Exhibit A).

Of those public charities that regularly pursue fundraising, more than four out of every five polled indicated that their organizations have already taken actions to increase fundraising.

This is not surprising. Of the many potential relief options, this is the most straightforward and seemingly avoids difficult organizational decisions around prioritization. In practice, however, public charities often discover that pursuing a strategy of increased fundraising kicks the proverbial can down the road – and this is often the best-case outcome.

Fundraising is complicated, costly and time intensive. The benefits may not accrue for many months or years, if at all. Further, extended periods of low investment returns – an environment that elicits widespread fundraising among peer organizations – only makes it more difficult to solicit new donors or larger contributions from existing ones. As the survey demonstrated, this overcrowded environment would seem to characterize the fundraising landscape confronting most public charities today.

Finally, if public charities are being honest about the impact of additional fundraising, wouldn’t efforts to raise more money already have been put into practice?

Investing

To be sure, the low rate environment has had a considerable negative impact on almost all institutional investors. For example, pension plans of all sizes have been forced to lower their return expectations (and therefore increase their obligations) amid reluctant acknowledgement that the future is unlikely to keep pace with the past. Endowments and foundations also struggle with historical distribution requirements and spending practices in excess of realized returns. And while there is no obvious solution that can altogether eliminate these challenges, thoughtful analysis and discovery – and, potentially, prudent changes to investment strategy – should take precedence over passive inaction.

Avoid “Time Sinks”

One of the more encouraging takeaways from the survey was that eight out of every 10 respondents viewed long-term strategic asset allocation as the most important investment decision (Exhibit B). Further, security selection and short-term, tactical asset allocation were cited most often as the second- and third-most important investment decisions, respectively. Finally, the use of Alternative investments, such as commitments to private equity, venture capital or hedge funds, was ranked as the least important investment decision in fulfilling the objectives of respondents’ organizations. These findings are well aligned with decades of academic literature and research that suggests over 90% of return variance is attributable to long-term strategic asset allocations.1

Exhibit B- Importance in Fulfilling Organizational Objectives

While respondents clearly recognize the importance of long-term strategic asset allocation as the most influential driver of performance, many dedicated time and resources elsewhere, often to little or no effect and at the expense of higher-impact decision making.

A successful Alternatives strategy often demands that organizations can access best of breed investment opportunities, have a long-term orientation to sustain lengthy lock-up periods, and have dedicated internal investment staff. This translates into organizations that typically have endowments greater than $100 million in size and longstanding and sophisticated leadership teams. They must be willing to commit significant resources to build out internal proficiencies and stay the course over the long haul. If these components are not in place, most organizations would be better suited to avoid Alternatives altogether.

In addition, investment committees should be cautious about their level of involvement in investment selection (i.e., choosing specific mutual fund managers). Beyond the time-consuming upfront due diligence, significant ongoing committee time is necessary to understand why certain investments or funds have performed better or worse than their benchmarks. And while it may seem that the allocation of resources to these areas is prudent, the investment committee should step back and ask key questions such as:

  • How effective are we at staying truly apprised of the underlying drivers of risk / return for any given fund manager?
  • Do we have a buy/sell discipline in place and if so, how well do we adhere to it?
  • How successful and timely have we been at rotating in and out of fund managers?

If the answers to the above aren’t overly flattering, investment committees should consider the use of indexed solutions or outsource these decisions to professional investment firms. Ultimately, such actions will have a two-pronged benefit: fewer self-inflicted wounds and more time to spend on higher impact areas such as asset allocation.

Focus on Asset Allocation

As discussed above, asset allocation is the most important investment responsibility for E&F boards and committees. A strategic asset allocation is typically set based on external factors (e.g., historical asset class risk and returns, expectations about future market drivers) and internal factors (e.g., specific cash flow needs). Ideally, such an undertaking happens at least every five years (usually no shorter than a full-market cycle), is performed with as little emotion or bias as possible, and results in a targeted range of acceptable asset-class weightings. Conversely, tactical asset allocation relates to more short-term adjustments within the strategic ranges to account for temporary market dislocations and/or unanticipated, one-time cash flow events. These tactical modifications may be pursued annually or more opportunistically.

