Many Foundations and Endowments Underestimate Investment Risk

Despite investing towards return goals in the 5% to 8% range, many endowments and foundations surveyed by CAPTRUST say they are unwilling or unable to withstand significant volatility.

Late in 2018, CAPTRUST conducted and published its first annual Endowment and Foundation Survey. Leading the research effort were Grant Verhaeghe, senior director and asset-liability practice leader, and Eric Bailey, principal and financial advisor.

The analysis considers some 150 responses to a detailed survey, according to CAPTRUST. More than 70% of survey respondents report investable assets below $50 million, while 63% of respondents identified their organizational mission as charitable. The most prevalent philanthropic missions of the charitable-focused organizations tie into health and social issues. Nearly half (46%) of survey respondents represented public nonprofits, with the majority of those representing organizations supported through public donations.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Survey results show a significant amount of diversity in the ways endowments and foundations conduct their long-term investing and shorter-term fiscal management, with some areas of broad consensus. For their investment portfolios, more than 72% of organizations report return expectations in the 5% to 8% range, and more than 10% of respondents expressed return expectations of greater than 8%. When asked how they define investment objectives, more than 75% of respondents selected “benchmark relative” as their choice. “Absolute return” was the least prevalent answer, the survey shows.

Notably, survey data shows 44% of respondents said they were only willing to lose up to 5% of their portfolio values, and 56% were willing to lose 5% or greater to accomplish their return objective.

“There was a clear disconnect between respondents’ willingness to experience short-term losses and their stated return objectives,” Verhaeghe and Bailey warn. “Additionally, most respondents, based on their reported asset allocation, would have historically experienced losses far greater than the expressed willingness to experience loss.”

Another sign of a disconnected cited by CAPTRUST’s survey report is that the asset allocations reported by respondents varied widely and were not necessarily tied to stated return and risk objectives.

“In fact, the most conservative responses with respect to willingness to experience loss had more aggressive asset allocations compared to those with more moderate risk tolerance,” the report states.

According to the CAPTRUST survey, domestic equity was the most frequently cited asset class where respondents identified a passive indexed allocation, with more than 74% of respondents who answered the question indexing the asset class. Over 56% of respondents who answered the question have at least some allocation to a passive investment strategy for fixed income, the survey shows.

“The distribution of the allocation between active and passive for organizations that answered the question suggests that endowments and foundations have a bias toward active management,” the report concludes. “However, there were instances where organizations maintained a 100% indexed investment structure, and there was a slight lean towards increasing index exposure for those who indicated a likely action to change their current approach.”

Asked for their thoughts about using environmental, social and governance (ESG) investing themes, more than 34% of respondents who answered the question indicated they were undecided about whether to decrease, maintain or increase such allocations. Nearly half (49%) of organizations indicated that they have not seriously considered allocating to ESG when asked for the biggest obstacle they see to such investing. More than half (56%) of respondents indicated that ESG factors were built on positive identification as opposed to negative screening.

According to CAPTRUST, most respondents have formal documented investment policies, spending policies, conflict-of-interest policies, and documented responsibilities for committees/boards.

“However, 12% of respondents do not maintain a formal spending policy, and 55% of respondents maintain their spending policies separate from their investment policies,” the survey report says. “Only 46% of respondents indicated an overlap between the committees responsible for overseeing spending and investments. These trends suggest there is room for improved communication on spending policy relative to investment results. There appear to be opportunities for board-level investment and fiduciary training as well as new board member orientation.”

Other results show 80% of respondents utilize mutual funds, while less than half of respondents utilize separately managed accounts or individual securities. Use of collective trusts or limited partnerships were below 30% of responses.

“Organizations with less than $25 million were just a likely as those with more than $100 million to utilize mutual funds, dispelling the notion that mutual funds are oriented towards smaller, retail investors,” the report concludes.

When asked in an open-ended manner what their most pressing single challenge is, only “a few” organizations cited portfolio growth and investment returns relative to spending needs.

The full survey report is available for download here.

Winning by Default

George White, from Custodia Financial, discusses how the IRS’ new distribution code for retirement plan loan defaults could help inform the retirement industry.

Many people were caught off guard last summer when the IRS announced a change to Form 1099-R, the tax form used to report distributions from retirement plans and pensions. After all, the government is not known for acting fast. Yet the IRS added a new distribution code to signify a loan offset after a participant loan defaults due to job separation or termination of the plan.

