For a nonprofit board or investment committee of a nonprofit, creating a sound investment policy and managing an investment portfolio with a fiduciary responsibility is complex and time-consuming. Without the proper attention or expertise, a 501(c)(3) nonprofit (or its board members) can run into legal issues or substandard investment results. However, with the appropriate advice and management, a nonprofit can create a successful investment plan that achieves its financial goals and grows the assets of the organization.
The Importance of an Investment Portfolio for a Nonprofit Organization
Like is true for individual investors, as the operating cash base of a nonprofit organization grows, there is increasing importance for the nonprofit to transition its cash to an investment portfolio. When an investment portfolio is implemented alongside fundraisers and other revenue sources, it can help nonprofits reach their financial goals more quickly and accomplish specific spending projects (e.g., fund a scholarship, construct a building, etc.). Additionally, it can set the nonprofit organization on the path to long-term operational viability.
Establishing an investment portfolio can also aid a nonprofit’s fundraising capabilities through noncash gifts. By opening a brokerage account, a nonprofit can receive investment securities (e.g., stocks, bonds, etc.) as charitable gifts. This is beneficial to both the nonprofit as well as potential donors, as it allows for tax-efficient charitable giving. To learn more about effective and tax-efficient planned giving strategies please click here.
Creating an IPS for a Nonprofit
Before any nonprofit organization attempts to establish an investment portfolio or begins to invest, it is imperative to first create an investment plan. A nonprofit’s investment plan is typically documented in an IPS. The nonprofit’s IPS serves as the investing framework for the organization, outlining the purpose of the nonprofit’s investment portfolio as well the objectives and unique characteristics of the organization regarding investing. The IPS provides a nonprofit organization, and in particular its board and/or investment committee, a clearly defined and documented road map to the organization’s investment plan, which can then be used to help construct an investment portfolio that aligns with the goals and objectives the organization has set out to achieve.
In its basic form, a nonprofit IPS should address the following items:
Before any nonprofit organization attempts to establish an investment portfolio or begins to invest, it is imperative to first create an investment plan. A nonprofit’s investment plan is typically documented in an IPS. The nonprofit’s IPS serves as the investing framework for the organization, outlining the purpose of the nonprofit’s investment portfolio as well the objectives and unique characteristics of the organization regarding investing. The IPS provides a nonprofit organization, and in particular its board and/or investment committee, a clearly defined and documented road map to the organization’s investment plan, which can then be used to help construct an investment portfolio that aligns with the goals and objectives the organization has set out to achieve.
In its basic form, a nonprofit IPS should address the following items:
Background of the organization
- A summary of the organization as well as the roles and responsibilities of the members of the organization held accountable for the oversight and management of the investment portfolio (e.g., board or investment/finance committee)
Investment considerations
- Investing time horizon
- Portfolio liquidity needs
- Regulatory and tax requirements
- Any other specific circ*mstances that are unique to the organization that may affect how the portfolio should be invested
Investment objectives and parameters
- Investment goals: Define the primary objective and any subsequent goals for the investment portfolio
- Risk/return objectives: Define the target long-term rate of return required to achieve the stated objectives of the organization as well as the potential risk required
Allowable asset classes and target asset allocation
- Set the parameters of available investments by defining the allowable asset classes for the portfolio
- Finally, considering all the above information in the IPS, notably the investment considerations and goals, construct a target asset allocation that aligns with the risk/return objectives. The target asset allocation for a nonprofit should outline the long-term, strategic weightings to each asset class as well as the allowable deviation ranges that will guide the investment of the portfolio
Portfolio measurement and reporting
- Determine the market benchmarks and/or develop a custom benchmark to be used for comparison purposes in order to measure the success of the investment portfolio over time
- Define the reporting standards and frequency of reporting that can be used to track the status and progress of the investment portfolio
For a nonprofit, an IPS provides additional significance because it is a portable and surviving document. Given the continual flux of board and/or investment committee members, a nonprofit’s investment policy statement is the constant that guides the long-term path of the investment portfolio. It also serves as a valuable resource for new board or investment committee members to clearly understand the purpose and structure of the organization’s investment portfolio.
However, as the nonprofit’s circ*mstances and needs changes, so too should the investment portfolio and the IPS. Therefore, it is imperative to periodically review the IPS to ensure that it aligns with the current and future objectives of the organization and to make timely updates if needed.
Opening and Funding a Nonprofit Brokerage Account
Once a sound investment plan has been created, the next step is to address the logistical aspect of managing an investment portfolio, which focuses on the opening and funding of a brokerage account. Setting up an investment account for a nonprofit is a bit different than a standard investment account that many individual investors are familiar with.
