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Inflation risk for trustees

Finance | 27 Aug 2010

Trustees are responsible for protecting charity assets from inflation, argues Georgina Hand.

It would be difficult to argue that the stock market had been anything but tricky over the past ten years. If you had invested £100 in the FTSE 100 ten years ago, you would only have £77.89 in capital terms at the end of the last quarter.

Against what can only be described as a turbulent background, trustees could be forgiven for choosing to avoid investing in equities. Investors had only just recovered from the collapse of the technology boom when we were launched straight into the ‘credit crunch’ and the recession that followed. Even if you managed to avoid owning Enron and Lehman Brothers, fear has been compounded by panic that not only companies, but whole countries could fail. Economic concerns continue as the debate rages over whether or not we will experience a ‘double dip’ recession. Can charities be seen by their benefactors to be experiencing such volatility, or even more importantly, afford it?

So why not keep your charity’s assets safely in cash at a reputable high street bank? Well, two arguments immediately spring to mind: the Trustee Act 2000 requires trustees to seek investment advice and stresses that they have a clear duty to act in the best interests of beneficiaries. With interest rates at 0.5 per cent and the annual CPI inflation rate remaining stubbornly high at 3.2 per cent (and the arguably more reflective RPI rate of 5 per cent), there is a clear rationale that firstly, cash is not providing a return and more importantly, charity assets are being eroded by inflation over the long-term. Using these figures (RPI), £100 would effectively be worth the equivalent of £10 in 50 years’ time.

But perhaps more persuasive than both of these points is the total return (in other words, the capital appreciation of the equities with the dividends that they have paid reinvested) of the £100 you invested in equities over the last ten years. It would be worth £127.80. Suddenly equities seem more attractive.

A delicate balancing act

In this environment, trustees are forced to take on risk in order to create a return. The important point is getting the correct balance when examining the risk/reward ratio. And ignoring cash, most assets classes do carry risk. Even traditionally safe gilts: an investment in this market at the beginning of the 1970s would have led to a loss of 32 per cent in real terms by the end of the decade. Yet, in 2008, when share prices were tumbling, investing in gilts would have produced a near 13 per cent increase on a total return basis.

Whilst the rise in correlation of other asset classes (eg equities, property, corporate bonds, funds of hedge funds) was shocking to investors, it could also be argued that the circumstances were unusual. To an investment manager, diversification is the key.

By providing a charity with a diversified portfolio (combining a range of different asset classes and underlying investments), some of the risk of investing can be removed. In 2008, a simple portfolio comprising one-third UK equities, one-third gilts and one-third cash would have provided a return of 3.9 per cent. Not as dramatic as a 29.9 per cent loss if all assets were invested in the equity market.

Stripping out the income, the same portfolio falls 8.5 per cent in 2008 – and this is why income is so important: even if your charity does not need to spend income, it can be reinvested to help increase capital return rather than to waste away in a bank account. This is highlighted in the Barclays Capital Equity Gilt Study 2010: £100 invested in equities at the end of 1945 would now be worth £7,149 without reinvesting the income. If income had been reinvested, it would be worth £119,238. It is easy to see the importance of income. Furthermore, the effect of inflation on this number is staggering: the real return is reduced to £4,011.

Which brings me back to my earlier point: protecting charities’ assets against the ravages of inflation is a responsibility. One thing that the majority of charities do have is a long time horizon. Therefore it can be argued that some measure of risk is acceptable for the increased protection and reward. The exact ratio between the two needs to be discussed with, and understood by, your investment manager: no two charities are exactly the same and their aims, future goals and income requirements should be taken into consideration and reflected by their risk profile and their ultimate asset mix.

Recognisably, investment portfolios are not suitable for all charities but, as an alternative to cash depreciating in a bank account, they are certainly worth considering.

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