Last month we introduced AER readers to the Happy Valley case study , in which the wealthy widow and matriarch of the fictional microcosm community sought an advisor’s help on how to create an endowment fund to be used to improve the social and environmental conditions of the community.

We’ve examined how to structure an endowment, so the next challenge is determining how to fund and create an adequate investment policy for that endowment. At the recent Institute of Advanced Financial Planning summit in London, Ontario. Brad Offman, vice-president of strategic philanthropy at Mackenzie Financial, outlined a number of different ways an advisor can structure how a client creates the principal investment for an endowment.

“A gift of $100,000 will reduce a donor’s tax bill by about $45,000. It’s probably the simplest way to save money on their taxes,” Offman says. “Mackenzie recently conducted a survey of advisors and found almost 100% said they should be talking to their clients about charitable giving. However, less than one half of the respondents were talking to their clients about charitable giving. So, there is room for significant growth.” Offman pointed out it’s possible to take a lump sum to set up a ten-year endowment. This could involve relinquishing the money to the board of trustees of a charitable foundation; or it could result in the creation of a completely new charitable foundation.

Many mutual fund companies also offer donor-advised funds, which are CRA-approved charities that take ownership of money from clients and manage the endowed fund on their behalf. Most of these are structured to allow the donor to direct which charities the endowment will disperse money to.

For advisors, the scenario is attractive if they run a fee-based book of assets, because they can be paid a trailer from the mutual funds held within the donor-advised fund. Whether it’s a stand-alone endowment or structured with a mutual fund company as a donor-advised fund, Offman says you don’t always have to use cash gifts to create the original principle of the endowment.

An increasingly popular method is to donate publicly traded securities, which are 100% exempt from the capital gains tax. For long-held stocks this is an attractive option, since the initial investment may have been relatively small compared to a large capital gain the donor would incur. It’s an efficient way to maximize a smaller donation into a bigger pay-off for the charity.

Same goes for insurance policies, Offman points out. Although in those cases, the client usually has to die before the charity gets its big payout.

“I’ve heard many people say charitable life insurance is the next frontier of the insurance industry,” Offman says. “There are huge opportunities around life insurance that need to be understood by more people. In the vast majority of circumstances, you can buy an insurance policy where the charity will receive the proceeds from the insurance when the policy holder dies.”

Making a charity the beneficiary of a life policy will defer the tax benefit to the estate when the policyholder dies. This can be an attractive scenario for estates that will incur a large tax bill on the terminal return of the deceased.

“Tax is treated the same as a testamentary gift or gift by will. A [receipt] filed on the donor’s final tax return is based on the value of the policy’s death benefit. The only little nuance here is that, instead being limited to 75% of maximum income, you can donate 100% of income and carry it back a year,” Offman says.

If the client chooses to transfer ownership of the policy to the charity, he or she can get an immediate tax benefit. He notes many advisors are aware that the charity will issue a receipt for the cash-surrender value of the policy. But there’s more to the story. “A lesser-known directive from CRA says charities can value a policy at its fair-market value instead of the cash-surrender value,” Offman says. “There can often be a huge discrepancy between a policy’s cash-surrender value and its fair-market value. The calculation of a policy’s fair-market value is usually an actuarial calculation, where the surrender value is available on the policy statement.”

Or, the client could choose to receive an annual tax credit on the premiums he or she pays to fund the policy.

“If you continue to have annual premiums of $12,000 on that $500,000 policy, you’re going to generate a tax credit on the amount of those premium payments of around 45% or $5,400,” he says. “The after-tax cost to fund that premium is substantially lower than the premium itself.”

Creating an investment policy

Creating the investment policy is the most important aspect of ensuring the longevity of the endowment. A keynote speaker at the IAFP Summit was Frank Pyka, executive director of Foundation Western, The University of Western Ontario’s endowment fund. He notes the financial crisis of 2008/2009 devastated endowments and exposed a lot of vulnerabilities in their investment and spending policies. That means advisors have to be realistic about the risk and returns the endowment needs in order to sustain an adequate spending level.

“If your granting policy is 4.5% (plus the foundation’s expenses, so you throw in another 1.25% for that), you need 5.75% to stay even — forget about inflation protection,” he says.

