Meeting a Nonprofit’s Fiduciary Obligation in Today’s Challenging Environment

Anne Bucciarelli, CFA
Published Date:
May 1, 2017

The environment today is challenging for nonprofits. Many organizations are feeling the twin pressures of ensuring consistent distributions while simultaneously maintaining and growing their endowment, often through fund-raising. Further complicating matters, the current capital-markets environment—marked by lower expected returns than what we’ve historically experienced, coupled with higher volatility—represents a major headwind to sustainable distributions and a stable endowment. Meanwhile, on the fund-raising side, the uncertainty surrounding future personal income tax laws is prompting a “wait and see” attitude among donors.

Fortunately, nonprofits have three major levers at their disposal to help overcome these challenges: investment policy, spending policy, and fundraising opportunities.

Investment Policy

The first lever, investment policy, includes the long-term strategic asset allocation of the charitable portfolio. Even at the best of times, determining an appropriate asset allocation represents one of the most important decisions that an investment committee undertakes. Today’s environment makes the decision that much more crucial, because it departs significantly from what we’ve seen over the last 30 years.

As Display 1 shows, returns over the last 30 years have been solid, as represented by the dashed lines over each bar. For instance, an all-stock allocation (far right) had a compound return of 9.2%. Fixed income (far left) also generated healthy returns of 6.4%, thanks to falling interest rates, which fueled a decades-long bull market in bonds. Given these building blocks, investment committees were likely to earn a return that exceeded the historical inflation rate for that period—2.6%—no matter how conservatively they allocated.

Today, however, we are forecasting lower expected returns over the next 30 years, especially for bond-heavy allocations. We are also projecting inflation to be slightly higher at 3.1%. As a result, an organization that was once able to adopt a conservative approach will now need to assume more equity risk in order to achieve the same after-inflation return. 

The combination of lower return and slightly higher inflation forecasts has major implications for sustainable spending. For a balanced 60% stock/40% bond portfolio, we project a sustainable, after-inflation spending rate of just 3.6%—a figure that falls short of the average endowment spending rate of around 4.0%. Faced with this shortfall, what can affected organizations do?

Those currently positioned as 60% stock/40% bond could add more return-seeking assets to help support a 4.0% spending target and increase their odds of reaching perpetuity. For instance, let’s assume that the nonprofit considers increasing its equity exposure to 70%.

This will raise its median expected return to 7.1% and boost sustainable spending to meet the 4.0% target—but that isn’t the only consideration. Investment risk, as measured by the likelihood of a short-term drop in portfolio value, is also a key concern. Our analysis shows that a 60% stock/40% bond portfolio has a 42% chance of experiencing a 20% peak-to-trough decline in assets at least once over the next 30 years. Moving to a 70% stock/30% bond allocation would raise the probability of a 20% loss from 42% to 59%—a material increase.

Adding diversifiers where appropriate, such as alternative investments, might help mitigate some of the incremental risk of a 70% stock/30% bond allocation. Some organizations, however, have previously shied away from alternative strategies that employ leverage, due to concerns about taxable income in the form of unrelated business taxable income (UBTI).

These concerns need to be put in context. The receipt of UBTI no longer imperils a nonprofit’s tax-exempt status. The requirement to file a tax return to report UBTI is only triggered if more than $1,000 of UBTI is received. If tax does need to be paid, UBTI is taxed at the corporate tax rate or—in certain circumstances—at the trust tax rate.

Because UBTI is most often debt-financed income generated by a partnership or other “flow-through” entity, UBTI risk can be minimized either by only investing in alternative investment partnerships that do not use leverage, or by investing in alternative investment funds through offshore entities (like a Cayman fund) that block the passing of UBTI to investors. But minimizing UBTI risk can sometimes be more expensive than actually receiving UBTI. For example, a Cayman fund is required to pay withholding taxes at a 30% rate on almost all U.S.-sourced income, whereas a tax-exempt investor in a domestic partnership will only need to pay tax on any UBTI it receives. Alternative investment strategies that are unlikely to generate significant UBTI, therefore, can offer nonprofit organizations attractive returns even when the investment is through a domestic partnership. Leveraged lending strategies, however, are best pursued through offshore funds (and, in many cases, the requirement to pay withholding taxes is waived for U.S.-sourced interest income).

