A well-managed reserve fund is a vital component of any organisation’s sustainability strategy. Reserves provide a safety net to carry organisations through the lean times but they also, crucially, offer the breathing space to enable meaningful collaboration, planning and growth so that organisations deliver the best, most transformative solutions to South Africa’s challenges.

Alan Wellburn from Citadel Wealth Management explains.

Public benefit organisations have a duty to be responsible stewards of public funding and trust – this means managing their finances wisely.

Benefits

A reserve is the balance of the previous years’ operating surplus – or unspent funds.  Some organisations set aside a specific percentage of their operating costs for a reserve each month or year.

The benefits of a reserve include:

• Protecting beneficiaries by making sure they receive services provided by the organisation, regardless of changes in funding cycles or funding delays;
• Providing funders with assurance that the organisation has the capacity and financial health to make the best use of grants;
• Creating a safety net to protect the organisation in unforeseen circumstances, such as a major funder pulling out suddenly;
• Providing capital that can be used for future projects (e.g. building maintenance), borrowed against or used for the expansion of the organisation’s activities.

Everyone in an organisation – from the trustees and directors through to fundraisers and programme managers – should support the building up of a reserve. A Reserve Policy should clearly define how the reserve should be invested and how and when it can be used.

Myth-Busting

Myth: Having a reserve discourages funders because they think the organisation has enough funding and is not as needy.

Reality: Most major funders today prioritise the sustainability and impact of the organisations they support and prefer grantees to have a reserve. Many specifically look for organisations that have enough in reserve to cover at least three to six months’ operating costs.

Sources of Funding

Building up a reserve can be a challenge, particularly in tough economic times. Some funders would rather support beneficiaries directly than contribute to a reserve fund.

But there are other ways to build a reserve:
Operate at a small surplus each year and invest any of the surplus, rather than spend it in the following year. Although this requires a level of financial discipline, it is a strategy that pays dividends in the future.
Unrestricted funding such as legacies, bequests, individual giving and self-generated income are also good sources of funds for a reserve.
Investment income (interest or dividends) generated by investing larger grants until the funds are needed for project implementation is also a great source of reserve funding.

Myth Busting

Myth: It is more responsible to keep funds in the bank, rather than to risk it in an investment vehicle.

Reality: Funding not being used for immediate operating expenses that is kept in a bank account is losing value over time because the interest rate does not keep up with inflation – this is called inflationary risk. But investing in the stock market can also be a risk because value can fluctuate rapidly in the short term (volatility risk). An experienced investment house will be able to select an investment strategy that takes into account both of these risks so that surplus funds will grow over time and stay ahead of inflation.

Investing Reserve Funds

The directors or trustees of public benefit organisations have a fiduciary responsibility to ensure that reserves are invested wisely. An investment approach which takes into account both inflationary risk and volatility risk is essential. The examples below show how investment decisions can make a major difference to the size of a reserve over time.

Two organisations have R10 million in reserves and choose to invest it differently.

In the Bank:

Organisation A chooses an interest-bearing bank account. The interest on the R10 million (four percent) in an inflationary environment like South Africa, is less than inflation at six percent. After 25 years, this reserve is only worth R6m in real terms. In other words, the purchasing power of the R10m reserve will be eroded by inflation and will be reduced to R6m, despite the interest earned.

Modelling assumptions: Inflation rate: six percent; Interest rate at bank:  four percent

Diversified Portfolio:

Organisation B chooses a diversified, prudent investment portfolio. The return over a 25 year period is more, at nine percent, than the inflation rate of six percent. Based on a projection rate of three percent in excess of inflation, the value of their R10m reserve increases to R20m in real terms.

Modelling assumptions: Inflation rate: six percent; Projection rate: three percent in excess of inflation (nine percent nominal)

Managing a Reserve

It is important to get advice from a reputable wealth management company with the knowledge and expertise to implement the best investment solution for an organisation.

Cash-flow modelling is used to make sure an organisation has access to its capital if needed (short-term liquidity) as well as long-term growth (to stay ahead of inflation). Knowing what cash will be needed and when, the two major portfolio risks of inflation and volatility can be managed over time.

This is achieved by allocating the reserve fund to three broad risk categories or portfolios:

The Stable Portfolio – This is the part of the organisation’s portfolio where short-term funding needs will be drawn from. This portfolio is often made up of Money Market Unit Trust Funds as they are liquid and their value is stable; and is toped up from the best performing assets in the Prudent and Growth portfolios.

The Prudent Portfolio – This portion of the portfolio is the reserve fund safety net. Market movements and fluctuations have little effect on this type of portfolio. Should the long term growth portfolio decrease suddenly, this portfolio would allow enough time for a recovery before having to use funds from the Growth portfolio for the organisation’s operational needs.

