What is a sustainable portfolio ‘withdrawal rate’ for charities?

Today’s harsh economic climate is enormously challenging for charities that see themselves as ‘perpetual’ in nature, and which rely to a material extent on their investments to support their activities. While yields on many traditional income-bearing asset classes have fallen significantly in the wake of the global financial crisis, the requirement for charitable activity is greater than ever. Continuing to spend at previous levels may appear unsustainable, but cutting spending may be undesirable or even impossible. The current financial backdrop questions assumptions about future returns and, therefore, reasonable levels of withdrawal which will protect long-term value, after inflation. Below, we summarise the main findings of a paper we wrote in 2013, exploring the question of what constitutes a sustainable rate of withdrawal for a charity to make from its investment portfolio.

A large part of the historical analysis was based on the data of Elroy Dimson, Paul Marsh and Mike Staunton of the London Business school, which covers the nominal and real total returns for bonds, equities and cash in both the UK and overseas for the 113 years from 1900 to 2012. We believe the very long-term nature of this data, and the subsequent analysis and modelling it allowed us to perform, provide long-term insights which remain relevant today.

• Charities’ current average asset allocation, using the WM Common Investment Fund universe in 2012 as a proxy, yields about 3% – some way short of many charities’ proposed rate of withdrawal of 4%, and this takes no account of fees.
• The long-term returns (from 1900 to 2012) as calculated by Dimson, Marsh and Staunton, and the current average asset allocation of charities, imply that a 3.5%-4% p.a. withdrawal would have been a reasonable level of sustainable distribution, if one had wished to protect capital against inflation[1] and market loss, and avoid excessive volatility in distributions.
• We looked at all 10-year and 25-year periods over the last 113 years, taking a portfolio comprised of 60% equities and 40% bonds, and assuming a total gross withdrawal rate of 4.0% a year. The final principal, after ten years of withdrawals, equalled or exceeded the inflation-adjusted original principal in 53% of cases. After 25 years, this rose to 55%. Based on this asset allocation and withdrawal rate, the real value of the portfolio was only maintained a little over half the time.
• Holding a higher proportion of equities increases the probability of maintaining the purchasing power of capital, albeit with greater volatility. However, even over 25-year cycles, no combination of asset allocation and withdrawal rate gave an implied 100% probability of maintaining the real purchasing power of capital. Over a 10-year horizon, we found that there was a 1-in-5 chance that even an all-equity portfolio distributing just 2% per annum would have failed to protect the real value of an average charity’s capital.
• Smoothing annual distributions reduces the volatility of income for charities, and also reduces significantly the chance of an annual distribution decline of 10% or more.
• Even a small over- or under-distribution will have a significant effect on the real value of the portfolio over 20 years. Based on our analysis, withdrawing 2% p.a. from the portfolio above the sustainable level over 20 years will reduce the real value of the portfolio by 33% by the end of the period. Conversely, under-spending by 2% p.a. would add nearly 50% to the real value of the portfolio after 20 years.

Implications

We suggest a number of approaches which trustees could consider as they plan for the future. These include:

• Using spending reviews judiciously to bring spending back towards a sustainable 3% level
• Spending income, but investing for greater levels of capital growth; an all equity portfolio would currently deliver a higher income yield, as well as greater income growth potential, than an average charity asset allocation
• Seeking to manage the downside in investment returns
• Using actively managed strategies
• Using a formula to smooth withdrawals

The most important implication of our analysis is that charity trustees should address this topic as part of the regular review of their investment portfolio. Each individual charity will have different priorities, and there is no single ‘right’ answer for all charities. As CC14 states, “a charity needs to be clear about what it wants to do, how it intends to do it and what the timescale for delivery will be…”, and, in uncertain times, this challenge is as great as ever for trustees.

For more information about our findings, please visit http://www.newton.co.uk/charities

Important information
The research and data contained in this document was commissioned by Newton in 2013. No warranty is given to the accuracy or completeness of this information and no liability is accepted for errors or omissions in such information. The opinions expressed in this document are those of Newton and should not be construed as investment advice or any other advice and are subject to change. This document is for information purposes only and does not constitute an offer or solicitation to invest. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. Past or current yields are not indicative of future yields. This document is issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority.

[1] Inflation in the UK over this 113-year period was 4.0% per annum.