Given the low-return environment, it might prove advantageous to give alternative investment strategies a second look. In some cases, alternative investment strategies might produce a higher risk-adjusted return even after accounting for higher taxes because of UBTI or withholding. While the benefits of receiving UBTI might outweigh the tax costs for charitable organizations, this is still not the case for certain charitable trusts.  Charitable remainder trusts, for example, would pay a 100% tax on any UBTI received. For these trusts, a UBTI blocker is much more important. 

An allocation to alternatives might introduce other considerations, such as limitations on near-term liquidity. For that reason, exposure should be evaluated in the context of the endowment’s overall allocation and spending policy, which is often documented in an investment policy statement (IPS). The IPS is an essential tool for a nonprofit, enabling the organization to outline its long-term objectives and establish both return and risk guidelines for its long-term strategic allocation.

A clearly articulated IPS will identify the organization’s return goals and target asset allocation, along with reasonable ranges that allow for some flexibility. The IPS should last for several years and ideally allow for small changes to the asset allocation without board approval. Including a reasonable band around the allocation and a definition of allowable investments adds flexibility to the investment policy while still adhering to board-established guidelines.

Although many investment policy statements clearly spell out return parameters, risk guidelines are, all too often, either missing entirely or defined as “risk appropriate for a long time horizon.” What does that mean? Clearly defining risk—whether as a decline in principal or in spending—represents an equally important component of the IPS. While an organization might require an aggressive asset allocation to meet a high spending need, the commensurate risk profile might be far too challenging for the board to justify. Alternatively, the IPS can support the rationale for spending from principal in low-return years based on risk parameters the organization has set in advance.

Spending Policy

Spending policy represents another key component of a successful IPS—and the second critical lever for sustaining distributions or maintaining the value of an endowment. To create a successful spending policy, organizations need to understand the trade-offs between the level and consistency of spending and the long-term value of the organization’s endowment. One useful way to dimension these trade-offs is a concept we call Total Philanthropic Value (TPV).

As we define it, TPV represents the median annual amount an organization can spend in today’s dollars over a given time horizon, plus the residual amount that would be left over in the portfolio. For example, Display 2 illustrates the philanthropic value of a $10 million charitable portfolio over a 30-year period. Assuming the organization’s endowment is invested in a 70% stock/30% bond allocation and distributes 4% of the portfolio value each year, we forecast that 30 years of spending will add up to $11.2 million in today’s purchasing power in the median case, while still retaining $9.0 million in today’s purchasing power in the portfolio. Adding these two values together, we find a 30-year TPV of $20.2 million.

From our perspective, maximizing TPV reflects maximizing the longevity of the charitable entity, yet TPVs can vary depending on the nonprofit’s vision. Consider a nonprofit seeking to prioritize its near-term impact on its mission. In this case, a higher spending rate—5% as illustrated on the right side of Display 2—would lead to a lower TPV over the long run of $18.9 million. Alternatively, some organizations prefer to spend down their portfolio over a set number of years. In this case, long-range TPV might be low, but near-term impact on the organization’s mission might be much higher.

For organizations with a long-term vision, consistency of distributions might be a priority. Let’s continue the 5% spending example with a 70% stock/30% bond portfolio, but this time considering the frequency of a 10% decline in distribution (a measure of consistency). As the green bar on the right side of Display 3 illustrates, this portfolio would experience such a decline in one of every five years.

To improve consistency, a smoothing policy provides a way for organizations to maximize value while maintaining consistent distributions. Smoothing essentially averages the portfolio value over a period of time, typically three to five years, and applies the distribution percentage—5%in this case—to that average. Instead of taking 5% of the portfolio value every year, incorporating a smoothing policy allows an organization to minimize volatility in the annual distribution.

For instance, in a period of rising portfolio values, a smoothing policy will rein in spending. On the other hand, during a period of market decline, the smoothing policy will enable the organization to spend more to maintain a given spending level. We researched many smoothing period options and found that five-year smoothing was most effective in increasing consistency of distributions without adversely impacting TPV. As shown in Display 3, we would expect a 70% stock/30% bond portfolio spending 5% with a five-year smoothing policy to experience a 10% decline in distribution just once every 17 years. That’s well below the one in five years for the no-smoothing policy, with little impact to TPV (as seen in the blue bars on the display).

