Is it time to consider a total return strategy?

Should charities adopt an income-only or total return strategy?

One of the key responsibilities of a charity’s trustees is to ensure the organisation has adequate financial resources to achieve its aims. In the past, many charities adopted an income-only approach for their investment strategy. This often led them down a path that allocated a large portion of their assets to UK equities, given the prevalence of companies paying high dividends in our domestic market. While this ‘income-only’ strategy provided a relatively stable level of income it did present a number of challenges.  

Legislative changes and evolving investment conditions have led some charities to take a more global approach in order to capture greater opportunity in recent times. Since global markets are not generally known for their dividend-paying policies, this means embracing a ‘total return’ approach – where an amount, comprising income and capital growth, is withdrawn from a charity’s portfolio to fund its activities. Although some charities are bound by their governing documents to an income-only strategy, it’s worth noting that it’s now much simpler to eliminate those restrictions and gain the freedom to invest more broadly.

Reviewing some of the advantages and disadvantages of both strategies helps explain why charities may want to consider moving from an income-only to a total return approach.

Pros and cons of an income-only approach

As well as providing a fairly stable level of cash flow for a charity, a very practical benefit of an income-only approach is that income arising from an investment portfolio, mainly from company dividends, is easily identifiable compared to capital appreciation. Another advantage is that income represents one of the more reliable measures for valuing an investment, providing evidence of the financial health of the company.  

On the flip side, an income-only approach may reduce the charity’s investment opportunity set. If your charity’s investment strategy is driven by income, it will naturally avoid fast-growing companies that reinvest their profits to capture future growth opportunities rather than distribute to shareholders through dividends. This could be unwise, since growth companies have tended to outperform those companies with high dividend-paying policies.  Furthermore, your portfolio will be leaning towards older, traditional sectors – some in structural decline – rather than more progressive sectors, such as technology, which is continually increasing its share of the equity universe.

Another disadvantage of an income-only approach is that it doesn’t benefit from any of the capital gains that might arise and, perhaps more importantly, ignores capital losses. Over the long term, income-only investors could miss out on real capital returns from equities.  

Finally, focusing too much on harvesting dividends might reduce portfolio capital growth potential. If trustees specify an income target that is unrealistically high, financial managers could be driven towards low-quality investments or are likely to select higher yielding equities, often associated with companies with poor prospects, or even worse, distressed assets and so inferior share price appreciation.

Pros and cons of a total return approach

The advantages listed above, with the exception of the ease of identification, also apply to the total return approach. Crucially, however, most of the disadvantages of income-only fall away.  

Due to its greater flexibility, a total return approach maximises a charity’s investment choices by giving it the broadest universe of potential investments and asset classes to choose from. What’s more, a slightly higher withdrawal rate may be possible as equities produce real capital returns over the long term. By stripping the bias towards high dividend-paying equities, your investment manager can also avoid the temptation to invest in companies with less impressive growth prospects.

As mentioned above, it’s not as straightforward to identify the returns with this approach, as it takes a little more attention to isolate and record the capital gains element. Moreover, there is the added complication of having to determine a sustainable withdrawal amount, and having to do so with a fluctuating portfolio value. This risk, however, can be mitigated by adopting a ‘smoothing’ policy, basing cash distribution on the average of your portfolio value over several years.

Finally, there is a risk that it might be necessary for trustees to sell investments at a time when the market is weak. This concern can be addressed by taking smaller, regular withdrawals as opposed to one yearly lump sum. Also, it’s worth remembering that income is still likely to be an important component of any charity’s total return strategy, minimising the impact of a potential fall in the markets.

What is a sustainable level of withdrawal?

Trustees often ask how much they can safely take out of their portfolio while preserving its real long-term value. Many studies have been conducted in this area and the consensus is around the 4-5% mark. However, no one size fits all, and the sustainable withdrawal rate should be calculated on the basis of the charity’s individual circumstances in discussion with your investment manager.  

Essentially, it comes down to the charity’s appetite for risk and ability to withstand volatility. A withdrawal rate of 5% (while maintaining or growing the capital value in real terms) which is common among the large, permanently endowed charities, requires a high level of investment in equities, which in turn carries a high level of risk that is not suitable for all. More mainstream charities are unlikely to have the same risk tolerance and might choose to settle on a lower withdrawal rate.

A complex field needs a tailored approach

An income-only investment strategy has served many charities well for centuries. However, with changing market conditions and the removal of investment restrictions, trustees now have the opportunity to access a wider range of investments as part of a total return strategy. This could give them greater flexibility and the potential for higher withdrawals.

At Rathbones, we take a step-by-step approach to help trustees choose the best strategy for their charity.  

For more detailed information, download our guide ‘Income-only or total return investing’. If you would like to speak to us about your investment needs, please contact your Rathbones investment manager or visit our contact us page.