The Long Term Growth Portfolio – This is invested for growth to make sure the reserve fund beats inflation over the long-term. This part of the portfolio is usually the most volatile but because it is invested over the long-term, this does not present a problem.

The next step is to allocate specific amounts to the underlying funds within each of these investment categories.

Whilst offshore diversification (investing some of the funds outside of South Africa) can have a very positive effect on a portfolio, the fluctuating value of the Rand (currency volatility) can have a significant effect on returns. Reducing currency risk through hedging, a technique to guard against foreign exchange fluctuations is a way that Wealth Managers manage this risk.

Endownments

An endowment is an established pool of assets (for example rented property, cash, shares, bonds) used to generate income to fund the operations of an organisation. This reduces the organisation’s dependency on donors.

Endowments are often established by bequests or restricted donations. In some circumstances, the donor will make a large grant and stipulate that it be invested, with the principal to remain intact in perpetuity or for a defined time period. The organisation can use the interest or dividends from the endowment to fund their operating costs while also keeping the original grant. This allows for the donation to have an impact over a longer period of time than if it were spent all at once.

Reserves can be used to create endowments. Once a reserve has been built to the required level, all income earned in excess of the reserve requirement and returns on investments in excess of inflation can be used to build an endowment.

Just like investing a reserve, it is important to get advice from a reputable wealth management company who has the capacity to choose the right investment solution for an endowment. Given the long-term nature, size and income-generating requirement of a typical endowment, the optimal investment solution can sometimes be more complex than that of a reserve.

Fees and Costs

All this wealth management expertise does not come for free and different investment solutions will have different costs and fees. Some wealth management businesses apply a fee based remuneration model for advisory, administration and fund management services, while others charge commission (a percentage of the funds under management). Registered public benefit organisations are sometimes offered discounted fees because of the charitable nature of their work.

All registered financial service providers are required by law to disclose all of these fees in a clear and understandable way. This means that an organisation can compare fees and be clear about what the investment will cost them.

Whether you are a new organisation just starting out or a large organisation with an established endowment, your Reserve and Endowment policy should be regularly revisited to make sure you are making the most of the funds you have. The investment solution you choose must be aligned with this policy and based on sound financial advice. This will ensure that these funds are optimally invested while minimising the organisation’s exposure to unnecessary risk.

To find out more about investing your reserve, contact: Citadel Wealth Management.

A well-managed reserve fund is a vital component of any organisation’s sustainability strategy. Reserves provide a safety net to carry organisations through the lean times but they also, crucially, offer the breathing space to enable meaningful collaboration, planning and growth so that organisations deliver the best, most transformative solutions to South Africa’s challenges.

Alan Wellburn from Citadel Wealth Management explains.

Public benefit organisations have a duty to be responsible stewards of public funding and trust – this means managing their finances wisely.

Benefits

A reserve is the balance of the previous years’ operating surplus – or unspent funds.  Some organisations set aside a specific percentage of their operating costs for a reserve each month or year.

The benefits of a reserve include:

• Protecting beneficiaries by making sure they receive services provided by the organisation, regardless of changes in funding cycles or funding delays;
• Providing funders with assurance that the organisation has the capacity and financial health to make the best use of grants;
• Creating a safety net to protect the organisation in unforeseen circumstances, such as a major funder pulling out suddenly;
• Providing capital that can be used for future projects (e.g. building maintenance), borrowed against or used for the expansion of the organisation’s activities.

Everyone in an organisation – from the trustees and directors through to fundraisers and programme managers – should support the building up of a reserve. A Reserve Policy should clearly define how the reserve should be invested and how and when it can be used.

Myth-Busting

Myth: Having a reserve discourages funders because they think the organisation has enough funding and is not as needy.

Reality: Most major funders today prioritise the sustainability and impact of the organisations they support and prefer grantees to have a reserve. Many specifically look for organisations that have enough in reserve to cover at least three to six months’ operating costs.

Sources of Funding

Building up a reserve can be a challenge, particularly in tough economic times. Some funders would rather support beneficiaries directly than contribute to a reserve fund.

But there are other ways to build a reserve:
Operate at a small surplus each year and invest any of the surplus, rather than spend it in the following year. Although this requires a level of financial discipline, it is a strategy that pays dividends in the future.
Unrestricted funding such as legacies, bequests, individual giving and self-generated income are also good sources of funds for a reserve.
Investment income (interest or dividends) generated by investing larger grants until the funds are needed for project implementation is also a great source of reserve funding.

Myth Busting

Myth: It is more responsible to keep funds in the bank, rather than to risk it in an investment vehicle.

