Special Report: Policy Primer

January 1, 2002       Nicholas Deane      

It seemed like America had entered a kind of economic nirvana early in 2000. The economy was going through the roof. The NASDAQ passed the 5,000 mark and the Dow was at an all-time high.

In cities fueled by the high-tech boom, real estate prices were getting out of control. Homes were being sold for more than the asking prices within hours of being listed. You couldn’t get into a high-priced restaurant or bar without a reservation made weeks ahead of time.

And, of course, donations to nonprofits were up big time.

That was then.

The stock market took a huge drop in April, 2000. The market started to climb back, but then at the end of the year it sank like a stone. And it wasn’t just tech high fliers that took a beating. By the beginning of 2001, new economy stalwarts like Microsoft and Intel, stocks that are now considered conservative investments, were trading at less than half of their values when they peaked. It was the same story for the entire NASDAQ index.

There’s no problem getting a dinner reservation any more.

Contributions have suffered, of course. In general, while they were up early on in the year, they ended up about the same as they had been the year before for most organizations. The bigger story was that some nonprofits didn’t ride the roller coaster individual investors rode. That’s largely because many of those that had cash to invest had investment policies that kept their investments sufficiently diverse or in safer investments.

Investment policies
An investment policy is generally a written policy produced and agreed upon by the board of directors to determine how the nonprofit’s funds are to be invested.

“Investment polices are so important, because it’s easier to earn a dollar than it is to raise one,” said Lisa LaMontagne, a spokesperson for the BoardSource in Washington, D.C. “Investment policies help an organization, including its directors and its public, understand the organization’s goals. And it becomes the guiding document to transfer those goals into action,” she said.

Investment policies affect every area of an organization, because they determine budgets and how much the nonprofit will have for current spending. They affect fundraising not only by affecting the amount that can be spent to raise funds but also by impressing donors that their contributions are being invested wisely. On the other hand, donors can be put off by what they consider poor investment decisions, whether because they are too risky or not aggressive enough.

Most nonprofits have at least an informal investment policy, which could be something as simple as leaving the cash surplus in an interest-bearing checking or money market account. Often an investment policy is simply left up to the treasurer or the chief financial officer. But surprisingly few organizations have formal, written policies. Dottie Johnson, associate executive director of the Nonprofit Financial Center in Chicago, estimated that a full 80 percent of nonprofits don’t have them.

In fairness, said Johnson, many of these groups can get by without investment policies. Nonprofits without surplus funds and very little cash don’t really need them. But Johnson encouraged all nonprofits to address the issue. “Regardless of the size or surplus of the organization, they should all give serious consideration to having an investment policy. In fact, I recommend they have a policy in place before they’re actually ready for one.” This way, a nonprofit can be certain that it is the mission that drives the investment policy rather than the investment opportunities driving the policy.

Covering your butt
One of the main reasons to have an investment policy is for protection of the board. Most states have a law on the books that codifies a legal principle called the “Prudent Investor Rule.” The Prudent Investor Rule essentially states that a board shall exercise ordinary care and prudence under the facts and circumstances at the time of any investment decision. If an organization does not comply with this rule, if it does not exercise that care and prudence, the board, including individual board members, can be held liable for any losses the nonprofit incurs. If the board complies with the rule, it can escape not only liability for itself but also personal liability for the board members. The best way to comply with this rule is to set up an investment policy that abides by the law, and stick with it.

Preliminary steps
For those who don’t have an investment policy, the first step is to delegate a committee to handle investments. This could be the board itself, or the finance committee, or a separate committee established just for that purpose, according to Johnson. This committee then typically hires an outside professional investment advisor. This investment manager would then handle the day-to-day management of the investments, and, explained LaMontagne, this person then should help draft an investment policy.

The investment manager must present periodic reports to the board, whether they are presented annually, quarterly or monthly. According to LaMontagne, many instances of financial trouble for nonprofits result “because the boards were not reviewing financial information the way they should have. They weren’t asking the tough questions when they should have.” But without adequate, timely information, they won’t know when to ask those questions.

Not to be overlooked, according to Johnson, is the appointment of a person or committee to whom the investment advisor reports. While this seems very simplistic, without this formal step a large crack is opened that the investment information can fall through.

You should next see just what it is you have to invest. What are your liquidity needs? Mary Dowling, a senior manager with McGladrey and Pullen in Phoenix, explained, “A guideline is six month’s operating expenses. Look at what it will take to keep you afloat for six months, and that’s what you should keep liquid.”

