Specialist Outlook

Charity focus: Returns, sustainable withdrawals and spending formulas

30 July 2013

Richard Maitland, Sarasin's Head of Charities, examines a total return approach to spending.

An increasing number of charities are adopting some degree of ‘total return’ approach to spending, withdrawing both income and capital from their endowment funds or reserves to meet their objectives. We have always embraced the concept of spending a little capital – as opposed to relying solely on an artificially high level of income – but this does require trustees to have a firm grip on how much capital it is prudent to spend over and above any income receipts.

The classic approach is to consider how much money you can make from your investments (the absolute return), the extent to which this needs to be discounted to take account of inflation (the ‘real’ return) and then consider whether further assumptions need to be factored in before deciding how much a truly sustainable level of annual expenditure might be.

Much has been written about the expected long-term returns from the different asset classes, the influence of inflation in calculating them and how they can be blended together to generate different absolute and real risk-return profiles. This is covered in detail in the Sarasin & Partners Compendium of Investment (click here for more information), and Table 1 below offers an update to this, taking account of market levels and valuations as at 30th June 2013.

One then needs to discount the portfolio return by the level of inflation your charity will have to bear to calculate the realistic ‘real’ return figure your charity’s investment portfolio will have to produce. In Table 1 below, you will see we have discounted the returns by 3% to account for inflation (though for some charities this may need to be more or less).


Table 1: Projected Long-Term Investment Returns

Asset Allocation % Asset Class 5-7 Year Trend Return per annum %
9.0 Government Bonds 2.5
8.5 Corporate Bonds 5.0
70.0 Equities 8.2
7.5 Property 6.5
5.0 Alternative Assets 6.5
100 Total Fund 7.2
Projected Inflation:   3.0
Projected Real Charity Returns       4.1

 Source: Sarasin & Partners LLP


We have assumed a figure of 3% for inflation over the next 5 - 7 years.  This takes into account the Bank of England’s 2% CPI target, plus a premium for ‘charity’ inflation that acknowledges service-sector inflation tends to be higher than the average. In our experience, charities have suffered slightly higher inflation than the national average but each charity should consider what they are spending their money on. We have also added in a small premium to take into account the Bank’s current unwritten growth agenda and the risk that sterling is weak, increasing inflation further.

The yield of securities within a typical long-term charity portfolio was probably a fraction over 3% as at 30 June. However, many fund managers should be able to distribute more than this without undermining the total return of a portfolio through a combination of option writing, a bias to higher yielding equities and active management. Trustees should therefore consider an income yield of 3% to 3.5% as a realistic income target for a charity to aspire to, depending on the tactics of their particular investment manager.


However, this is far from the end result: the projected ‘real’ return is not the figure trustees should aim to spend each year, as it is almost certainly optimistic. Specifically, one needs to consider a range of other factors. Three important ones will be:

1.    Investment costs: even if you are pursuing a passive approach, custody, dealing and the underlying costs of a good index fund or ETF are unlikely to be less than 0.25% per annum and most charities should assume that their total costs will be more like 0.5% to 1% per annum.

2.    Active management: while trustees appoint fund managers on the basis they will add value over a given index or benchmark (after accounting for all costs) their record doesn’t necessarily justify this optimism! This isn’t just a problem for the relative return brigade: many absolute return managers have failed to achieve their goals too. We certainly wouldn’t assume in one’s long-term planning that fund managers will definitely add value, although their success or failure is likely to have a significant impact on your spending.

3.    Volatility: even if one projects future market returns accurately, and the average annualised return produced by your fund manager is in-line with your assumptions, the ‘shape’ of the returns and the real-world volatility you will have witnessed will almost certainly mean that you could not actually have spent all of the projected compound annual return and retained the ‘real’ value of your capital. It really matters when the good and bad years occur.

These three factors mean that one should probably discount the amount one can afford to spend from the projected annualised real return that the portfolio has been constructed to achieve by more than just inflation.

Even then, once an appropriate spending percentage has been agreed – which can range between a low 2.5% and a surprisingly high 5% in the US – there then becomes the thorny issue of ‘x% of what?’, and how the initial level of spending will evolve over time.

Specifically, the difference between increasing the first year’s withdrawal by inflation each year (to maintain year-on-year spending in ‘real’ terms) to simply spending the agreed percentage of the capital each year can have a significant impact on both the amount you spend and the future capital value of your portfolio.

The more sophisticated withdrawal programmes typically use a combination of a 3 or 5 year rolling average year-end value and the natural income generated by the portfolio.

