Why Non-Profit Boards MUST Reduce Investment Costs and How They Can Do It

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1 Why Non-Profit Boards MUST Reduce Investment Costs and How They Can Do It by Craig D. Price, CFP and Will Thompson, CFP, CFA Abstract: This white paper demonstrates the dramatic impact of investment fees on non-profit organizations budgets and endowments. To support board members who serve non-profits in their financial fiduciary duty, six specific opportunities for fee savings are presented. Non-profit organizations, foundations and endowments may reduce their annual investment costs by as much as 50% employing the recommendations of this paper, resulting in substantial financial benefits. Too many successful, high-impact non-profits pay high fees to manage their investment portfolios. In our twenty years of work with non-profit boards, we find that once all hidden costs and expenses are truly identified, total investment management fees of % per year are commonplace. This is especially true for the large segment of non-profits, foundations and endowments with investments of less than $25 million. In contrast, the Council on Foundation s 2014 national survey of 184 private and community foundations with under $500 million reported the average cost of managing investment programs was 0.72% to 0.79% per year. This fee range represents a benchmark which non-profit boards and investment committees should strive to attain for their own investment portfolios. Board members who supervise their organization s investments may be skeptical that their portfolio pays high fees. However, that skepticism is frequently unfounded because many fees are not adequately disclosed or easily identified on account statements. Following a rigorous review, a non-profit board may learn it is paying as many as six distinct investment fees. The specific types are: 1. Custodial fees 2. Commissions or brokerage fees 3. Wrap fees 4. Investment consultant fees 5. Product-level fees or manager fees 6. Incentive fees Without monitoring, each of these fees can eat away at a non-profit s investment returns, resulting in more time fundraising and less time spent on the mission. Below, we define each fee type, and recommend strategies to lower an organization s investment costs by as much as 50%. We illustrate how fee reductions can dramatically impact a non-profit s annual operating budget.

2 2 Fees Are a Drag, Man Consider two hypothetical non-profits each with a $5,000,000 portfolio. The portfolios grow 7% per year before fees are deducted, and each distributes a 4% payment at the start of each year to support the nonprofit s operating budget. It is noted that private foundations must distribute 5% annually. However, in today s low return environment, we observe that non-profits other than private foundations have reduced their spending policy to a typical withdrawal rate of 4-4.5%. Figure 1 illustrates the financial impact caused by a 1.5% annual investment cost. For comparison, Figure 2 illustrates the lesser impact caused by a 0.75% fee which is in the Council on Foundation s benchmark range. Both Figures 1 and 2 show the cumulative effect of the different fees at 5-, 10-, and 20-year intervals. YEAR Figure 1, $5,000,000 Portfolio with a 1.5% Investment Cost FIRST YEAR 5 YEARS 10 YEARS 20 YEARS Value $5,000,000 $5,284,893 $5,663,943 $6,505,554 CUMULIVE TOTAL 7% Growth $350,000 $369,942 $396,476 $455,389 $8,010,138 Minus 1.5% in Fees $(80,250) $(84,823) $(90,906) $(104,414) $(1,836,610) Minus 4% Withdrawal $(200,000) $(211,396) $(226,558) $(260,222) $(4,577,222) Ending Value $5,069,750 $5,358,617 $5,742,955 $6,596,306 Over twenty years, the non-profit paying 1.5% a year spends a staggering $1,836,610 on investment management. Over that time, the distributions total $4,577,222. In other words, the board spends $1,836,610 in investment fees to earn $4,577,222 for its operating budget. YEAR Figure 2, $5,000,000 Portfolio with a 0.75% Investment Cost FIRST YEAR 5 YEARS 10 YEARS 20 YEARS Value $5,000,000 $5,454,200 $6,080,404 $7,556,752 CUMULIVE TOTAL 7% Growth $350,000 $381,794 $425,628 $528,973 $8,673,348 Minus 0.75% in Fees $(40,125) $(43,770) $(48,795) $(60,643) $(994,337) Minus 4% Withdrawal $(200,000) $(218,168) $(243,216) $(302,270) $(4,956,199) Ending Value $5,109,875 $5,574,056 $6,214,021 $7,722,812

