Association Specialty Practice Managing Reserves When Cash Flows are Uneven EXECUTIVE SUMMARY Many associations struggle with issues surrounding asset allocation in light of their complex liquidity and cash flow needs, especially given an environment marked by increasing degrees of focus on governance and fiduciary oversight. Specifically, organizations want to be able to answer the following questions: How much should an organization like ours retain in reserves? How should these reserves be divided between short term funds for safety and security versus long term funds for growth and sustainability? How do we further determine appropriate allocations within each of these reserve portfolios to optimize our financial results? How do we demonstrate and document our fiduciary oversight? This paper considers the importance of asset allocation, the documentation required, and the variability of optimal results based upon risk tolerance, market conditions and desired financial outcomes within the realm of cash reserves. GOVERNANCE AND INVESTMENT ALLOCATION BETWEEN RESERVES Governance After the fallout from the 2008 financial crisis and the great recession that ensued, officers at associations with financial oversight faced increased scrutiny around their fiduciary responsibilities and the required demonstration of appropriate governance policies and procedures. We advise organizations to have several protocols in place in order to document and explain their association s management and oversight of investment reserves: 1. 2. 3. Have a Board appointed finance and/or investment committee that oversees investments and reports regularly to the Board Have a detailed investment policy in place that is reviewed annually Formally review any investment management relationship every three to five years to ensure the managers are performing in line with investment objectives The following chart highlights considerations for inclusion in any investment program review, which will be the foundation for developing an Investment Policy Statement (IPS). What to Consider for Reserve Governance IDENTIFY KEY QUESTIONS AND CONSTRAINTS Cash Flow Variabllity Sources of Revenue Liquidity and Spending Needs Risk Constraints BUILD INVESTMENT FRAMEWORK Asset Class Diversification Allocation Ranges Benchmark Selection Investment Policy Statement The Fiduciary Road Map
Length and complexity of Investment Policy Statements vary substantially. Some associations have successful policies that are as short as two pages while others require much lengthier policies. The IPS is unique to each organization as it reflects the specific circumstances that influence each portfolio. With that in mind, we offer the following graph as a framework: How Much to Hold in Short Term Reserves? Inevitably, the question arises around the appropriate amount that should be set aside for a rainy day. This is the amount that is held in excess of day to day operations and can be identified by different names such as operating reserves, short term reserves, budget reserves, surplus fund, or strategic cash. Most organizations appreciate having an extra cushion over and above the day to day operating cash to allow for an organizational margin of safety. Often, reserves simply function to smooth out monthly cash flows due to highly variable seasonal flows. Here s an example of spending in a cyclical cash flow environment: In the chart below, an association gathers dues in January, collecting $8 million in revenue, then offers additional programs later in the year, netting an additional $5 million in income. In general, operating costs month to month are stable. However, during the summer months, the association holds conferences, which increases expenses and requires use of operating reserves to cover expenses until its income picks up again in September. $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $- $(2,000,000) $(4,000,000) January February March April May June July August While the above chart is a relatively simplistic illustration, we work with a national association that mirrors this general cash flow pattern. Member dues come in month one. Low revenues and moderate expenses take place throughout the year with negative monthly cash flows usually occurring in months two through six. Higher expenses occur prior to this organization s annual meeting in months seven and eight. Fees and other convention related revenues come in during months nine through eleven, with the next fiscal year s dues coming in month twelve. This cash flow scenario is further complicated because one of their major advocacy programs is funded by the federal government, so there is a question not only in the timing of receipt of funds, but also whether or not it will be received at all. September October November December Periodic Cashflow Expenses Cumulative Net Many associations start with a six month requirement for short term reserves. That said, the client example given illustrates that a case could be made for adjusting reserve levels based on the cash flow variability of the individual organization. At a minimum, most associations will want three to five months of operating cash set aside, but each organization will need to make this determination based on their needs. The 2016 American Society for Association Executives Investment Study 1 shows that most organizations hold just north of six months in reserves. If there is low cash flow variability on both the funding and expense side, and there is high confidence in the timing and assuredness of funding sources, one could argue for lower levels of ready cash. Conversely, with a high variability of cash flows due to revenue timing or source, an organization may be inclined to hold as much as a year s worth of expenses in liquid reserves, if not more. For further illustration, let s consider two associations that we work with that are still processing the emotional backlash of the financial crisis. As a result, they continue to have a very low risk tolerance and choose to hold approximately 18 months of operating cash in money market funds. Recently, they have become receptive to discussing a slightly more aggressive positioning. We are partnering with their respective Board Treasurers, CFOs and finance staff to review cash flows and determine an optimal amount to take prudent market risk, mindful of the fact that there will be a minimum cash level that must remain accessible. Recalling the graphic above, after setting the target operating reserves, additional cash may remain. This creates an opportunity for organizations to consider taking some market risk with these assets in the hopes of earning incremental income, consistent with their overall risk tolerance. Excess cash could also be designated to longer duration fixed income, or perhaps even equities, for long term growth. ASSOCIATION SPECIALTY PRACTICE 2
