Investment strategies so your foundation can keep on giving

How to help ensure that your charity becomes a real legacy.

05 Oct 2016

Foundations are governed by the 5% rule, which, along with the need to keep up with inflation, can be the biggest challenge they face for long-term sustainability. Under the rule, at least 5% of assets, minus certain deductions, must be paid out in grants or used for allowed administrative expenses each year. If you oversee a foundation, deciding on a prudent investment approach and formalizing your investing plan in an investment policy statement are crucial—and both of these are discussions you can have with your Financial Advisor, who can offer you the benefit of experience.

How tough is it to earn a consistent return of 5% plus inflation?

Going forward, it’s likely to be harder. A study of private foundation portfolio performance by the Council on Foundations–Commonfund Study of Investment of Endowments for Private and Community Foundations over the past five years found average annual returns roughly where they need to be to meet a foundation’s minimum distribution target during that period. But UBS expects portfolio returns for the next five years to be substantially lower than during the past five years. In some of those years, portfolios are likely to have minimal gains or lose money.

Key takeaways

  • A key requirement of a foundation is to give 5% of its assets to charity each year, known as the 5% rule.
  • Consider using a goals-based investing approach for meeting your foundation’s financial needs.
  • Foundations can benefit from having an investment policy statement to guide its investment decisions and performance evaluations.
  • Your Financial Advisor and other experts can help you meet the requirements and regulations of a foundation in your state.

“It’s important not to try to meet that 5%-plus-inflation hurdle every year,” says Michael Crook, Head of Portfolio & Planning Research in Wealth Management at UBS Financial Services, Inc. “Getting 6% to 7% year in and year out is very hard.”

That’s especially true with today’s persistently low interest rates for income-producing investments. Although it might seem ideal to have a foundation portfolio that generates enough income from bond interest and stock dividend payments to keep up with its distribution requirements, that may not be practical.

Divide and conquer

As an alternative, Crook suggests using a goals-based wealth management framework, an approach that UBS developed in 2015. “It’s about dividing assets so that different segments can be directly aligned with your goals,” he says. This method separates the portfolio into multiple parts, each of which is invested to meet a particular objective. “For a private foundation, that means having some investments dedicated to meeting that 5% distribution over the next few years.”

“Higher returns can help a foundation remain sustainable over the long term.” – Crook

That part of the portfolio might take the form of a bond ladder—several bonds or bond funds that mature at different times. Ordinarily, as a bond in the ladder reaches maturity and the bond principal is returned to an investor, the proceeds would be reinvested in another bond. But these days, says Crook, because bond returns are so low and many portfolios need to reduce their dependence on them, “we sometimes recommend spending bond principal as it matures.” The money can help meet the distribution goal.

Meanwhile, another part of the portfolio could be invested in stocks, including international equities, which have been less expensive than U.S. stocks and could have larger gains in the years ahead. “Those higher returns can help a foundation remain sustainable over the long term,” Crook says.

Write a blueprint for investing

With the 5% rule, there’s little room for error when investing private foundation assets. That’s why it’s essential not only to have a well-considered strategy for meeting foundation goals but also to formalize its principles in an investment policy statement to help guide ongoing investing decisions—something you can discuss with your Financial Advisor.

According to Crook, an investment policy statement serves several purposes, from clarifying investing strategies and goals for the foundation to stipulating who will make investment decisions and how performance will be measured. “It’s also a great place to put a rebalancing strategy,” Crook says. This could help a foundation’s managers do what’s best for the portfolio even when that’s emotionally difficult—for example, buying stocks to restore investment balance after the market has plunged. “That’s a lot easier to do if you’ve already decided ahead of time,” he says. Creating an investment policy statement can also spark conversations about your family’s values and establish roles for younger family members. “Your kids may not be so excited about the technical aspects of investing,” says Bill Sutton, Head of Client Philanthropy in the U.S. for UBS. “But they will pay attention when you talk about how to make more money to support the charities they love.”

The law requires a prudent investor

A final challenge for private foundations is to meet the requirements of state laws that establish a “standard of care” for foundation officers and managers. Although the specific requirements of these regulations differ state to state, they generally call for those in charge of a foundation’s investments to act as an “ordinarily prudent person” would. Your Financial Advisor and UBS investing and foundation experts can help you follow the rules while finding the most effective approach for meeting your foundation’s goals and perpetuating its influence.