Pandemic-era lessons for charities about endowment funds

When an economy goes into recession – or there is a cost-of-living squeeze – there can be a reduction in charitable giving. People struggling to meet their domestic bills often stop making donations to good causes. In these conditions, charities that have built up an endowment fund can find themselves in a stronger position than those that have not.

Organisations with endowments can draw down funds to keep going in leaner times, awaiting the return of a better backdrop for collecting contributions. If the charity spends all that it collects each year, any major shock that interrupts fundraising can have a range of negative consequences. For example, it may mean a reduced workforce – something that damages the organisation and its good work. Husbanding cash and surviving takes over as the priorities from doing a good job for those you want to help.

Securing a financial future

The main advantage of building an endowment fund – and investing it well – is it allows a charity to do more in the future than it has done in the past. As the value of the endowment grows, and as the income from endowment investment rises, so it is possible to take more money from the endowment to leverage the charity’s purpose. Many charities have a concept of sustainable income in the way they manage their fund. It is often the case that these funds invest in longer-term and higher-risk assets.

Much of the return on shares or property can come from capital gains on the asset, in addition to income from dividends and rents, which rises over time in a growing economy. Charities decide how much it is safe to take from the fund each year, which may be more than the income the fund generates to reflect the fact that part of the investment return usually comes from capital gains.

The idea is to choose a reliable figure the fund can afford each year, allowing for the swings you get in capital values as markets rise and fall. Many believe that taking 3-4% out of a fund each year will be fine, as investment returns (taking income and gains together) will, on average, be higher than that.

The charity usually aims to ensure the fund rises by more than inflation over a run of years, so the real value of the endowment is rising even after allowing for withdrawals to pay current bills. The charity may wish to use a specialist index of inflation that reflects its own cost structure. What matters is having more to spend on what the charity does in ten years’ time thanks to the endowment’s real growth when compared to actual costs.

It can be easier to persuade a donor to give money to a charity’s endowment fund than just to give for current-year spending. Charities should use this feeling by some donors that they want something that lasts to raise money for the future. Some donations from deceased estate can be substantial, when people die and leave a house or other large asset to a charity of their choice. They may die without children to inherit, or they may die when their children have their own homes and good incomes which means they do not need all their parents’ wealth.

Someone’s tax planning for inheritance tax may include leaving money to charity which is exempt from inheritance tax. The charity has a big advantage overprivate individuals as it is tax free and often operates at a scale which means it can afford and command good advice from the investment community. A charity that aims to be around for many years can build an evergreen source of money – a fund that does not plan to “cash out” but seeks to contribute a few percent of its total value every year reliably to the charity – leaving more for the future than the past. It is always there as a backstop should the charity suddenly need more cash for an approved purpose.

Endowments open new options

A charity’s options get better and wider if the fund is invested well and it sustains a good rate of real return. To do this it is usually necessary to take the risk of buying claims on real assets such as shares and property-backed investments. Over the longer term, experience shows they usually outperform inflation as a group and deliver real returns. Individual equities or specific properties may do badly or go bust, which is why charities are advised to buy a portfolio to spread the risks.

A charity needs to set out investment principles to guide any external investment managers it employs. A charity needs to rule out allocating funds in areas that could conflict with its aims. Medical charities are unlikely to want to invest in tobacco companies, for example. Green charities may wish to avoid investment in fossil fuels. Religious charities may have an aversion to investing in defence-equipment manufacturers. These important priorities can be reflected in the investment policy laid down with the manager.

Charities can be positive and set their investors aims to invest for the good. Green charities might seek a bias towards investments that further the electrical revolution they want to see. Medical charities may favour pioneering companies in drugs and medical electronics. Religious charities may like shifting some more capital into social housing. Charities, like other investors, need to form a view of the dynamics of the economic world in which we live. A Charles Stanley, we think the two great revolutions of the modern world are the digital revolution and the green revolution.

Investors who backed the US digital giants in their earlier days have done particularly well over the last decade, as US technology stocks such as Apple, Amazon, Alphabet and Microsoft have led both the US and world equity markets to much better returns.

Today, we look for the areas that might emerge with the winning products of the electrical revolution, as we wait to see how hydrogen, battery and renewable technologies develop. The iPhone, iPad and Microsoft software led the digital revolution – with their products flying off the shelf. Who will produce the Mini or Golf of the electric car journey? Which company will make the ultimate ‘beefburger’ of the meat-free food revolution? Which business will find the popular way to heat the home to replace the ever-successful gas boiler? Getting these big trends right should help a long-term endowment fund stay up to date with investment fashion – and give it more access to the growth opportunities of our era. Meanwhile, the investment manager needs to keep an eye open for the shorter-term matters that propel shares and properties up and down.

A good time to buy

Last year was a bad year for most endowments, as the central banks decided they needed to hike interest rates substantially to correct inflation. This lowered the price of bonds directly as rates rose and, in turn, hit the price of real assets.

Most assets are worth less to a buyer if you can get a better return with little risk by simply placing money on deposit. It looks as if the US might now have reached peak interest rates, and in Europe people are beginning to look to a pause in rate rises later this year.

Markets know about the higher rates and have priced shares accordingly. It is true there is still more of an economic downturn to come in the advanced economies, but again market participants understand that. It is often a good time to be adding to real assets for an endowment when they have had a bad year – and when you can start to anticipate a recovery from downturn in due course. That is the advantage of the long-term endowment fund. It can not only help the charity out in the bad years, but it can look around for cheaper assets to buy as markets sell off, placing itself in a stronger investment position for the better days that lie ahead.