Changes to Charitable Spending

So far calendar year 2022 has been a challenging period for investors. Both equities and fixed investments have delivered negative returns and there are no obvious signs of any immediate improvement in the outlook as we navigate rising interest rates and high inflation. Not the ideal scenario for the introduction of changes in the charitable spending requirements for registered charities announced in the 2022 federal budget and expected to come into effect in 2023. This article provides a recap of key considerations for charities and the implications for the long-term growth of investment portfolios to ensure continued support of charities’ missions and objectives.

New Spending Requirements

The 2022 federal budget proposed an increase in the minimum distribution requirement for registered charities with fiscal years beginning on or after January 1, 2023. The proposed changes were met with concerned feedback on the timing from the charitable community and as such the new requirements have yet to be passed. It is anticipated that the changes will be in the next Budget Implementation Act, which could be passed before the end of the year. The key points of the changes are:

• The minimum distribution quota (DQ) will increase from 3.5% annually to 5.0% for property above $1.0 million that is not used directly for charitable activities or administration
• The calculation is based on the average value of property exceeding $1 million during the prior 24 months
• Administration and management fees do not qualify for satisfying a charity’s DQ, which was a previous source of confusion
• The Canada Revenue Agency (CRA) can grant a reduction in a charity’s DQ in any given tax year
• The accumulation of property rule which exempts charities from including certain property in their DQ calculation will be removed
• If certain requirements are met, registered charities can make “qualifying disbursements” to non-qualified donees.

What are the Implications?

While charities and foundations have different missions and objectives, most have a common goal to operate in perpetuity by generating returns sufficient to grow their assets after accounting for spending distributions and other costs. The potential implications to such a goal will depend on the actual spending practices of charities. Some charities as a practice may already be distributing close to the 5% minimum, while for others this will signal an increase in their spending policy.

As discussed in a previous article, establishing a regular spending formula and adhering to it is appreciated by grant recipients who receive a consistent cash flow. However, the strategic asset mix of a charity’s investment portfolio and associated risk and return profile typically supports the spending target. Specifically, to support a spending target of 3.5% implies a different asset mix and associated risk and return profile compared to a higher 5% target.

For those charities where the new requirements will imply a higher distribution, there are two options in their toolkit to meet the higher target:

• Generate higher returns from invested assets; and
• Receive additional donor contributions

While a combination of the two options will be beneficial, generating higher returns from its investments can be more in a charity’s control.

Strategic Asset Mix

Notwithstanding calendar year 2022 is on track for negative returns, with both equities and fixed income declining year-to-date to the end of October, one positive outcome of the rapid rise in fixed income yields is the higher longer-term outlook for fixed income. This is because there is a strong relationship between the actual return investors earn and the current yield. For example, for the Canada Universe Bond Index, Figure 1 illustrates how the current yield provides an indication of the expected return for the next 10 years, as well as the direction of returns. The chart plots the universe bond yield over time (blue line), as well as the actual subsequent 10-year returns represented by the purple line.

Figure 1 – Universe Bond Yields versus Subsequent 10-Year Returns

With the rapid rise in yields, the longer-term outlook has vastly improved. The yield on the Universe Bond Index at the end of October had risen to 4.3%, suggesting the expected return over the next 10 years would be similar, although with the potential for further interest rate hikes, there could still be shorter-term periods of negative returns. Despite the shorter-term challenges, it suggests a portfolio of fixed income alongside an allocation to equities could be well positioned to achieve a 5% return.

However, for many charities the return goal also considers inflation to maintain the real value of the portfolio of assets. While inflation is currently elevated, for the purpose of illustrating the impact of inflation combined with higher distributions, and assuming an annualized inflation of 2.5% for the next 10 years, then the minimum real return goal would be 7.5%. It is less likely that a portfolio of fixed income and equities can achieve the higher 7.5% return, unless it is largely invested in equities, implying a risk and return profile that many charities would not be comfortable adopting.

One action item for committees would be to include an agenda item at a future meeting that considers potential alternative investments, such as private market investments including real estate, infrastructure, and private debt, and the extent to which these could improve the risk and return profile of the investment portfolio. It would also be appropriate to consider other higher yielding assets, including commercial mortgages, emerging market debt, as well as the potential role of hedge funds to contribute to the return and diversification role. However, a careful assessment of specific alternative investments would be needed to understand any implications from the higher interest rate environment on the longer-term outlook for these types of investments.

Understand Your Circumstances

During these turbulent times, it is important to maintain a long-term perspective for the charity’s investments. With the new spending requirements, it will be beneficial to review your own circumstances and goals to understand the ability to gather additional support for the charity through contributions compared to the requirement for higher investment returns. Make time at a future committee meeting in 2023 to review your long-term outlook and requirements.