She stressed, however, that you shouldn’t take that as a hard and fast rule. “Every nonprofit, obviously, is different, with different inflows and outflows of cash. If your nonprofit has had regular periodic streams of income, your liquidity requirement may be a little less. If, instead, your organization relies on just a few major contributions a year, you might consider even more than six months operating expenses.”

Liquidity doesn’t mean keeping cash in a checking account. You should look at income-producing investments that provide full liquidity, like money market accounts or some mutual funds. Johnson also stressed looking at the funds that you have available for investment, and seeing exactly how long you can afford to invest them. Will you need access to the funds in 12 months? How long you can keep them invested will be a determining factor in the kinds of investments you can choose.

Creating the policy
In designing an investment policy, the first section of the document should spell out the nonprofit’s investment objectives. Is the primary objective the preservation of funds? Is it the preservation of operating funds, and income and/or growth for funds that can be invested for a longer period of time? For example, operating funds should throw off less of a return than endowment funds, which are invested for the long haul.

The next section of the document should address diversification. According to Dowling, “there are two kinds of diversification: diversification of the type of investment and diversification of the specific investment.”

Diversification of the type of investment means not all your funds should be invested in stocks; some should also be invested in bonds and cash or cash-like investments. Diversification of specific investments means not all your funds earmarked for a type of investment, stocks for example, should be invested in a particular instrument, say Microsoft or Intel. It also means they should not be invested all in a particular sector, such as the technology sector. This is what has saved nonprofits from the pitfalls that have befallen individual investors over the past year.

This is the section where you determine how much risk you’ll be willing to bear. All investment entails a certain amount of risk, whether you’re investing in oil and gas futures, shares of stock or a savings account. One of the main functions of the investment policy is to determine how much risk the organization is willing to bear.

Robert P. Fry, Jr., in his handbook “Creating and Using Investment Policies,” published by the National Center for Nonprofit Boards, lays out a good example of how to handle type of investment diversification. He suggests using a chart that lays out each type of fund that the nonprofit has (e.g.: operating fund, annuity reserve, and endowment), and the amount of that fund that may be invested in each of three different asset classes (e.g.: stocks, bonds, and cash or one-year notes).

For instance, in his example, 0 to 50 percent of operating funds may be invested in bonds, and 50 to 100 percent can be invested in cash or one- year notes. None may be invested in stocks.

However, for the endowment fund, 50 to 80 percent could be invested in stocks, 15 to 50 percent could be invested in bonds, and only 5 to 20 percent in cash or one-year notes. He explained that this chart with these ranges should then be adhered to by the investment advisor.

Diversification by specific investment should also be addressed in this section. This should spell out how much of your funds may be invested in a single stock or in a single sector.

“Typically,” said Dowling, “organizations will limit investments in a particular stock to 5 percent, but this figure tends to go down with larger organizations with more funds.” Also, Johnson highlights another form of diversification: Her group has a policy that says that no more than one-third of the nonprofit’s funds may be invested with any single institution.

Kicking the tires
The next section of the policy should address asset quality. Again, this is a section focused on risk. Here, you should lay out any investment restrictions based on ratings of the investment. For instance, you can restrict the manager from investing in junk bonds or penny stocks. The simplest way to do this is to refer to ratings by Moody’s or Standard and Poor’s. For example, you might say that the nonprofit can invest in bonds only that have a Standard and Poor’s rating of BBB or better. This section should also spell out whether the investment manager has the authority to buy on margin, to sell short or to buy options.

Another section of the policy would deal with prohibited investments. You don’t want your investments to conflict with your mission. For instance, a nonprofit set up to keep the environment clean probably wouldn’t want to invest in the stock of companies that pollute.

A lot of organizations, the Girl Scouts are one, won’t invest in companies that profit from the sale of alcohol or tobacco.

According to Rick Cohen, president of the National Center for Responsible Philanthropy in Washington, D.C., this section is very important. “All too often, a nonprofit will allow the investment issue to take on its own life, and thereby overtake their mission.” In other words, if you have a stock that is taking off, you might be a little more willing to compromise your principles and hold on to if you don’t have something in writing proscribing you from holding it.

Finally, according to Fry, you should spell out the responsibility the board has to the investment manager to keep him apprised of cash needs. The advisor is responsible for maintaining sufficient liquidity, and a surprise call for cash from the board can throw his plans into disarray.

As a final step, Fry also recommended having your counsel look the policy over before you approve it.

L. Nicholas Deane is a Montauk, N.Y.-based freelance writer.