3 The long term benefit of the lower fee scenario is eye-opening. The 0.75% benchmark fee portfolio generates $378,977 more budgetary support for annual operations and leaves $1,126,506 more for its endowment over twenty years. 3 Figure 3, Fees are a Drag $8,000,000 $7,500,000 $7,000, % Fee 0.75% Fee $1,126,506 difference $6,500,000 $6,000,000 $5,500,000 $5,000,000 1 Year 5 Years 10 Years 20 Years The total economic benefit of the lower fee is a striking $1,505,483 over twenty years. However, the benefit of the lower fee is much more than financial. The board of directors should consider the substantial effort and time that would have been expended by staff to raise the same $1,505,483 from its donors. The profound financial benefit of lower fees may allow an executive director to reallocate staff and volunteer priorities away from fundraising toward essential programs. Figure 4, Benefit of Lower Fee Over Twenty Years ANNUAL INVESTMENT COST IN % TERMS 20 YRS OF 4% PMT TO FUND OPERIONS ENDING VALUE OF PORTFOLIO IN 20 YRS ALL PAYMENTS PLUS ENDING VALUE Low Fee 0.75% $4,956,199 $7,722,812 $12,679,011 Full Fee 1.50% $4,577,222 $6,596,306 $11,173,528 Difference 0.75% $ 378,977 $1,126,506 $ 1,505,483

4 4 How To Reduce Annual Investment Costs 50% To lower fees, the board must understand the fundamental nature of the relationship between its financial adviser and the organization. If the organization s adviser is professionally licensed under the Investment Advisor s Act of 1940, the adviser is a fiduciary who legally owes a duty to act in the client s best interest. On the other hand, if the adviser is licensed under the regulatory body called FINRA, the adviser is a broker whose duty is only to recommend suitable investments, but not necessarily ones that are in the client s best interest. Whether a non-profit s financial adviser is a fiduciary or not can significantly impact the investment recommendations and fees borne by organization. For the board to uphold its own fiduciary duty to the organization, it must be informed about financial matters, including investment costs. To help in this regard, the board must understand that there are six expense layers that may contribute to the cumulative investment cost. Implementing the recommendations below, the board may potentially reduce annual investment expenses by 50% or more. 1. Custodial Fees A custodial fee is payment for safekeeping of financial assets and producing periodic statements. There are many financial firms which provide custodial services for % a year. If the firm that provides investment custody is also the brokerage firm which executes trades for the organization s portfolio, the custodial fee may be waived in lieu of commission revenue. If your organization is paying custodial fees, investigate whether the fee is competitive by comparing among institutions in your part of the country. 2. Commissions A commission is the brokerage fee charged to buy or sell an individual security like a stock or bond. The rise of discount brokerage firms has driven down the cost of commissions by over 95% in the last thirty years. Today, competition among low cost brokerages like Charles Schwab, Fidelity, TD Ameritrade, and Interactive Brokers has driven transactions below $10 per trade, often regardless of transaction size. However, non-profits which execute trades through a national full service brokerage firm like Merrill Lynch, UBS, Morgan Stanley or Wells Fargo Advisers typically pay commissions of $ per trade. Full-service brokerage firms frequently financially penalize brokers who offer clients discounted trades through a policy known as discount sharing. The widespread policy creates a material conflict of interest between a client s best interests and the broker s best interests by reducing the compensation of brokers who offer discounted trades. Discount sharing financially rewards the broker who does not offer discounted commissions. Some full-service brokerage firms go so far as to pay their brokers no compensation at all for any client s commission of $100 or less. High commissions and the conflicts of interest from discount sharing policy make full-service brokerage firms a smart target for lowering investment costs. By moving the non-profit s investment accounts to a low cost brokerage firm, the board of directors will reduce commissions sharply. Plus, the board will eliminate a conflict of interest because brokers of such low cost brokerage firms are paid salaries, not

5 compensation based on commissions. Salaried brokers are motivated to provide efficient trade executions and customer service, not generate commission revenue at the expense of their client. 3. Wrap Fee A wrap fee is the quarterly charge for all of a broker s services when they wrapped together in one allinclusive cost. An investment adviser will sometimes charge a wrap fee instead of charging commissions. At national, full-service brokerage firms, a wrap fee is typically between 0.50%-1.0% per year for portfolios under $10 million. By charging a fee instead of commissions, the broker usually avoids the punitive financial effect of discount sharing. However, for charities which trade their portfolio infrequently, paying a wrap fee is a costly mistake. It is far less costly for organizations with low trading activity to pay occasional commissions per trade than to pay a wrap fee. Consider the example of a foundation which trades just 50 times per year (equal to roughly 2 buys and 2 sells per month). 5 Figure 5, Wrap Fee Savings Assets Trades Fee/Trade Wrap Fee Total Fees Wrap Account $5,000, N/A 0.50% $25,000 Commission Account $5,000, $50 N/A $2,500 Savings $22,500 Imagine if the non-profit paid just $10 per commission! Brokers who charge a wrap fee may have a material conflict of interest because the non-profit s best interest could be the opposite of the broker s own best interest. In the example above, the best interest of the non-profit is to pay $2,500 in commissions. The wrap fee, which is in the best interest of the broker, is $25,000. That is 10 times more costly! To make the correct judgement regarding a wrap fee, the board must analyze whether it is financially better off paying commissions for each trade or paying an inclusive wrap fee. Following careful analysis, many financially astute boards will find eliminating a wrap fee is a significant source of cost savings. However, when a wrap fee is better for the organization, securing a competitive wrap fee requires negotiating by the board. Whether paying commissions or a wrap fee is better, the board may find its best interests do not align with those of its broker. Plus, if the broker is not a fiduciary, there is no legal obligation for the charity s interests to come first. 4. Investment Consultant Fees Board members are acutely aware that liability accompanies their oversight of the organization s finances and investments. As a result, non-profit boards often hire an investment consultant. Generally, the board s goal is not simply to access the consultant s investment expertise, but to alleviate themselves of sole fiduciary liability for the organization s investment results. Consultants are usually compensated