However, this can still lure charities into significant over or under-expenditure if the valuation of markets changes appreciably over an extended period of time, or if governments step in and change tax regimes. For example, over the past 40 years, we have seen:

  • Massive wealth destruction in the 1970s, where any level of spending would have been too much. In real terms, equity investors lost about 70% of their capital in 1973-1974 and even multi asset portfolios would have produced negative ‘real’ returns before any spending over the decade as a whole.
  • The 25-year upwards re-rating of equity valuations post the mid 1970s. During the 1980s and 1990s, charities achieved returns of over 15% per annum, with just two down years in 20 years. Real returns over this period were nearly 11% per annum.
  • The equity de-rating post 2000: the noughties produced absolute returns of just 2.7% per annum, which was much the same as inflation, so like the 1970s, no ‘real’ or excess spendable return.
  • The government’s approach to Advanced Corporation Tax in 1997, which resulted in UK equity dividends received by charities falling by over 20% and the capital value of the market effectively falling by the same amount.
  • The secular and then ultimately government-driven re-rating of bonds from 1980 to the present day. Between 1900 and 1980, government bonds produced a negative ‘real’ return of -0.4% per annum. After inflation, bonds were a consistently poor investment: 5 of the first 8 decades of the 1900s produced negative real returns. This puts the excellent ‘real’ return achieved by government bonds of 5.9% per annum since 1980 in context and should remind investors with shorter memories of the dangers of investing significant amounts of money in bonds.

Sarasin & Partners have modelled a wide range of scenarios using both historic and forecast market conditions, and different combinations of withdrawals/spending, from income only approaches to total return, inflation uplift and withdrawals based on snapshot and rolling capital values.

If one’s main objective is to generate year-on-year uplifts in spending and, over a reasonable period of time, to match the needs of today’s and tomorrow’s beneficiaries, then the first conclusion one can draw is that there is no one single ‘mechanical’ approach that can guarantee success.

It really does matter when one enters markets for the first time and while ‘averaging in’ programmes can help, deploying significant amounts of capital at the start of a 2-3 year bear market is going to be damaging to any portfolio’s health. Interestingly, while investing monies at the very bottom of a bear market is wonderful for one’s capital base, the supra normal returns generated in the early years means trustees could easily overspend, leaving future trustees struggling to match the spending levels achieved in better times. Does that sound familiar?

In conclusion, while a great deal of effort goes into calculating future returns, rather less time is spent working out how such a programme can be most effectively implemented and what sort of market conditions exist at the time of one’s deliberations. All three of these need to be considered as equally important factors when deciding how much to spend – and two of them are at least as much art as science.

Ultimately, one has to acknowledge that one will only truly know what could and should have been spent after one has spent the money!

At Sarasin & Partners, we use a relatively simple, model and suggest trustees discount this figure by a conservative margin. We also ensure that trustees are aware of the different ways agreed levels of spending can be withdrawn from a portfolio, and the impact this can have on their capital over the longer term. While we embrace the concept of total return, we feel uncomfortable if natural income makes up less than 70% of a year’s spending: income receipts are much less volatile and much more predictable than capital returns. Lastly, we review our market forecast and long-term return assumptions regularly ensuring that these more strategic matters are discussed with our clients.

Taking everything together, if we are right about an absolute return of just over 7%, which we think will equate to an inflation-adjusted return of just over 4%, this will result in a sustainable withdrawal of 3.5% to 3.75% per annum. Given that a well-diversified and un-stressed portfolio can be constructed to yield 3%, we would suggest that investors could top up their income stream with 0.5% to 0.75% of capital per annum if they want to try and maximise spending each year. The most prudent trustees are likely to just spend the income generated by the their portfolio and then review every so often whether a surplus of real capital gain has (or has not) built up which can be harvested and spent.

This article first appeared in Sarasin & Partners House Report Quarter 3 2013.


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Richard Maitland

Richard Maitland is a partner and Head of Charities at Sarasin and Partners.

Richard has more than 22 years of investment experience and joined Sarasin & Partners in 1992. In addition to UK equity research, Richard has led the firm’s third party funds research team, analysing specialist equity funds and alternative assets while managing portfolios for a range of charities, pension funds and unit trusts. He now focuses on managing diversified multi-asset portfolios for charities and assists in setting the firm's long-term strategic asset allocation. He is author of the Sarasin & Partners Compendium of Investment. Richard has a degree from Newcastle University and is a member of the St Paul’s Cathedral Investments Committee.  He has been a visiting lecturer on investment and endowment management at the Judge Business School and the Universities of Stellenbosch and Vienna.

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