Reserves

The charity reserves conundrum

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Just before Christmas the Charity Commission published its findings on Charity Reserves. Although 92% of the charities sampled explained their Reserves Policy and 90% explained why they were being held, a third of charities failed to disclose the actual level calculated in accordance with the Commission’s guidelines.

There will be several reasons for this lapse but an underlying one is that there is confusion about what people think ‘charity reserves’ mean. At a simple level there were differences between the Commission’s definition (in CC19) and the SORP definition which charities follow when preparing their accounts. At a more fundamental level there is real confusion amongst users. The formal definition of reserves excludes illiquid assets such as the property the charity uses in its work (which suggests the focus is in part on liquidity) but investment property is included which suggests it is not. To many a charity’s reserves will be Trustees’ long term policy of what they feel is the right size of cushion to underpin their long term charitable purpose.

The problem for the Commission is surely that they are pulled in two different directions – some charities keep far too much, and some (Kid’s Company is the usual suspect) keep far too little. These are difficult aims to reconcile in one formula. Focussing on liquidity suggests that charity Balance Sheets can never reshape themselves into something more efficient, and arcane calculations undermine efforts to allocate more  reserves to beneficiaries.

Reserve levels in charities are a complete substitute for the profit line in commercial companies. Finance Directors should drive their organisations based on long term reserve planning. Unlike a business, in a charity a profit or loss only matters in the context of its reserves. 

We believe that Trustees should always be able to answer these three questions:

  • Do we currently have sufficient cash to pay our bills as they fall due?

  • In accounting terms are we fully solvent? 

  • How large a reserve to we want to keep, and for what purpose? 



A Fable of Aesop

Saint Anthony the Abbot Tempted by a Lump of Gold, Fra Angelico (1436)

Saint Anthony the Abbot Tempted by a Lump of Gold, Fra Angelico (1436)

There was a man who was so worried about the safety of his possessions that he sold them all and bought a lump of gold which he buried on the outskirts of town.

He had no greater pleasure than to visit it and to muse or dream. He did not own the gold, but the gold owned him.

One day he found the gold gone. He was distraught and told a neighbour of this loss.  The neighbour told him to put a stone in its place – “since you never meant to use it, the stone will be just as good as the gold”.

Aesop’s moral is that the value of money depends not on its accumulation but on its use. It remains as true today for trustees and advisers as it did 2,500 years ago.

A false stop - having confidence and conviction on future returns

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We've just come across an old report dated 2013 from an investment management firm.

It sensibly suggested that portfolio returns had been so good that they must now be unsustainable and charities should begin to reduce the spending they funded from their endowment. There were many other similar reports making the same point and also suggesting charities should reduce their spending. So what did happen?

In fact the world’s stock markets went up by almost 16% a year for the next four years, an astonishing rise by any standards, especially when inflation barely moved above 1% a year. Longer-term analysis, based on Barclays data, shows the real return on UK and US equities, from 1900 to 2016, was 5% and 6.6% respectively.

If you were a charity trustee or executive in 2013 and received that advice from your professional adviser, what did you do? Did you do as advised and accept a lower distribution and lower spending? If you did, what choice did you have in the face of such confident advice?

Think of it another way: if a fundraiser had said that they wanted a lower their fund raising target for the year because they had done so well recently it couldn’t carry on, what would you do? Both markets reply on past performance and there is no guarantee that this will continue.

A trustee should listen, understand, push back and then decide. Trustees and CEOs are much better at pushing back when they are familiar with the subject, such as fund raising, but in a world such as investment management it often appears too complex or high risk to ask some of these very basic questions.

This shouldn’t be the case, and trustees have a duty to push back to make sure that the advice they are being given is reasonable and reliable - whether its comes from a fund raiser or a fund manager. That’s the law and this responsibility lies ‘upstream’ of the normal business of the investment management community and amongst trustees and the executive themselves. One common barrier to this taking place is the absence of any ‘neutral’ support that charities can call upon when trying to push back – everyone has an angle - so the key is to find the one that is most trustworthy for the task in hand. 

For most charities, they have a degree of discretion on both income and expenditure. Even the best budgets allow or forecast for some volatility of these measures as there is no certainty. 

There can be no doubt that where trustees did push back against such advice in 2013 and stayed with their spending plans (or even increased them), their charities would have made a distinct additional contribution for many people who were experiencing times of considerable hardship. If they had been wrong, they still had the chance to pull up the drawbridge, but not before they had made sure everyone was inside.

When the Community Chest is empty?

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We know what would happen if every player in a game of Monopoly was given a huge amount of extra money by the bank in the middle of the game. Assets would go up in value, but rent and mortgage values would not change because they are set out on the Title Deed card for each property and can’t be changed.

In this new situation staying in Mayfair and Park Lane hotels had become very affordable because everyone had a lot of cash. The only people struggling were those that had bought too many properties at expensive prices, had less luck than others, and therefore less cash. When they sold their properties they still received inflated prices. 

What happens if the situation is reversed and the bank decides that it wants its money back again? Things would be very different: asset prices would fall, very quickly if the money was to be returned in one tranche, and players would no longer have a fat pile of cash as a cushion. Many would go bankrupt much faster, and these forced sellers would trade in their properties for distressed prices (or even the mortgage value), realising great losses.

The only thing that will save the game will be the discovery of another source of money to replace the money being withdrawn by the bank. What could do that? The plan is for it to be global economic growth but it needs to be a large number. Will enough be available when it is needed? Can we rely on Chance or Community Chest? No one knows.

While they may have some discretion, Trustees with assets and contracts need to have sufficient liquidity to meet their ongoing obligations.