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New rules allow charities to adopt total-return investment strategies

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New guidelines have been published by the Charity Commission – the independent regulator of charities in England and Wales – to enable charities to adopt a total-return approach to investing their permanent endowment.

The guidelines accompany the Charities (Total Returns) Regulations 2013, which come into effect on 1 January 2014 and amend the Charities Act 2011, allowing trustees of permanently endowed charities to use a total-return approach to investment without previously seeking permission from the Charity Commission.

Normally, capital gains on investments of endowed charities are retained within the charity’s investment fund to provide a permanent source of income.

Only investment income such as dividends or rent can be allocated to the income fund for use on the charity’s activities.

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The new rules, which follow a consultation earlier this year allow charity trustees to treat all investment returns – capital gains and income – as a whole, allocating the total return so as to best further their charity’s aims now and in the future.

They will be able to do this by passing a resolution to adopt a total-return approach. At present, they must obtain permission from the Charity Commission.

The new power hinges on the so-called ‘unapplied total return’, defined as the portion of the total investment return from the charity’s investment fund that has not yet been allocated to either the income fund or the investment fund.

Once the resolution has been passed, unapplied total return may be allocated between capital and income as the trustees consider appropriate.

There is, however, a cap on the amount of unapplied total return that can be added to the investment fund.

This will be determined by the investment fund’s value at a specific date, indexed in line with inflation.

The regulations aim to provide robust safeguards to respect the principle of permanent endowment, while allowing trustees the opportunity to take this new approach to managing their investments.

For example, trustees of endowed charities will also be able to allocate a limited amount of their capital – up to 10% of the value of the investment fund – to the income fund.

But this amount will have to be repaid over a reasonable period of time.

And trustees must be able to demonstrate that they have acted with caution in taking a total return approach, including taking advice where appropriate.

Charities that choose not to acquire the new power may still opt to apply for authorisation from the Commission to remove restrictions on spending permanent endowment.

Heather Lamont, director of client investments at the CCLA, said: “It’s helpful that endowment trustees will have more flexibility to manage the distributions they make and won’t have to get Charity Commission approval on the details.

“However, the arithmetic around transfers between capital and income can get pretty complicated, especially if the trustees want to take advantage of that flexibility to ‘borrow’ from the endowment, or if they later decide that they don’t want to use a total-return approach after all.”

She added: “Many trustees may decide that they’ll be more confident of balancing the current and future needs of the charity if they just follow an investment strategy that will generate a reliable and sustainable income stream.

“That way, they won’t have to decide how much capital is ‘safe’ to take out of the pot without eroding the real spending power of the endowment.”

Peter Knapton, director of charities at M&G, said: “Many trustees dislike the total-return approach, under which any shortfall in income is topped-up by sales of capital assets.

“These trustees prefer to monitor income and capital separately so as to ensure the charity does not overspend and that the capital value of the endowment at least maintains its spending power in the face of inflation.”

And he warned: “Under a total-return regime, when economic recession hits, any reduction in distributions is topped-up by sales of capital assets at what will, almost certainly, be very low stock market levels.”

The regulations and guidelines are available here.

The Charity Commission will review the working of the regulations in five years’ time.

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