The impact of inflation for foundations

We see a foundation paradox in Canada. The large majority of foundations with assets of more than $1 million are set up to achieve long-term objectives, such as contributing to education, health care or community development. Yet, based on our analysis of over 2,500 private foundations in Ontario, about one in three foundations mostly hold cash, Treasury bills or other short-term investments, while two in three foundations mostly hold long-term investments such as stocks and bonds. If foundations are set up for the long term, why are so many investing for the short term?

Reasons and feelings for holding cash

Cash is a short-term asset, typically matched to short-term liabilities. There are two main reasons for foundations to hold a significant level of cash:

  • The foundation receives and disburses funds on a current-year basis (some corporate foundations fall under this category).
  • The foundation is in the process of winding down and intends to disburse all of its funds in the next few years.

With about 35% of foundations mostly holding cash, we estimate that the above reasons account for about 10% of the total, still leaving about 25% of foundations holding cash, less for reasons than feelings. These feelings are valid and can reflect important truths about financial markets:

  • Greater familiarity with private companies, which are often the source of a foundation’s assets.
  • Healthy scepticism of public markets after the global financial crisis of 2008 and the dot-com collapse of 2000.
  • Well-founded belief that many investment managers do not reliably add value.

Required versus expected returns

Given modest expected returns for cash and bonds over the next decade, risk-averse foundations are likely to experience a funding gap between their required return and expected return:

Required return     Expected return  
Disbursements 3.5%   Cash (3% x 0.5) 1.5%
Inflation 2.0%   Bonds (4% x 0.5) 2.0%
Required return 5.5%   Expected return 3.5%

Expected return is based on a conservative portfolio, split equally between cash and bonds. Expected return for cash is just under 3%, which at half of the portfolio is 1.5%; expected return for bonds is just under 4%, which at half of the portfolio is 2%. Estimates for cash, bonds and inflation are from the Financial Planning Standards Council, projection assumption guidelines for 2017.

Mind the gap

While foundations have a required return of 5.5% to cover disbursements and inflation, their expected return from cash and bonds is only 3.5% – a funding gap of 2%. Below is what a funding gap of 2% looks like over the long term:

Starting amount After 10 years After 20 years After 30 years
$10 million $8.2 million $6.7 million $5.5 million

Cash-rich Canadian foundations have two principled options to address the funding gap:

The first option is to maintain the current risk tolerance. This offers a high likelihood of losing funding power over the long term, together with a high likelihood of preserving capital in even the worst year.

The second option is to adjust the risk tolerance (remaining similarly able to take risk but becoming more willing, perhaps with a different approach to setting the asset mix or managing risk). This offers a fair likelihood of losing a moderate amount in a bad year, together with a fair likelihood of preserving funding power over the long term.

From the perspective of the next generation, which one sounds better to you?