6 with a quarterly fee which is calculated as a percentage of the non-profit s investment assets. In other words, investment consultants are paid a wrap fee which is similar to some brokers. However, consultants usually offer a broader range of services than brokers are able, including drafting investment policy statements, assuming fiduciary liability, recommending alternative investments, educating investment committees, and measuring performance. Annual Investment consulting fees range from % for portfolios under $1,000,000 to % for portfolios of $50,000,000. Larger investment portfolios enjoy better pricing due to competition among national consulting firms. 5. Product Level Fees or Manager Fees The term product refers to the following vehicles commonly found in non-profit portfolios: activelymanaged mutual funds, passive index mutual funds, exchange-traded funds (ETFs), alternative investments such as hedge funds or private equity funds, and managed futures funds. All investment products have internal fees which are expressed in an annual percentage called the expense ratio. Product level fees are not visible on an account statement, and it is easy to forget your organization is paying them. However, all mutual funds, exchange-traded funds, and alternative investments charge fees via the seemingly-hidden expense ratio. These costs are disclosed in the product prospectus or offering documents, but they are not easy to find. Among these products, index and exchange traded funds are the least costly, with expense ratios ranging from % per year. The term manager fee refers to the expense incurred when a separate, third-party money manager is directing the organization s investments, instead of using the products described above. Investment manager fees range from 0.25% to 0.75% per year, depending on the type of manager and the size of the account. High product level fees are the norm, not the exception. For example, 2016 data indicates that activelymanaged mutual funds have an average expense ratio of 0.81% 1. With that fee as the average, the simplest way for non-profit boards to reduce annual fees is to liquidate all actively-managed mutual funds and replace them with low fee index funds or ETFs. Some board members may fear that lower fee index products offer inferior performance. Numerous academic and industry studies have demonstrated that 60-80% of actively-managed mutual funds perform worse than comparable index funds. 2 For non-profit boards looking to drive down expenses, simply shifting from active mutual funds to index funds may produce % of annual fee savings. 6. Incentive Fees Alternative investments like hedge funds, private equity funds, and managed futures funds have higher fee structures than mutual funds. The most common fee structure for these products is 2 and 20 which means an annual expense ratio of 2% charged for investment management, plus an incentive fee of 20% 6 1 Investment Company Institute, 2016 Factbook 2 Price, Craig D. The Triumph of Indexing, 18 Aug

7 paid on the net profits earned by the fund. Mutual funds and exchange traded funds do not charge incentive fees. In general, fees for alternative investments mentioned above are not negotiable. The best way to lower fees in this investment category is simply to avoid investing in such products. When Portfolio Assets Increase, Renegotiate Fees After analyzing the six types of fees, a board will identify several areas of possible savings. But these are not the only opportunities to drive down fees. Like many industries, non-profit organizations will find that discounts are often available due to one s increased size as a customer. When a foundation s assets increase, it is time to approach your various investment vendors and renegotiate fees. If a charitable portfolio grows from $10,000,000 to $20,000,000, the workload of the adviser does not double. However, a wrap-fee broker or fee-based investment consultant will be delighted because his or her compensation will double if their fee percentage remains the same. This is an easy target for investment cost savings. It is imperative to renegotiate fees if your organization s investment assets have grown in recent years. Brokers and consultants expect to reduce their fee rates when client asset levels increase. However, they will seldom reduce them voluntarily, unless they are concerned about competition or they are asked by the board to do so. 7 Capitalize on the Organization s Reputation Investment service providers are extremely competitive, and this reality can be worked to the advantage of a non-profit organization. In any given geographic area, whether by reputation, assets or other criteria, there are certain non-profit organizations which are regarded as the most desirable clients. A highly desirable non-profit organization may use its favorable position to negotiate a more competitive fee for investment services by permitting the investment firm to publicly acknowledge the organization as a client. A so-called trophy client like this constitutes a reputational win for the investment provider. If the board recognizes its trophy value to the investment provider, the board may use this stature to secure a fee concession and offer its reputation value as a prize. Let s Review What Kind of Advisor Does Your Organization Use? Why it s Critically Important A registered investment adviser or RIA firm is, under the Securities & Exchange Commission, an investment fiduciary who must act in their clients best interest and must be attentive to investment expenses. When a non-profit board receives investment advice from a brokerage firm, the board is not owed a legal duty to receive full transparency regarding fees and expenses, nor is the board owed a duty to put the organization s interests first. Brokers are not, by law, fiduciaries. The advice standard for brokers or brokerage firms is lower than for RIAs, and brokers are permitted to recommend investments which may not be in the best interest of their client.