In the survey, it was notable that more than one in three respondents addressed lower rates by altering their exposure to allow for increased risk taking (20%) or are considering such action (16%). This is an example of a strategic asset allocation change, which can have a pronounced effect on overall performance. Hopefully, such decisions are being reached in a measured, disciplined manner and only after other less-risky options have been exhausted. Moreover, one would also hope that such action was overdue anyway, as frequent changes to strategic asset allocation ranges defeat the purpose and more likely result in performance chasing (i.e., buying high and selling low).

Whether strategic or tactical, investment boards and committees must avoid the urge to overreact or take too much of a short-term approach. A key enabler of a high-functioning organization is the level of education that occurs between the investment committee and broader stakeholders, and the ongoing time spent on such activities should not be underestimated.

Explore a Total Return Approach

In the past, by statute or by design, organizations may have employed investment programs that limited distributions to income from bond interest or stock dividends. Over the years, however, the shortcomings of such an approach became evident. Almost half of the survey respondents have either already embraced a total return approach or are considering it, which is an encouraging sign. However, it is also concerning that nearly half haven’t considered it. The data doesn’t provide insight into why so many have failed to consider this option, but it should raise concerns around how well informed organizations are about industry trends and evolving best practices. A total return approach benefits organizations in three ways:

  1. Greater consistency and control over distributions
  2. Superior investment management decision making
  3. Potentially higher overall distributions

In overlooking this option, organizations may be placing undue hardship on themselves or their grant recipients. It should be noted that statutes such as UPMIFA (Uniform Prudent Management of Institutional Funds Act) or private foundation rules under the Internal Revenue Code2 require that boards of nonprofits consider the total return of an investment portfolio and mandate proper diversification of investments unless circumstances dictate it is prudent not to do so.

Maintain an Investment Policy Statement

An Investment Policy Statement (IPS) is arguably the most important E&F investment document. It should serve as a record of key agreed-upon investment decisions and considerations, and should guide future investment-related action and implementation. It is effectively an executive summary that maps out the mandate of each nonprofit’s unique investment program with respect to goals, constraints, time horizon, risk tolerance, and liquidity needs, among other considerations. The IPS should also capture important quantitative information such as strategic asset allocation targets, performance measurement and benchmarks, and risk controls. These documents should be multi-faceted and facilitate consistent communication, both internally and externally (i.e., for an organization’s outsourced chief investment officer or third-party investment managers).

Moreover, the process of completing and updating Investment Policy Statements traditionally leads to mutual discovery that leverages available expertise and builds consensus across the board or investment committee. A periodic review of an IPS can be an effective means of revalidating or refocusing decision making, and given the level of personnel turnover on E&F boards and committees (especially if run by volunteers), it can also be viewed as an important training and development tool.

Surprisingly though, almost 40% of respondents review their IPS every three to five years and longer, if at all (Exhibit C). Given the complex decisions and fiduciary responsibilities bestowed upon trustees and board members overseeing investments, best practices would normally dictate a more frequent review cycle. Generally, we recommend reviewing the IPS at least every two years and more frequently as market conditions or organizational needs change.

Exhibit C- Frequency of Investment Policy Review

Grant-Making and Spending

While fundraising strategies influence what goes into the top of the funnel and investment decisions maximize and protect the capital that comes in, spending and grant-making decisions ultimately govern what goes out. For many nonprofits and grant-making institutions, cuts in these areas are often only considered as a last resort.

Determining Levels of Grant-Making

Due to the challenges imposed by a lower rate environment, more than half (51%) of foundation respondents (excluding “other nonprofits” that participated in the survey) at least considered or were still considering reductions to their level of grant-making. Over a quarter (26%) indicated that they already made the difficult decision to moderate their giving programs to ensure ongoing viability. One would likely hope that other options are thoroughly explored and pursued prior to entertaining the idea of grant-making reductions.

Public Charities: Understanding UPMIFA

Considering that nearly half of all respondents (46%) already took steps to reduce spending or reviewed such alternatives, it’s interesting that so few were aware of other potential options for relief (Exhibit D).