Considerations before opening a nonprofit brokerage account
When selecting a custodian to open a brokerage account, there are a few considerations that should go into the decision.
- Fees: Compare the different types and amount of fees the account would be subject to. This includes but is not limited to account maintenance fees, trading fees and money movement fees (e.g., wire transfers).
- Investment options: While most custodians offer a vast selection of securities and investment vehicles, their offerings do not include everything in the investment universe and each custodian will differ from one another. Make sure the custodian offers a wide variety of investment products, particularly those anticipated purchases.
- Customer service: Attempt to ascertain the level of customer service that will be provided. Additionally, understand the level of technological offerings the custodian offers. A technology-forward experience will likely ease the process of reporting, trading, downloading and completing paperwork, and moving money, etc.
Application process for a nonprofit brokerage account
To open a brokerage account at a custodian, a 501(c)(3) nonprofit will need to complete an organization/corporate account application. The account application will include basic information about the nonprofit as well as the personal information for the individuals who will act as authorized agents on the account. The authorized agents will need to be high-ranking members of the organization (i.e., president, executive director, etc.) and/or a member of the finance department (treasurer, chief financial officer, etc.). The authorized agents will be the only individuals granted access and allowed to make changes and transactions within the brokerage account.
Certain documents are needed to open a nonprofit account, in addition to the account application. A 501(c)(3) nonprofit will need to provide the custodian a copy of the following supplemental documents to prove its corporate and tax-exempt standing:
- Articles of incorporation
- 501(c)(3) determination letter for the Internal Revenue Service (IRS)
Funding a nonprofit brokerage account
After the nonprofit account has successfully been opened, the next step is to appropriately fund the account. For a nonprofit that is creating an investment portfolio, the source of funding will likely be cash or stock contributions. Cash can be transferred into the brokerage account by either an electronic transfer (ACH) or a wire. Setting up ACH transfers for the brokerage account is typically preferable, as this will link the brokerage account to the funding bank account, which can then be used to facilitate any future cash contributions or withdrawals. Similarly, the opening of a brokerage account creates the opportunity to receive donations of stock or other publicly traded securities. To make the security donation process as seamless as possible, it is best practice to develop gifting instructions to provide interested donors. These instructions should include the following information regarding the nonprofit brokerage account:
- Custodian of account
- Custodian’s Depository Trust Company clearing number
- Account name
- Account number
How Should Nonprofits Invest? Key Investment Considerations for Nonprofit Organizations
Every nonprofit is different and thus each organization’s investment objectives will differ. However, there are a few characteristics inherent to nonprofits that make them unique compared to an individual or taxable investor, which can alter how the nonprofit investment portfolio is managed. A few considerations for how nonprofits should invest are discussed ahead.
Time horizon: The investing time horizon is typically defined in a nonprofit’s IPS. A nonprofit’s time horizon may vary greatly from a traditional individual investor. While many individual investors are investing to save and fund for a specific, time-constrained goal such as retirement, nonprofits generally display a much longer time horizon and aspire to invest in perpetuity with no tangible end point. This dramatically changes a nonprofit’s investment approach.
Investing in perpetuity may sound abstract, but a long-term investment horizon produces a few valuable benefits. First, investing with a long-term perspective allows nonprofits the ability to take on more risk to achieve enhanced returns, as it makes them better able to weather short-term volatility or temporary market impairments. Additionally, with a long-term investment horizon, nonprofits are presented with a broader array of investment options and the opportunity to invest a portion of the portfolio in more illiquid, alternative investment strategies that have the potential to offer higher return potential than traditional investment products.1
Portfolio cash flows: While a nonprofit may aspire to invest in perpetuity, the portfolio’s time horizon may be shifted by the organization’s cash flows. For many nonprofits, the investment portfolio is the primary source of capital for their spending policy or large expenses (e.g., funding a scholarship, constructing a new building, etc.). On the other hand, a nonprofit’s investment portfolio can be aided by the inflow of fundraising efforts and charitable gifts. It is imperative for the nonprofit to project future cash flows both into and out of the portfolio, as these cash flows will have a material impact on the investing time horizon and consequently the risk level and asset allocation of the portfolio. For example, a nonprofit with adequate current year cash flows may invest the portfolio more aggressively for larger long-term returns.
Nonprofit tax-exempt status: Perhaps the most impactful investment characteristic of a nonprofit organization is its tax-exempt status. Given their status as a 501(c)(3) entity, nonprofits are provided an income tax exemption that applies to their investment portfolio. As a result, nonprofits invest as a tax-exempt entity without the burdens of realizing capital gains or ordinary income.