The organization could also change its investment policy to improve consistency of distributions. A more conservative 50% stock/50% bond allocation will lower overall portfolio volatility, thereby lowering the volatility of the annual 5% distributions. Such a move, however, is not without trade-offs. By emphasizing greater distribution certainty, the long-term TPV of the 50% stock/50% bond portfolio would be lower than the 70/30 allocation.

Our analysis shows that a clearly articulated spending policy in an IPS provides vital direction to boards. By defining the spending policy, the nonprofit can also develop a better understanding of the trade-offs involved and how those trade-offs impact the organization’s long-term objectives.

Fundraising Opportunities

Fundraising, which represents the last lever for organizations, can help close the potential gap between capital-market returns and what the nonprofit actually needs. While the IPS does not touch directly on fundraising, it should certainly take potential fundraising income into account.

Recent proposals from both the administration and Congress suggest that individual tax reform might significantly cap the deductibility of charitable donations—or reduce tax rates to a level where charitable donations become less advantageous. Without predicting the outcome, nonprofit fundraisers can use this uncertainty as an opportunity to reengage with donors regarding their long-range plans.

For instance, fundraisers have found that many donors say they will continue to make gifts regardless of their tax deductibility. There are, however, a few near-term strategies that might benefit both the donor and the charitable organization. Assuming tax law changes take effect in 2018, this year might be the last to make gifts without a significant cap on their deductibility. Thus, a fundraiser might encourage donors to accelerate annual gifts into 2017. For donors who have benefited from the recent U.S. stock rally, fundraisers might point out that a gift of appreciated stock makes more sense than selling shares to donate cash. This way, the donor will receive an income tax deduction for the gift and avoid paying capital gains taxes on the stock’s appreciation.

Another strategy that might be uniquely attractive right now—especially for individuals who have both philanthropic and wealth transfer goals—is a Charitable Lead Annuity Trust, or CLAT. In its simplest form, a CLAT is an irrevocable trust that pays a fixed amount to charity each year for a term of years. Any assets remaining in the CLAT after its term are transferred to the donor’s family or other noncharitable beneficiaries (Display 4).

A CLAT can be “zeroed out”—that is, the value of the annuity payments, discounted at a government-determined interest rate, known as the Section 7520 rate—can be made exactly equal to the value of the assets initially contributed to the trust. If the annuity equals the initial contribution, there are no transfer tax consequences to setting up the trust.

This can be an effective way to “pre-fund” a donor’s desire for annual giving because the CLAT can accomplish two goals: donations and wealth transfer. Unlike annual gifts, however, the CLAT is irrevocable, less flexible, more complex, and tends to be larger in size given the administrative costs involved in establishing the trust.

The reason these trusts are attractive in this environment is that the 7520 rate is currently near historic lows, which means that there is a greater likelihood of transferring a remainder to family members. Certain variations of CLATs—namely, non-grantor CLATs—also might remain attractive if personal income tax deductions for charitable donations are significantly capped because the trust, rather than the donor, receives the tax deduction each year.

While the environment today is challenging for nonprofits, organizations have several compelling ways to improve their odds of success. The optimal combination is a clearly articulated investment policy, a spending policy that acknowledges the requisite trade-offs, and an approach to fundraising that creates a sense of urgency. The common thread uniting them is an emphasis on planning and the documentation of decision-making in a high quality investment policy statement. For nonprofits today, it can mean the difference between surviving and thriving.

The Bernstein Wealth Forecasting System seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios, and for taxable accounts, it takes the investor’s tax rate into consideration.

Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

AnneBucciarelliAnne K. Bucciarelli, CFA, is a director of the Wealth Strategies Group at Bernstein Private Wealth Management in New York. She is responsible for wealth management research and provides customized advice on complex financial issues for private clients and their advisors on wealth transfer strategies and asset allocation decisions including concentrated stock exposure and planning for corporate executives. Anne is also responsible for providing investment advice and solutions to not-for-profits and philanthropic individuals as well as next-generation wealth owners. She has been the author of and a contributor to the firm’s published research on several topics. Anne joined Bernstein in 2004, became an analyst in the Wealth Strategies Group in 2006 and assumed her current position in 2014. She is also a member of the New York Society of Security Analysts (NYSSA) and is a founding member of the American Brain Foundation Ambassador Program.

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