Among public charities, for instance, a surprisingly low percentage of respondents (21%) stated they were very familiar with the rules and requirements of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). This may be due, in part, to the fact that not all public charities have endowment funds with restrictions to which UPMIFA applies. For those that do, certain degrees of freedom within the UPMIFA guidelines can bring needed relief, particularly during periods when realized returns fall short of expectations. For example, under certain conditions, it is possible to relax constraints on certain qualified endowment assets. Yet only one out of every 10 respondents (9.5%) have explored this alternative. Due to the perceived complexity or lack of understanding surrounding relief options, nearly one half of respondents have not reviewed their spending policies and practices.

Exhibit D- Actions Taken or Considered in the Prior Two Years

Private Foundations: Strategies for Meeting Distribution Requirements

Conversely, a much higher percentage of private foundation respondents (71%) indicated they were very familiar with IRS rules related to their organization’s 5% annual distribution requirement. Importantly, these regulations do not dictate that 5% of assets must be distributed for public charitable purposes, necessarily; rather, the amount represents the total charitable distributions as well as related expenditures required to operate the foundation. This includes costs such professional-services fees and operating expenses.

Obviously, when rates are low and returns suffer, meeting the 5% threshold can be more challenging, but it is important for organizations to understand all that can be applied toward the 5% distribution requirement to avoid undue hardship in subsequent years. Equally important, they should understand what expenses cannot be counted, such as expenses related to investment management. Of note, less than half of the foundations surveyed (45 percent) reviewed their prior-year returns to ensure excess distributions are being properly carried forward.

The 5% distribution requirement was introduced in the Tax Reform Act of 1969, a time when interest rates, were far higher – around 8 percent. The purpose was to ensure nonprofits were not hoarding excess capital and benefiting from their tax status without pursuing the charitable mission upon which it was premised. As rates have fallen dramatically, the 5% payout has remained fixed and for many foundations presents a burdensome unintended consequence. Many have pushed for reform around the 5% distribution requirement, such as tying it to inflation or 10-year Treasurys3, although these calls have largely fallen on deaf ears. As such, it remains on the shoulders of foundations themselves to find a better balance between inappropriately under-distributing and implementing organizational controls that prevent over-distributing. It should be noted that “under-distributions” are subject to a 30% excise tax in year one and a 100% excise tax in year two.

Exhibit E- Familiarity with UPMIFA

Board Governance

Boards of directors and trustees of nonprofit organizations have the privilege of stewarding assets for public charitable purposes. However, this privilege also comes with the fiduciary duties and responsibilities incumbent in the roles. The law imposes two primary duties upon boards of nonprofit organizations:

  • Duty of Care: The duty of care means any individual serving must act with such care as an ordinarily prudent person would employ.
  • Duty of Loyalty: The duty of loyalty means an individual serving must act in good faith and in a manner the individual reasonably believes is in the best interests of the organization.

These duties are essential in the many decisions boards must make as part of overseeing their nonprofit organizations. Their application to investment and spending decisions for the nonprofit organization is clear. In addition, boards of directors and trustees must remain vigilant about conflicts of interest. Transactions or engagements between a company affiliated or controlled by any board member and the nonprofit organization should receive heightened scrutiny by all board members. Such actions may be considered self-dealing and, in some situations, self-dealing is flatly prohibited even if the transaction may be fair. Self-dealing refers to a fiduciary, such as a board member or officer, taking advantage of his or her position to benefit from related transactions rather than acting in the best interests of the organization.

For example, in the context of a public charity, a board’s responsibility toward endowment funds means self-dealing with these funds is absolutely prohibited. Private foundations are also expressly prohibited from engaging in self-dealing and penalties are enforced through an excise tax. Given the foregoing, it was notable that the survey showed nearly half of the respondents (44%) have not reviewed their self-dealing policies over the past two years (Exhibit F).

Exhibit F- Policies Reviewed During the Prior Two Years

Boards of directors and trustees of nonprofits often bring together a group of diverse individuals. These are individuals with professional talents and skills, those with a passion for the charitable missions, leaders in the community, individuals affiliated with the organization (in the case of a public charity), or family members (in the case of private foundations). In fact, it is arguable that a “best practice” in board formation is to assemble a diverse group of talents and perspectives among its members. As a result, not all members will have the investment skill and acumen to assess complex investment data.