Not only does this tax-exempt status provide a significant tax savings and thus increase the overall return potential, but it also allows for more flexibility in the portfolio. The nonprofit can freely make changes to the portfolio’s asset allocation or underlying investments without the inhibition of tax implications (being required to pay capital gains tax if a certain investment is sold). It also eases the decision of which investments to sell when raising cash for liquidity needs (i.e., taking withdrawals from the portfolio).
Additionally, the status of nonprofits as a tax-exempt investor removes the barrier for nonprofits to consider investing in tax-inefficient investments. Tax-inefficient investments can include high-income strategies or funds that generate significant short-term capital gains, for which individuals are taxed at ordinary income rates that are above the tax rate for long-term capital gains. Relative to an individual or taxable entity, the barrier to investing in tax-inefficient investments is nonexistent for nonprofits, as this will not create any elevated tax liability. While a taxable investor must consider what the after-tax return of the investment opportunity is, a nonprofit should focus on the strategies with the most efficient gross return potential for a specified level of risk.
While investing as a tax-exempt entity provides significant benefits for nonprofits, it does mitigate the attractiveness of tax-advantaged investments, particularly municipal bonds. To encourage investment in states and local municipalities, the interest income paid by municipal bond issuers is exempt from federal income tax (as well as exempt from state income tax for those who are residents of the state in which they are issued). Thus, many taxable investors, specifically those in high-income tax brackets, allocate to municipal bonds to alleviate their overall tax burden. However, to counteract their tax-exempt status, municipal bonds have historically offered a discounted yield to comparable taxable bonds. Since nonprofits are tax-exempt entities, they do not receive any incremental benefits of a municipal bond’s tax-exempt income. Thus, nonprofits should avoid investing in municipal bonds in almost all circ*mstances, as more attractive yields can be found elsewhere in the fixed-income asset class with similar risk characteristics.
Additionally, it is critical that tax-exempt entities avoid investments that may be subject to unrelated business taxable income (UBTI). UBTI is defined as net income derived from any unrelated trade or business that is regularly carried on by any tax-exempt organization or tax-advantaged account.2 UBTI is typically generated from two main sources of income: 1) any pass-through income from an unrelated business (e.g., direct investment in limited partnerships), and 2) debt financed income (e.g., debt-financed real estate investments). If a tax-exempt entity recognizes more than $1,000 of UBTI in a given tax year, the organization is subject to income tax on that income and will be required to report it on IRS Form 990-T. Additionally, a nonprofit may lose its tax-exempt status if it is determined that the organization is deriving an excessive amount of income from unrelated businesses. The most common investments that generate UBTI are alternative investments exhibiting a pass-through limited partnership structure, such as master limited partnerships, private equity, private real estate funds and hedge funds.
Investing alongside the mission and values of the organization: Nonprofits provide immense assistance and welfare to society, guided by their stated mission and a defined set of values. Given the evolution of the investing landscape over the last decade, it is now possible to invest capital in accordance with those values and align the investment portfolio with the mission of the organization.
The emergence of sustainable, responsible and impact investment strategies can provide nonprofits the opportunity to achieve their financial goals while continuing to “do good” through their investment approach as well. SRI investing is a broad investing discipline and is inclusive of a wide array of investment approaches that balance both the social impact of the investment and the financial return potential. Below are the most commonly employed SRI investment strategies.
- Value alignment: The value-alignment approach attempts to remove some of the negative or socially destructive companies from an investment portfolio. The process is exclusionary in that it starts with an investment universe and attempts to screen out the negative options. Many investors express an aversion to investing in “sin stocks,” which are typically defined as companies involved in activities widely considered to be unethical or immoral such as tobacco, alcohol, gambling and weapons manufacturing. Meanwhile, other investors insist on excluding investments in specific countries from their asset allocations that are notorious for human rights violations or companies that have done environmental harm. The overarching investment goal is to maximize investment return while meeting socially responsible restrictions. The simplified, exclusionary nature of value-alignment investing makes it the most popular and widely available investment strategy within SRI investing. For many nonprofits, it provides the easiest and most efficient way to remove the worst social offenders that may contradict the mission and value of the nonprofit. Value-alignment strategies are offered across almost all asset classes and some strategies allow for customization to exclude specific industries or types of companies from the portfolio.