The graphic below demonstrates using a holistic framework for all organizational reserves. Asset Allocation Framework Investment Reserves Short-Term Long-Term Tier 1: Operating Tier 2: Core Tier 3: Strategic Equities Fixed Income Alternatives Cash For short term reserves, we advocate a tiered approach to asset allocation. ASSET ALLOCATION WITHIN SHORT TERM RESERVES In the past, organizations would often maintain a single pool (or fund) to hold reserves for all short- term operational needs. We believe that significant economic value can be gained by separating these funds into distinct short term tiers. The drivers of the change in economic value fall into two broad categories: Money Market Reform During and following the financial crisis, institutional investors urgently sought to increase their liquidity and hold cash. In 2008, one of the original money market funds (the Reserve Fund) broke the buck meaning that its net asset value (NAV) fell below $1 due to poor investment experiences in its asset portfolio. As a result, beginning in 2010, the SEC implemented reforms to address the systemic risk of money market funds, including reducing the weighted average maturity of all money market funds from 90 days to 60 days. Additional reforms were implemented by the SEC and went into effect in October 2016. These have had a wide ranging impact on the structure of money market funds. The current rules allow for treasury and government money market funds to maintain a stable NAV of $1 however: Institutional prime and tax-exempt money market funds now have a floating NAV Institutional prime and tax-exempt money market funds now have the ability to impose liquidity fees and/ or redemption gates based on the daily and weekly liquidity levels in the fund The changes are intended to increase transparency while reducing systemic risk during periods of market stress and give money market fund companies the tools to moderate fund flows in the event of extreme market volatility. It is clear that these measures change the risk profile and reward expectations for money market funds. Federal Reserve Outlook Let s consider the Federal Reserve outlook for the economy through the lens of a membership organization. Client A continued to hold upwards of $100 million in money market funds despite the low yields following the financial crisis. During regular discussions over the years, the CFO shared that he would, rather explain why he was earning no money on their reserves than explain why he lost any of the principal value of their reserves. In recent years, the client became more comfortable with the level of risk versus return in the short end of the market and decided to ladder approximately $50 million in treasury securities out a maximum of two years. Without taking undue risk, an incremental return is now being generated on behalf of this organization. These earnings are real and can be used to offset current operational expenses, start a new program, or increase advocacy efforts. There are other investors similar to Client A, who tolerated extremely low returns on cash balances in the interest of extreme risk avoidance, thus illustrating the environment that has sustained historically low short term interest rates in recent years, even as economic conditions improved more broadly. As the impact of the 2008-2009 crisis ASSOCIATION SPECIALTY PRACTICE 3
recedes in time, risk tolerances should likewise recover and short term investors will begin reaching out to both longer maturity instruments and prime instruments in an effort to earn incremental return. WHAT TO CONSIDER FOR SHORT TERM ALLOCATION Recent legislative and monetary changes over the last few years have changed the risk/reward expectations for short duration investments significantly. The inclusion of a more diverse array of investments in this space can have meaningful investment benefits which serve to advance an organization s mission. In 2008, prompted by the market turmoil and dislocation following the financial crisis, the Federal Reserve lowered the federal funds rate to a range of 0.00% to 0.25%. Rates remained in this range for seven years until December 2015 when the Federal Reserve made the decision to raise rates through open market operations by 25 basis points (0.25%). Since then, they have raised rates an additional four times with the Fed now targeting a range of 1.25% to 1.50% and additional moves are anticipated in the next 12 to 18 months. With these changes, there is economic value at the short end of the curve, and there is incremental yield available between 90 day treasury bills and two year notes. The opportunity to earn additional income by going a bit further out the yield curve is substantial compared to recent history. 