Find out how a charity can generate income to pay their annual running costs and how we achieve this objective through a lower/medium risk approach.

What is a realistic level of income from a charity’s investments?

The Trustees of the Charity had set a requirement for a return of 5% from its investments in order to meet the annual running costs of the Charity; and had indicated that this should be from income.

To pursue an income yield of 5% the Charity would have to invest almost entirely in equities as well as infrastructure and property, which would result in the portfolio being classified as medium-high risk.

Within the equity element the focus would be on high yielding equities which sometimes may lead a portfolio to be significantly biased towards specific sectors as well as the concern as to how sustainable the dividend income is. Below are the forecast top ten highest yielding stocks in the FTSE 100 in 2017 – none of these companies have dividend cover of more than 2 times. (Dividend cover is the amount of profit a company makes divided by the dividend it pays out to shareholders).


What is the right risk profile for the charity?

The Trustees had stated that they felt that a medium-high risk portfolio was not the right course of action and they felt more comfortable with a lower to medium risk portfolio. A lower-medium risk portfolio at Quilter Cheviot has the following attributes:

  • Asset allocation: Typical equity weighting up to 50%
  • Estimated range of annualised return: Between -3% and +15%
  • Investment period: Suggested minimum of 3 years
  • Estimated peak-to-trough decline: Around -20% over the investment period

What is the right risk profile for the charity?

Within a lower-medium risk portfolio a maximum of 50% may be allocated to equities … and a reasonable portion of the portfolio will be invested in government and high quality corporate bonds, as well as alternatives in the form of specialist (e.g. GP surgeries, retail warehouses, student accommodation) property and infrastructure. The difficulty being that apart from equities, the estimated nominal (i.e. before inflation) returns from these asset classes are all below 5% per annum (even on a total return basis) so if a lower/medium risk approach is adopted the expected total return of capital and income would be in the region of 4-4.5%.

Government and high quality corporate bonds are at historically low yields and they have an integral role in managing the perceived risk within a portfolio. Lower/medium risk doesn’t work given the expected returns from bonds.


What has changed?

Historically when government bonds and cash yielded a much higher level of income (remember 5% interest rates on instantly accessible cash?) it was possible to construct a portfolio to generate 5%, within a lower risk profile as you were able to allocate more to bonds. However as seen by the estimated nominal returns above, this is no longer possible and therefore a medium risk approach has to be adopted in order to generate the required return.

What is the right income target and risk profile?

The Trustees discussed the charity’s risk profile and felt that they whilst they could not accept a medium-high risk profile; they accepted that investing on a lower-medium risk profile would not achieve their aims. We then discussed with them whether a return of 5% purely from income was really their requirement. After much discussion it was agreed that the Trustees would accept a total return of 5% and that whilst historically the requirement had been for this to be generated from income, they accepted that given the current environment and their risk profile this target was not possible. The issue remained that by withdrawing 5% per annum from the portfolio there would be (based on estimated nominal returns) limited opportunity for maintaining the real value of the capital over the long term.

What was the decision?

We agreed a medium risk profile that aimed to generate inflation (as measured by CPI and assumed to the Bank of England target rate of 2%) plus 3.5% annualised over the long term. Within this, c. 3-3.5% would be generated in income and any additional requirement for funds from the portfolio would be met from capital. We also agreed to work closely with the Charity on monitoring cash-flow and to discuss at appropriate points whether the Charity should draw down capital to meet future funding shortfalls. Within a medium risk framework we would have a maximum allocation of 75% to equities, and would also hold fixed income and alternative. Within the latter category we focus on infrastructure and specialist property, both of which generate attractive (c. 4-6%) income yields, however in some cases the income return represents an overwhelming proportion of total return, and therefore the ability to maintain the capital value of the portfolio in real terms (i.e. keep pace with inflation) means that whilst on paper these investments may look like the perfect solution, they work best in conjunction with other assets which have capital growth characteristics.

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