- Environment, social & governance (ESG) investing: ESG investing moves a step beyond value-alignment. ESG investing can be thought of as a value-alignment strategy with a more proactive approach to finding companies that positively align with the core philosophies of environmental, social and governance criteria. The environmental standard is self-evident. It covers a company’s environmental impact and focuses on issues such as carbon footprint, pollution, the use of renewable energy or sustainable workplace practices. Social issues are more closely tied to a company’s employee base and community, focusing on issues such as workforce diversity, fair wages, labor conditions and community involvement. Governance issues are tied to the treatment of shareholders, the independence and diversity of the board, transparency in accounting and political influence. When these core values are combined in the investment process, the ESG approach aims to target investment in companies that operate under positive environmental, social and governance standards and avoid those that score poorly.
- Thematic investing: The thematic approach to SRI investing allows investors to focus on a specific theme or industry. Thematic investment strategies are concentrated in highly impactful industries or themes and allow for a specific investment focus where an investor may be most interested. For a nonprofit, this can mean targeting investment strategies that acutely align with the organization’s mission or values. A common SRI theme is faith-based, but other themes include gender diversity and companies with women in leadership. Alternatively, these strategies can be focused within influential industries, such as renewable energy or water resources, which produce a tangible social or environmental impact. For many thematic or focused investment strategies, the financial return is balanced with the influence an investor can have on social impact.
- Impact investing: Impact investing provides financial capital to address social or environmental issues, with the primary purpose to create a direct and measurable social or environmental impact. The investment’s financial return is a secondary consideration. The concept of impact investing originated with microfinance loans, which are small loans made to low-income individuals who may not have access to capital through traditional means. Microloans allow these individuals to pursue a small business venture and generate sustainable income. However, impact investing has expanded well beyond microfinance loans and now ranges from investments to establish affordable housing to the development of sustainable food products to venture capital firms focused on minority-owned and operated start-ups. Given their priorities, impact investments are often more esoteric and unique in nature, but they also tend to be more illiquid investments and not offered in the public market.
The Benefits of Partnering With a Specialist Nonprofit Investment Advisor
Successfully managing a nonprofit investment portfolio is complex and time-consuming. Furthermore, it requires an investment sophistication and fiduciary responsibility that a nonprofit board or investment committee may not be fully qualified to undertake alone. As a result, it is recommended to partner with a nonprofit specialist investment advisor to help guide you through these steps and manage the investment portfolio on a day-to-day basis.
Below are some of the valuable benefits an investment advisor can provide a nonprofit investment committee or board:
Professional investment management and portfolio oversight: An investment advisor provides professional investment expertise to a nonprofit investment committee or board that may lack experience or sophistication to appropriately manage the organization’s investment assets. Additionally, as a third-party representative, the investment advisor can act as an unbiased and objective member during the portfolio decision-making process.
Expanded resources and investment opportunities: While a nonprofit may be constrained regarding the investment resources at its disposal, an investment advisor will have significant investment resources and research tools available to perform in-depth due diligence and investment analysis. Additionally, an investment advisor will likely be able to offer a larger opportunity set of investments (e.g., access to hedge funds, private equity strategies, etc.) due to their credibility within the investment industry and institutional status.
Share fiduciary responsibility and legal accountability: Nonprofits are generally required to manage their investment as prudent investors, creating a fiduciary responsibility for the nonprofit. An investment committee or board can satisfy its fiduciary responsibility by engaging with an investment advisor to guide portfolio management. Having an investment advisor manage the portfolio may deflect individual liability on board members who are making investment decisions for the nonprofit.
Saves time: By partnering with an investment advisor, the members of a nonprofit can relinquish the day-to-day responsibilities of investment management and concentrate their time and attention on the core mission and strategic direction of their organization.
Working with Cerity Partners to Manage a Nonprofit Investment Portfolio
At Cerity Partners, we have experience working with nonprofit organizations to optimize and manage their investment portfolios. We assist our clients by acting as an outsourced chief investment officer and partner with the organization to achieve all its investment and financial objectives.
Common issues we frequently advise nonprofits upon include:
- Creation/review of investment policy statement
- Opening and funding a brokerage account
- Cash flow management
- Gifting strategies and coordination
- Portfolio construction and investment management
- Investment research and due diligence
- Portfolio reporting and performance measurement
We believe our specialized expertise and high-touch service can offer tremendous value and peace of mind for nonprofits striving to achieve their investment goals. To learn more about our nonprofit offerings or to speak with an advisor about your particular situation, we encourage you to reach out to our team.
Footnotes:
1 To participate in many illiquid investment structures, investors may need to qualify as an Accredited Investor or Qualified Purchaser. These qualification parameters are defined by the Securities and Exchange Commission (SEC).
2 IRC § 512(a)(1). Pursuant to IRC § 511, applicable accounts include 501(c) entities (i.e., charitable entities, foundations), accounts under IRC § 401 (i.e., pensions, 401(k)s), and accounts under IRC § 408 (IRAs).
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