Reality: Funding not being used for immediate operating expenses that is kept in a bank account is losing value over time because the interest rate does not keep up with inflation – this is called inflationary risk. But investing in the stock market can also be a risk because value can fluctuate rapidly in the short term (volatility risk). An experienced investment house will be able to select an investment strategy that takes into account both of these risks so that surplus funds will grow over time and stay ahead of inflation.

Investing Reserve Funds

The directors or trustees of public benefit organisations have a fiduciary responsibility to ensure that reserves are invested wisely. An investment approach which takes into account both inflationary risk and volatility risk is essential. The examples below show how investment decisions can make a major difference to the size of a reserve over time.

Two organisations have R10 million in reserves and choose to invest it differently.

In the Bank:

Organisation A chooses an interest-bearing bank account. The interest on the R10 million (four percent) in an inflationary environment like South Africa, is less than inflation at six percent. After 25 years, this reserve is only worth R6m in real terms. In other words, the purchasing power of the R10m reserve will be eroded by inflation and will be reduced to R6m, despite the interest earned.

Modelling assumptions: Inflation rate: six percent; Interest rate at bank:  four percent

Diversified Portfolio:

Organisation B chooses a diversified, prudent investment portfolio. The return over a 25 year period is more, at nine percent, than the inflation rate of six percent. Based on a projection rate of three percent in excess of inflation, the value of their R10m reserve increases to R20m in real terms.

Modelling assumptions: Inflation rate: six percent; Projection rate: three percent in excess of inflation (nine percent nominal)

Managing a Reserve

It is important to get advice from a reputable wealth management company with the knowledge and expertise to implement the best investment solution for an organisation.

Cash-flow modelling is used to make sure an organisation has access to its capital if needed (short-term liquidity) as well as long-term growth (to stay ahead of inflation). Knowing what cash will be needed and when, the two major portfolio risks of inflation and volatility can be managed over time.

This is achieved by allocating the reserve fund to three broad risk categories or portfolios:

The Stable Portfolio – This is the part of the organisation’s portfolio where short-term funding needs will be drawn from. This portfolio is often made up of Money Market Unit Trust Funds as they are liquid and their value is stable; and is toped up from the best performing assets in the Prudent and Growth portfolios.

The Prudent Portfolio – This portion of the portfolio is the reserve fund safety net. Market movements and fluctuations have little effect on this type of portfolio. Should the long term growth portfolio decrease suddenly, this portfolio would allow enough time for a recovery before having to use funds from the Growth portfolio for the organisation’s operational needs.

The Long Term Growth Portfolio – This is invested for growth to make sure the reserve fund beats inflation over the long-term. This part of the portfolio is usually the most volatile but because it is invested over the long-term, this does not present a problem.

The next step is to allocate specific amounts to the underlying funds within each of these investment categories.

Whilst offshore diversification (investing some of the funds outside of South Africa) can have a very positive effect on a portfolio, the fluctuating value of the Rand (currency volatility) can have a significant effect on returns. Reducing currency risk through hedging, a technique to guard against foreign exchange fluctuations is a way that Wealth Managers manage this risk.

Endownments

An endowment is an established pool of assets (for example rented property, cash, shares, bonds) used to generate income to fund the operations of an organisation. This reduces the organisation’s dependency on donors.

Endowments are often established by bequests or restricted donations. In some circumstances, the donor will make a large grant and stipulate that it be invested, with the principal to remain intact in perpetuity or for a defined time period. The organisation can use the interest or dividends from the endowment to fund their operating costs while also keeping the original grant. This allows for the donation to have an impact over a longer period of time than if it were spent all at once.

Reserves can be used to create endowments. Once a reserve has been built to the required level, all income earned in excess of the reserve requirement and returns on investments in excess of inflation can be used to build an endowment.

Just like investing a reserve, it is important to get advice from a reputable wealth management company who has the capacity to choose the right investment solution for an endowment. Given the long-term nature, size and income-generating requirement of a typical endowment, the optimal investment solution can sometimes be more complex than that of a reserve.

Fees and Costs

All this wealth management expertise does not come for free and different investment solutions will have different costs and fees. Some wealth management businesses apply a fee based remuneration model for advisory, administration and fund management services, while others charge commission (a percentage of the funds under management). Registered public benefit organisations are sometimes offered discounted fees because of the charitable nature of their work.

All registered financial service providers are required by law to disclose all of these fees in a clear and understandable way. This means that an organisation can compare fees and be clear about what the investment will cost them.

Whether you are a new organisation just starting out or a large organisation with an established endowment, your Reserve and Endowment policy should be regularly revisited to make sure you are making the most of the funds you have. The investment solution you choose must be aligned with this policy and based on sound financial advice. This will ensure that these funds are optimally invested while minimising the organisation’s exposure to unnecessary risk.

To find out more about investing your reserve, contact: Citadel Wealth Management.