It should be noted, however, that fiduciary duties imposed upon a nonprofit board do not require that an individual serving possess such skill. Rather the fiduciary duties require that the individual make informed judgments about important matters affecting the nonprofit and seek the advice of competent outside advisors when necessary. Moreover, a board member must always use his or her own judgment, and not just rely on the word of a financial officer or CEO of the nonprofit.

Best practices around board governance that can effectively help institutions confront investment challenges would dictate regular training of all board members on the duties of loyalty and care, as well as the establishment and periodic review of important policies such as conflicts of interest. Given best practices, it was interesting that more than half of the survey respondents (56%) either indicated they had never conducted board training regarding their fiduciary duties and responsibilities (19%) or only conducted it for new board members when they joined (37 percent).

Oversight and investment stewardship of endowment and investment funds donated for charitable purposes is arguably one of the most important responsibilities of a nonprofit board, and fully implicates the duties of care and loyalty. Given the low rate environment and the always-changing dynamics of the domestic and global markets, care and loyalty would necessitate a regular review of investment conditions and capital markets.

Moreover, as discussed above, nonprofits should have written Investment Policy Statements approved by the board that set forth the investment objectives and risk parameters, and connect those objectives and parameters to the organization’s spending policies and goals. With respect to the spending rate for endowed funds, or the amount to be distributed under the 5% payout rule for private foundations, a board should also document its reasons for adopting a given distribution rate. Finally, while nonprofit boards are permitted under various laws to delegate investment management to outside managers, they must act prudently in selecting managers and reviewing their performance. Documentation of decisions with regard to board delegation is advisable.

Exhibit G-Frequency of Board Training to Understand Fiduciary Obligations

Conclusion

A low rate environment is expected for the foreseeable future. For this reason, endowments and foundations will likely be inclined to take a more proactive approach in addressing these issues going forward. Those that have already increased fundraising will likely seek to sustain or even amplify these efforts, while continuing to hold unnecessary spending in check. This is especially true if spending comes at the expense of grant-making activities. Among the investment levers to be pulled, many also likely recognize there is not only more that can be done, but more that must be done to meet the fiduciary duties that govern most trustee and board positions. Even something as simple as establishing a regular and more frequent cadence to review the Investment Policy Statement can help institutions recognize when their investment strategies no longer fit the market environment or their changing organizational needs.

Perhaps the most overlooked lever remains governance and the impact that tactical – and necessary – stewardship can have on an organization’s ability to meet its objectives. For instance, awareness around the fees and operating expenses that either can or cannot be applied toward private foundations’ 5% distribution requirement can go a long way in easing the pressure of low returns. And for those public charities falling under UPMIFA guidelines, simple modifications to spending policies can smooth out the year-to-year volatility that can make planning so difficult.

To be sure, few endowments and foundations were established with investment strategies in mind, yet so often investment performance dictates what kind of impact these institutions can have. The trusted guidance of professional investment advisors, particularly those with experience around the unique needs of endowments and foundations, can be critical to meeting the challenges that face these organizations in uncertain markets. By taking a long-term approach and through incorporating best practices around governance and stewardship, institutions can ensure they’re prepared for whatever market environment awaits to create a solid foundation and fulfill the missions of their charitable or grant-making organizations.

Leveraging Fiduciary Trust’s Expertise

Fiduciary Trust has served nonprofits for over 50 years, providing clients with objective and comprehensive investment management, personalized relationship management, investment policy development and other services. We take a customized approach to investment management based upon expertise, strong performance and a genuine commitment to act in your organization’s best interests.

We have received numerous awards for the quality of our services, including the 2017 Best Independent Trust Company award. We are also active in supporting nonprofits beyond our firm’s services. Our employees serve on over 50 nonprofit boards and committees, and Fiduciary Trust has been named a Top Charitable Contributor in Massachusetts by the Boston Business Journal for the past four years.
We encourage you to reach out to us to discuss how we can be of service to your organization.

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The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.

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