Trustees must understand
appropriate risk strategies
In the last year I have several times listened to trustees of charities debate their investment strategy. Arguably these discussions should be challenging as trustees grapple with their own investment histories and biases while feeling the responsibility of looking after funds that are not theirs. Unfortunately, the default position, rather than investigate and learn, often seemed to be “these are not my funds therefore I should take a conservative position and invest only in the bank”.
Clearly taking on too much risk is inappropriate. But so is taking too conservative a position, such that losing purchasing power against inflation becomes a realistic threat or longer-term spending and capital outcomes are undermined. A key question therefore is “what is risk?”
A reference guide for how trustees should think can be found in the Trustee Amendment Act 1988. Trustees are required to act with the prudence expected of someone managing another’s affairs rather than their own. They must consider, among other matters, diversification, the risk of capital loss, the potential for capital appreciation, the likely income return, the possible duration of the trust and the effects of inflation.
The risk of inflation is important. Interest rates are much lower than they were a decade ago and likely to be lower for some time to come. Charities don’t pay tax, providing an extra buffer. But even a 1% inflation impact over and above return can be material - in 10 years $100,000 will only buy $90,400 worth of goods and services. That cannot be regarded as a good outcome. At 2% the number is $81,700.
Conversely, what benefit is there from a higher return than the bank? A 1.5% return will grow $100,000 to $116,054 in 10 years. But a 3.5% return improves the outcome to $141,000. The magic of time and compounding.
Timetable is important. There are funds that might be needed within the next 12 to 24 months. The bank is the appropriate place. But there are also medium-term funds, where perhaps a combination of income and growth investments is appropriate. And longer-term funds, likely to remain untouched for 10 years or more, that could include a higher portion of growth investments. One solution for all the charity’s funds may well be short-sighted and inappropriate. Inherent is that whatever mix of investments are chosen they are well diversified, seeking to avoid permanent capital loss and that the key risk is occasional periods of volatility.
What though if the income is being spent in part or whole each year? Does that mean that shares are inappropriate? No. If instead we were discussing a residential rental – the value of the house can fluctuate but the rent is still available from the tenant. So, it is with bonds and shares. The income returns from which are often higher than from a term deposit.
Of course, trustees must be willing to stay the course, avoid projecting their personal risk tolerance onto their decision making, and be comfortable adopting an allocation that might be more diversified than the “norm” among similar funds in the community. But if trustees are to do right by the entities they are governing they need to move beyond the paradigm that cash and term deposits are always the answer.
Clearly taking on too much risk is inappropriate. But so is taking too conservative a position, such that losing purchasing power against inflation becomes a realistic threat or longer-term spending and capital outcomes are undermined. A key question therefore is “what is risk?”
A reference guide for how trustees should think can be found in the Trustee Amendment Act 1988. Trustees are required to act with the prudence expected of someone managing another’s affairs rather than their own. They must consider, among other matters, diversification, the risk of capital loss, the potential for capital appreciation, the likely income return, the possible duration of the trust and the effects of inflation.
The risk of inflation is important. Interest rates are much lower than they were a decade ago and likely to be lower for some time to come. Charities don’t pay tax, providing an extra buffer. But even a 1% inflation impact over and above return can be material - in 10 years $100,000 will only buy $90,400 worth of goods and services. That cannot be regarded as a good outcome. At 2% the number is $81,700.
Conversely, what benefit is there from a higher return than the bank? A 1.5% return will grow $100,000 to $116,054 in 10 years. But a 3.5% return improves the outcome to $141,000. The magic of time and compounding.
Timetable is important. There are funds that might be needed within the next 12 to 24 months. The bank is the appropriate place. But there are also medium-term funds, where perhaps a combination of income and growth investments is appropriate. And longer-term funds, likely to remain untouched for 10 years or more, that could include a higher portion of growth investments. One solution for all the charity’s funds may well be short-sighted and inappropriate. Inherent is that whatever mix of investments are chosen they are well diversified, seeking to avoid permanent capital loss and that the key risk is occasional periods of volatility.
What though if the income is being spent in part or whole each year? Does that mean that shares are inappropriate? No. If instead we were discussing a residential rental – the value of the house can fluctuate but the rent is still available from the tenant. So, it is with bonds and shares. The income returns from which are often higher than from a term deposit.
Of course, trustees must be willing to stay the course, avoid projecting their personal risk tolerance onto their decision making, and be comfortable adopting an allocation that might be more diversified than the “norm” among similar funds in the community. But if trustees are to do right by the entities they are governing they need to move beyond the paradigm that cash and term deposits are always the answer.
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Stephen McFarlane is an adviser with NZ Funds Private Wealth in Timaru. The opinions expressed in this column are his own. A copy of Stephen’s Disclosure Statements are available on request, free of charge.
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First published in the Timaru Courier on 13 August 2020, as 'Trustees must understand appropriate risk strategies.'
