2. Factor the operating budget and funding needs into the equation – As components of an overall funding and operating plan, the spending policy and investment strategy naturally complement each other. To that end, investment committee members need a clear picture of the institution’s funding requirements affected by its mission, liquidity constraints, time horizon, and legal and regulatory requirements. For example, U.S. private foundations must comply with the “5 per cent spending rule”—which requires them to spend at least 5% of the endowment’s value annually—so they must adapt their investment policies accordingly.
As in the U.S., many Canadian endowments and foundations cannot see individual endowments fall below the principal donation amount adjusted for inflation over sustained periods, or they may have to suspend spending until the situation is rectified. This is often referred to as encroachment. Investment strategies that minimize the potential for encroachment are important not only for continued spending but also for continued fundraising by the institution.
3. Define the asset allocation and investment objectives to maximize risk-adjusted returns – When formulating an investment policy, the investment committee makes important decisions on risk tolerance levels, asset allocations and investment vehicles. The investment committee must align these variables with the institution’s goals and payout policy.
If spending is volatile—leading to less predictability in funding needs—a short-duration high-liquidity low-risk low-volatility strategy might be most effective. Conversely, a non-profit with an indefinite time horizon and predictable payouts might be better served by an investment strategy that introduces more risk but reaches for larger returns over a medium- to long-term investment horizon.
These decisions call for financial expertise. Boards are encouraged to include members with considerable knowledge in this area on their investment committees and to supplement their knowledge with expert advice as needed.
4. Align the investment management structure with policy – An institution’s investment policy should clearly define the role and composition of the investment committee, as well as address the necessity of employing external managers. The investment committee of the endowment or foundation must decide whether to rely on in-house capabilities for asset management or outsource this task. In either case, strict oversight must be maintained.
If an organization decides to employ external investment managers, an investment committee or external advisor appointed by the committee must formulate a selection strategy and then hire, monitor and, if necessary, fire those managers. This process calls for adherence to due diligence guidelines and a careful selection approach.
Selecting specialized asset managers can be complicated and time-consuming, especially for institutions that lack the necessary in-house capabilities or resources to monitor and analyze manager performance. In these cases, hiring an external consultant to screen and select managers might make sense.
If an endowment or foundation decides to outsource the implementation of its investment strategy—either in part or in its entirety—the outsourcer can play the role of an advisor while the investment committee operates as chief information officer (CIO), hiring and monitoring managers. Another approach to expanding the investment committee’s governance capability transfers the CIO function to external consultants, allowing them to hire and monitor asset managers. The responsibility of complying with standards of conduct lies not only with the governing bodies of the endowment or foundation, but also with those organizations or persons that have been assigned the investment management responsibility.
The investment committee should include at least some members with financial expertise and experience—especially if the intent is to implement a more complex investment structure, such as one that includes alternative asset classes. According to the Commonfund Institute, larger institutions are more likely to have a CIO and portfolio management expertise within their investment committees than smaller ones. This is worrisome, as smaller institutions are also increasing the complexity of their portfolios—even if, in some cases, the committee members lack the necessary expertise to fully understand and monitor the implications of these investment strategies.
While these four practices may seem straightforward, implementing them is a challenge for many endowments and foundations. The difficulty lies in applying these precepts to the particular circumstances that confront each institution: its mission, vision, values and culture.
As endowment and foundation assets continue to grow, the demand for greater expertise in the governance capabilities of investment committees will grow as well. Endowments and foundations can reap significant benefits from making concerted efforts to understand and adopt best practices in investment and spending policy governance.
Janet Rabovsky is practice leader, investment consulting, central Canada, with Watson Wyatt Worldwide.
janet.rabovsky@watsonwyatt.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the August 2009 edition of BENEFITS CANADA magazine.