Only five of the last ten years have produced excess returns above that, and foundations need those types of returns if they want to squirrel away for future spending, Pyka points out. Even more troubling is the downswings in the market have tended to outshoot the up years. Such shortfalls are more amplified than the excesses.

“Foundations are operating on the absolute thinnest of margins. It’s very challenging to run a foundation, because you have that spending that is coming out every year,” he says. “It’s unlike that RRSP where somebody has 30 years to retirement. When you’re talking about risk, to me it’s not volatility but tolerance for negative returns.”

Pyka says a well-designed endowment will build up protections during the years when times are good. But this also likely requires a relatively conservative asset mix. “If volatility during the last decade is 7.8%, what does that mean? That means your return in any one year could be between negative 1.8% and 13.8%, two thirds of the time,” he notes. “You would have to be looking at an asset mix of 50/50 to get your 6% fixed return.” So, if the goal is to gain returns over 7%, then the equity level most be pushed to 75%. In a bad year, that can produce an 18% loss.

There can be some capital retention through structuring of a spending policy that works with the goals of the endowment. And spending is something the endowment usually has control over, beyond the mandated disbursement quotas they have to follow in order to maintain charitable status.

Pyka identifies these three fundamental spending policies as:

Disburse First – In this model the endowment gives the money away before worrying about operations issues.

“There is just one bucket of money [DASH] we’ll call it capital. The $10 million donation goes into that bucket and you get your total return. Every year you’re going to make your grant; you’re going to disperse 4.5% and you’re going to take out a little bit for operating income,” he says. “Inherent in that model, it’s sort of implied, is capital preservation.”

The expectation is that, over the long run, the total return is going to be enough to fund grants and operations and it will inherently grow by the excess returns protecting against inflation.

Of course in bad years, the capital will drastically decline, and this accelerates depletion of the endowment.

Protect the capital first – As the name implies, this model requires the endowment to protect the fund’s capital at all costs.

“You have two buckets. You split the donation and you split your investment income. Investment income now goes into an expendable income bucket. We track that value, and it’s from that bucket that we’ll make a disbursement or a grant,” says Pyka. “We’ll pay some operating allocation and you will have a policy that says every year we take a piece of that and roll into capital to protect that original value against the effects of inflation.”

The caveat with this is if investment income is negative, there’s nothing to grant. “Now you’re saying to the students who rely on Foundation Western that investment returns were nothing last year, so there is nothing to grant, sorry about your luck,” Pyka says.

Stability first – This is the model that Pyka employs at Western and it has three buckets. Investment income goes into a stability fund for all of the 1,300 named endowments at Western, and then 4.5% of that will then be granted.

“We do a little bit of capital preservation,” he says. “We take a little bit off from below for our operating allocation but within the stability bucket, we try to build a level of excess [DASH] it’s called an unallocated income [DASH] so that when we have an event like we did in 2008, it eats into that value.”

The policy is to maintain a stability fund that’s equal to 15% of the value of all of the endowments. And, when that one- in-20-year event happens, the stability fund hopefully absorbs it, and the foundation can keep granting.

Although Pyka concedes the strategy wasn’t able to weather what happened in 2008, the fund encroached on its capital to meet its core granting requirements.

“The stability fund wasn’t even close to 15%. It was a big fat negative and we had to do some different things,” Pyka says. “There’s a cost to not granting. There’s value, there’s value to society even though it’s difficult to quantify. You need to ask what the donor intention was when they established this endowment fund. Was it to maintain a value of capital for ever? They created that endowment fund to help create grants, to fund research and help kids get through school.”

The results

The R.F.P. holders at the summit were asked to create investment and spending policies for the Happy Valley endowment.

When the votes were tallied it was a mixed bag. John Hope, an R.F.P. with Manulife Securities who co-authored the study, said no consensus could be reached on what to do with the Happy Valley money.

The majority of attendees chose to implement a moderate investment policy that essentially was reminiscent of 50/50 stocks to fixed income asset split and targeted a conservative rate of return.

  • Mark Noble is a Toronto-based investments writer.