8 8 There are six distinct fees which may be borne by a non-profit s portfolio. The more fee layers there are, the greater the drag on the portfolio s contribution to the organization s operating budget and long term sustainability. Each of the six fee types should be thoroughly researched, fully disclosed, quantified in dollars, thoughtfully analyzed and seriously considered for potential savings. For each fee type, the table below outlines the typical fee versus the optimal fee which is readily available in the competitive market for investment services. Figure 6, Six Layers of Fees Typical Fee Optimal Fee Custodial Fees % % Commissions or Brokerage Fees $ trade <$10 a trade Wrap Fees % % Investment Consultant Fees % % Product-level Fees % % Incentive Fees 20% of net profits None Total Fees % % Seek a Registered Investment Advisory (RIA) Firm with a Supportive Business Philosophy To save further on investment expenses, non-profit boards should consider employing fiduciary firms which discount the cost of services for non-profit clients. RIA firms with this business philosophy support their non-profit clients by providing investment advice at subsidized fee levels. By doing so, these RIAs tangibly support the financial health and sustainability of their clients. It is good business with a social conscience. Hiring such firms, proactive boards can take advantage of this favorable pricing and benefit the non-profit s bottom line. Modest Fee Reductions Are Powerful It is easy to underestimate the impact of seemingly minor fee reductions. However, non-profit organizations have institutional lifespans and fee reductions will be beneficial for decades. Albert Einstein famously remarked, Compound interest is the eighth wonder of the world. So too, is the profound effect of reducing fees when the savings are compounded over decades. The table below clearly illustrates how even modest fee reductions yield powerful financial gains.

9 9 Figure 7, Twenty Year Financial Benefit of Reducing Annual Fees (7% Assumed Return before Fees) Size in Millions -0.1% -0.3% -0.5% -0.7% -0.9% -1.1% $5,000,000 $358,460 $1,056,540 $1,730,197 $2,380,241 $3,007,458 $3,612,609 $10,000,000 $716,920 $2,113,080 $3,460,394 $4,760,482 $6,014,916 $7,225,217 $15,000,000 $1,075,379 $3,169,621 $5,190,591 $7,140,723 $9,022,374 $10,837,826 $20,000,000 $1,433,839 $4,226,161 $6,920,788 $9,520,964 $12,029,832 $14,450,434 $25,000,000 $1,792,299 $5,282,701 $8,650,985 $11,901,205 $15,037,290 $18,063,043 $35,000,000 $2,509,218 $7,395,782 $12,111,379 $16,661,687 $21,052,206 $25,288,260 $50,000,000 $3,584,598 $10,565,402 $17,301,970 $23,802,411 $30,074,580 $36,126,086 Summary The true investment management cost paid by a non-profit organization is often underestimated. The positive budgetary impact of lower fees is highly significant for non-profit organizations, especially when compounded over long time periods. By analyzing the six layers of fees a non-profit organization may be paying, a non-profit s board of directors will identify several opportunities for cost savings. Using the information about fees and following the suggestions in this paper, a non-profit board or investment committee can reduce their total investment costs by as much as 50%. In so doing, the board of directors will achieve one of its highest fiduciary objectives: to strengthen the financial sustainability of its mission and to ensure that decades from now, the non-profit s ultimate beneficiaries will continue to be served. This white paper provides a framework for non-profit boards and investment committees to deconstruct and renegotiate the fees they pay for investment advisory services. This paper is just a starting point. For an independent analysis of your non-profit s investment costs, Price Wealth Management, LLC offer objective fee analysis for an hourly rate. Our findings are confidential and our recommendations may be implemented anywhere the non-profit chooses to invest.