Could your charity benefit from taking a ‘total return’ approach?

Trustees face a balancing act to ensure they generate sufficient income for current beneficiaries, while growing income over time so that future beneficiaries have the same spending power, after the effects of inflation.

In the past, a charity with permanently endowed capital was restricted to only being able to spend its income. This put it at a disadvantage to unrestricted charities, where trustees had the flexibility to spend both the income and capital.

From a legal perspective, Section 4 of the Trusts (Capital and Income) Act 2013 [1] amended the Charities Act 2011 to give permanently endowed charities the power to adopt a total return approach to investment, while preserving a charity’s permanent endowment. In addition to spending income, trustees can spend some of the capital gains provided the initial capital value rises with inflation over the long term.

Embracing a total return approach to investing allows for a more diversified portfolio with less dependence on income-generating assets and potentially better overall performance, while giving trustees more flexibility as to how they meet their long-term spending requirements. This approach does not automatically skew a portfolio into low-yielding assets, but it provides the flexibility to invest in them.

Why choose a total return strategy?

Our experience in the sector tells us that an investment portfolio invested over multiple decades which had only spent its natural income would have likely generated excess capital. Moreover, most projections of total returns by fund managers and consultants suggest a ‘real’ return (after inflation) in excess of the income yield is likely. Consequently, many trustees opt to adopt a total return withdrawal or spending policy, recognising that the level of withdrawals required to meet  the needs of both current and future beneficiaries often exceeds the income generated.

In our view, a total return spending policy will almost certainly be necessary if the charity's investment portfolio has a large allocation to international equities, private equity, commodities, or other asset classes where the lower level – or absence – of dividend distributions means that income yields are a small or negligible part of the overall total return.

Long-term charity portfolios in our experience typically yield around 2% – 2.5%. That said, there are a variety of styles: some may yield only 1.5%, while others could yield 3.5% to 4%, depending on the investment philosophy, tactical approach, and methods employed by each investment manager.

Ultimately, the extent to which capital can be spent beyond the natural income stream will depend on the total return generated by the portfolio and the proportion of that return made up of natural income.

For example, a portfolio may generate an expendable return of 4% per annum (after inflation and costs). But, if invested in-line with market averages, may only yield 2.5% in income.

• A total return investor could top up the 2.5% income, with 1.5% of capital.
• A permanently endowed charity not taking a total return approach, either has to generate a yield premium, such that the same asset mix yields 4% (taking on more concentration risk) or be satisfied to spend less on current beneficiaries.

If trustees choose to adopt a total return approach to spending before a capital buffer has been built up, they will need to fully understand 1) the absolute return that is likely
to be achieved from their portfolio; 2) the expendable return that might be delivered after taking account of inflation and investment management costs; and 3) how the natural income will relate to the expendable return.

What is the correct spending level?

There is no definitive answer, as it depends on a range of factors. A portfolio’s asset allocation plays a key role in determining its long-term return, and historic trends show that higher levels of risk typically result in higher potential returns [2]. Therefore, a portfolio with a sufficiently long investment horizon and the capacity to handle risk (or short-term volatility) should be able to support higher spending than a portfolio with a larger allocation to more defensive assets.

Another important consideration is inflation. The higher the inflation rate, the more capital must be reserved for the future, which in turn reduces the amount available
for spending today. While global inflation has fallen from the heights of 2022, central banks remain cautious about cutting interest rates too quickly, given the persistence
of inflationary pressures. In the UK, the headline Consumer Prices Index of inflation, came in at 2.6% in March, still above the Bank of England’s 2% target [3].

The premise behind adopting a total return policy is that it allows for the spending of some capital gains, in addition to the natural income flow. However, this has not always
been the case. There have been periods in history when a portfolio's income exceeded its real return, and during such times, it would have been prudent to reinvest some of that income.

Figure 1, taken from Sarasin’s Compendium of Investment, illustrates the income yield on a typical endowment portfolio with a long-term spending level of 4% [4]. It shows that there are periods when reinvesting some of the income is necessary (such as in the 1960s, 70s, and 80s), and other times – like the current period – when it is necessary to spend some of the excess capital in order to maintain the desired spending levels.

Figure 2 shows the returns produced by the same endowment model in each decade since 1900 from an absolute, real, and expendable (after costs) basis. It also shows the income yield that such a portfolio might have produced during each decade. It shows that there have been three decades when spending any element of the return would have resulted in a reduction in the real value of the assets over the decade: the 1910s, the 1970s, and 2000s.

In the 1900s, 1930s, 1940s, and 1960s, the average expendable return was about 2.4% per annum, which was typically lower than the income generated by the portfolio's natural asset allocation, requiring reinvestment of a portion of the income to maintain the real value of the portfolio. In contrast, during the 1920s, 1950s, 1980s, 1990s, and 2010s, the average expendable return was approximately 8.6% per annum, allowing for an additional 4% or so to be withdrawn from the portfolio’s capital, beyond the income generated.

What this exercise draws out is a pattern of distinct feasts and famines. While it is interesting to note the discrete experience within each decade, it is also worth considering the experience of those who stayed invested through multiple cycles.

Taking the violent swings in markets, which are exacerbated by spending plans, we would make the following observations in terms of how this historic data can help us navigate the future. As other studies have shown, no formulaic spending plan guarantees success. You cannot assure year-on-year growth in expenditure in either absolute or real terms, nor can a formulaic spending model avoid overspending in a downturn.

This is the case whether one withdraws:

• just the natural income generated by the portfolio.
• an initial sum which is increased by inflation each year.
• a fixed percentage of the year-end capital value of the portfolio.
• a fixed percentage of the three or five-year rolling average year end capital value.
• any combination of the above.

We would recommend that investors operate a model for spending that is in keeping with the absolute and real returns they expect their asset mix to generate over the medium

to longer term. However, we would warn against applying such a model too rigidly, regularly reviewing the impact of withdrawals, fees, inflation and market returns on the real capital value of the portfolio. Moreover, given the volatility of markets, there will surely be moments when investors will need to hold their nerve and persevere. Markets have a strong self-righting mechanism and it can be seen that spending 3.5% to 4.5% per annum has, over the longer term, allowed investors to maintain the real value of their capital.

Delivering discipline

There is little doubt that adopting a total return policy provides charity investors with greater freedom and the ability to invest more widely in lower-yielding asset classes. While it might be easiest to have your investment manager take control of your spending policy, we would suggest that this is something that should be owned by trustees. On
balance, we believe that a total return approach will yield better overall results. Please do get in touch with a member of our Charities team if you wish to discuss your options.

[1] www.legislation.gov.uk/ukpga/2013/1#
[2] www.fca.org.uk/investsmart/risk-returns
[3] www.ons.gov.uk/economy/inflationandpriceindices/bulletins/
consumerpriceinflation/march2025
[4] https://sarasinandpartners.com/compendium/

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