The IRS knows that loan defaults and the resulting loan offsets most often occur after separation[1] and that these amounts, estimated at $6 billion more than five years ago, are not separately reported today. How is it that billions of dollars can go unreported at a time when no number seems too small to be scrutinized?

Never miss a story — sign up for PLANSPONSOR newsletters to keep up on the latest retirement plan benefits news.

While loan offsets are, technically, reported, they are lumped together with other types of distributions and reported as general benefit payments on Form 5500, so policymakers don’t know how big the problem is or who it affects the most. It can even be difficult for plan sponsors to see their own default information. As Ned Johnson, former chairman of Fidelity Investments once said, “You can’t manage what you can’t measure.” Hence the need for a new distribution code.

Loan default leakage diminishes retirement outcomes

What’s more, loan defaults act as a catalyst for other losses or “leakage”—the early payment of retirement plan assets intended for, well, retirement. By failing to repay a loan, the plan participant forfeits the future investment earnings those dollars would have gained over as much as decades of compounding. Add in the acceleration of federal and state income taxes and penalty taxes, and a defaulting borrower stands to lose up to four times—i.e., 400%—of the original investment.

With the average loan for an uncovered medical emergency at $7,800, that translates to a large gap at retirement. Furthermore, participants often elect to withdraw their entire account balance the following year to pay those taxes and fare much worse. According to a recent study by Deloitte[2], these workers can lose up to $300,000 in future retirement value—effectively returning to the starting point as far as saving for retirement.

Sure, it’s their money—but it could have been so much more

When you hear someone say, “It’s their money,” it’s likely that person has not looked at the problem through this lens. True, the $7,800 loan represents assets the employee had already saved. But what about the rest of the loss? The government is happy; it received an early payment. In fact, the government gets extra money due to the penalty taxes most defaulters owe.  Unfortunately, the investment gains belong to no one because that money was never earned.  As Jimmy Stewart’s character reminded us in “It’s a Wonderful Life,” money that is never invested never has a chance to earn anything.

The G-Men are coming

Back in Washington, D.C., the IRS is torn. The U.S. government consistently runs big deficits, so it likes collecting money early when it can. Besides, why shouldn’t it be entitled to a free 10% once in a while—the amount most defaulting participants have to pay? But government leaders are also worried—worried that American workers won’t have enough money to live on when they do retire and that maybe this whole 401(k) “experiment” won’t work out. So they are taking action.

Even before the revisions to Form 1099-R were enacted last year, Congress added a provision to the 2017 Tax Cuts and Jobs Act (TCJA) that extends the time participants have to roll over a previously defaulted loan into another qualified plan or individual retirement account (IRA) from 60 days to the date they file the following year’s tax return.

Will it work? Nobody knows, but most practitioners shrug and think not much will change. They feel that the average participant, aside from not understanding the law or how it applies to them, simply won’t have the money to contribute or they wouldn’t have borrowed in the first place. Some experts have even voiced concern about how the IRS might use the new data it collects.

Plan sponsor worries—and a new solution

The government is turning its attention toward the problem of loan defaults in workplace retirement plans. But are retirement industry stakeholders—a web of recordkeepers, investment managers, consultants and the plan sponsors that hire them—getting the message? Some providers seem satisfied with efforts that promote restricting access to loans. But, after seeing those ideas fail to meaningfully affect loan volumes or reduce defaults, many plan sponsors are unsure what to do.

One solution now available to plan sponsors is an evolving program that prevents defaults in the first place: loan insurance. Loan insurance will automatically protect participants’ loans when they borrow from a 401(k) plan, keeping the borrower on track through timely financial counseling and payment assistance, and, most importantly, repaying the loan if a participant remains unemployed for an extended period after losing a job. For today’s plan sponsors and the people they employ, that turns a loss into a win.

George White is chief operations officer at Custodia Financial. He has worked with institutional retirement programs for more than 25 years, including as an executive at Fidelity Investments and Newport Group.  

 

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.

[1]Timothy (Jun) Lu, et al., “Borrowing From the Future: 401(k) Plan Loans and Loan Defaults,” National Tax Journal (March 2017)

[2]Loan Leakage: How can we keep loan defaults from draining $2 trillion from America’s 401(k) accounts?” Deloitte (October 2018)

«