2.00% 1.75% 1.50% 1.25% 1.00% Current Interest Rate Environment US Benchmark Bond - 2 Year Yield 2017 US Benchmark Bond - 2 Year Yield 0.75% Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 The goal is to take advantage of opportunities in the yield curve while maintaining much needed short term reserves in the face of variable cash flow. A thorough review and analysis of cash flow variability will assist in determining the amount of short term assets that can tolerate fluctuations in value versus how much cash must remain in a stable NAV product. This may be an iterative process that evolves over time. We recommend that clients look at a tiered approach utilizing as many as three tiers of funds as illustrated below. Along the y-axis, organizational liquidity needs are assessed while the x-axis considers the potential for risk and reward. The first tier represents Operating Cash for general operating funds with daily cash flows and ready liquidity. We recommend the use of treasury or government money market funds with a stable NAV as they are used to protect from market volatility and manage liquidity needs with yield as a secondary concern. The second tier represents Core Cash and is for short to medium term needs such as annual bonus and/or pension payments, insurance premiums or expenses for annual meetings. With more moderate liquidity needs, this tier can pursue a higher yield than operating cash. Maturities in this tier tend to range between three and twelve months and might include a floating NAV money market fund or a separately managed account. The third tier represents Strategic Cash and is for a longer term time horizon with more of a focus on total return. Building and construction costs and land acquisition funds are often held in this tier. Maturities in this tier are generally for funds needed in more than twelve months and might include a separately managed account or the use of ultrashort bond funds. We continue to recommend that organizations focus on stable NAV funds for their immediate cash needs. Organizations that are willing to tolerate a floating NAV or are looking for enhanced yield have additional options including: floating NAV money market funds ultra-short fixed income funds, and separately managed accounts In summary, we propose that the division of assets between short term and long term reserves is a function of risk tolerance and cash flow variability. Short reserve allocation can meaningfully improve organizational outcomes and is more than simply reviewing money fund rates. Associations that face the challenge of variable cash are well positioned to benefit from a stratified approach to managing cash. ASSOCIATION SPECIALTY PRACTICE 4
About SunTrust Foundations and Endowments Specialty Practice SunTrust has nearly a century of experience working with not-for-profit organizations. Fiduciary stewardship is the heart of our culture. We are not merely a provider for our clients; we are an invested partner sharing responsibility for prudent management of not-for-profit assets. Our client commitment, not-for-profit experience and fiduciary culture are significant advantages for our clients and set us apart from our competition. The Foundations and Endowments Specialty Practice works exclusively with not-for- profit organizations. Our institutional teams include professionals with extensive not-for-profit expertise. These professionals are actively engaged in the not-for profit community and are able to share best practices that are meaningful to their clients. Team members offer guidance and advice tailored to the various subsets of the not-for-profit community, including trade associations and membership organizations. Our Practice delivers comprehensive investment advisory, administration, planned giving, custody, trust and fiduciary services to over 700 not-for-profit organizations. We administer $33.5 billion in assets for trade associations, educational institutions, foundations, endowments and other not-for profit clients. 2 1 Association Investment Policies, Practices, and Performance. American Society of Association Executives, 2016. 2 As of December 31, 2017 A special thank you to Colleen Doremus, Director and Fredric Walls, Managing Director for their contribution to this white paper. For more information about the SunTrust Association Specialty Practice, please visit us at www.suntrust. com/foundationsandendowments or www.suntrust.com/nonprofitinsights www.suntrust.com/foundationsandendowments 866.223.1499 1 Association Investment Policies, Practices, and Performance. American Society of Association Executives, 2016. The information and material presented in this commentary are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this commentary. Investing in any security or investment strategies discussed herein may not be suitable for you, and you may want to consult a financial advisor. Nothing in this material constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. SunTrust Bank and its affiliates and the directors, officers, employees and agents of SunTrust Bank and its affiliates (collectively, SunTrust ) are not permitted to give legal or tax advice. Clients of SunTrust should consult with their legal and tax advisors prior to entering into any financial transaction. Securities and Insurance Products and Services: Are not FDIC or any other Government Agency Insured Are not Bank Guaranteed May Lose Value SunTrust Private Wealth Management is a marketing name used by SunTrust Bank, SunTrust Banks Trust Company (Cayman) Limited, SunTrust Delaware Trust Company, SunTrust Investment Services, Inc., SunTrust Advisory Services, Inc. and GenSpring Family Offices, LLC which are each affiliates of SunTrust Banks, Inc. Banking and trust products and services, including investment management products and services, are provided by SunTrust Bank and SunTrust Delaware Trust Company. SunTrust Bank and its affiliates do not accept fiduciary responsibility for all banking and investment account types offered. Please consult with your SunTrust representative to determine whether SunTrust and its affiliates have agreed to accept fiduciary responsibility for your account(s) and you have completed the documentation necessary to establish a fiduciary relationship with SunTrust Bank or an affiliate. Additional information regarding account types and important disclosures may be found at www.suntrust.com/investmentinfo. 2018 SunTrust Banks, Inc. SUNTRUST and the SunTrust logo are trademarks of SunTrust Banks, Inc. All rights reserved. DGD403302 02/18 CN2018-8039-EXP02/19 ASSOCIATION SPECIALTY PRACTICE 5