December/January 2013/14: Making reserves go further

Charity reserves are for a rainy day and it has been raining for some time. But the sector has work to do to make sure charities and their beneficiaries get the maximum value from their reserves, argues Maurice Mcleod

CHARITIES EXIST to provide services for their beneficiaries and trustees have a responsibility to ensure any money they raise is spent within a reasonable period of time on the aims of the charity.

Most well run charities have a pot of money, their reserves, which is built up over time and serves as a safety net for when the organisation falls on hard times, has an unusual hike in costs or has an unexpected dip in income. This money is unrestricted and can be spent on any of the charity’s activities.

The size of the reserves charities build up depends on a number of factors. The size of the charity, the vulnerability of its income streams and the climate it exists in should all be factored in when working out how large a reserve pot an organisation should accumulate.

Setting this level is something of a tightrope walk for trustees. If reserves are set too low, the charity is left living a ‘hand to mouth’ existence where it is incredibly vulnerable to the sudden income changes that all organisations face. If the levels are too high, funders might look unfavourably at bids because they can argue that the charity is in a position to fund itself.

Beyond reserves
The reportBeyond Reserves: How charities can make their reserves work harder, which was produced by charity accountants Sayer Vincent, ACEVO, Charity Finance Group (CFG) and the Institute of Fundraisers (IoF), includes a case study which demonstrates this dilemma.

Patricia Yearley, finance manager at The John Ellerman Foundation, says:
“Reserves which are ‘too high’ may mean they have sufficient funds of their own and are not applying what they have already accumulated in a way which benefits the charity. Conversely, reserves which are ‘too low’ raise questions about the financial stability of the charity.”

The thinking that goes into building reserves is more important than the actual level and charities should ensure they have a clearly defined reserves policy with regular reviews. “The most important thing for us is that charities have a good understanding of their financial position, including their reserves, and a clear plan,” Yearley adds.

Four main approaches charities use when deciding their reserves policy were cited.

These were: Justifying the status quo: a reserves policy is created to justify whatever the reserve level happens to be.

The Armageddon approach: trustees set aside reserves needed to fund the closure of the charity, including redundancy pay, leases and other commitments.

The actuarial liability approach: the reserves are treated like an endowment fund and levels are set high enough to generate income needed to meet future
expenditure commitments.

The risk identification approach: trustees set levels after looking at how risky the various income streams are, what expenditure the charity is committed to and the overall risk environment in which the charity operates.

The argument here is that the risk identification approach is by far the most effective and most charities now adopt a policy on this basis.

Rainy day
Of course reserves are built up for a rainy day and the challenging funding environment means, for many charities, it has been raining for some time.
Research for the PWC, IoF and CFG report, Managing in the ‘new
normal: Adapting to uncertainty
, found that 63 per cent of charities were planning or considering drawing on their resources this financial year. 39 per cent already plan to use some of their reserves and 24 per cent were considering doing so.

Worryingly, the vast majority of these were planning to use reserves either to maintain services (49 per cent) or cover operating costs (43 per cent). Using reserves to fund services or operating costs is obviously not sustainable and so can only be a short-term fix while charities secure more funds or cut costs. Some of the charities that planned to draw from their reserves were doing so to finance new initiatives such as new CRM systems or launching new services.

A smaller number (13 per cent) planned to use the money to finance a restructure, collaboration or merger. Spending reserves in order to increase income or reduce costs in future often makes sound financial sense.

While some charities reported not needing to dip into their reserves, half of those who had no intention of drawing on their savings said that reluctance from either management or trustees was a factor in this decision.

Reserves should not just be a comfort blanket though and so if there are clear
reasons to use this money for the good of the charity and its beneficiaries, it
should be used. The nature of charity governance, with trustees being responsible for the financial probity without personally benefiting from riskier ventures that might pay off, means the sector is typically risk averse. Beyond Reserves reported that a number of finance directors and fundraising directors believe the charities they work for could be more ambitious when it comes to using their reserves.

Investment return
Many fundraisers would like charities to compare the return they could earn from investment in fundraising or new services with the return earned from investing the funds in gilts when deciding whether it is prudent to dip into their reserves.

Reviewing their reserves in this way led a number of charities to reduce the level of reserves considerably. Caron Bradshaw, CEO of CFG, comments: “Traditionally reserves have tended to be viewed as being for a ‘rainy day’. It’s been a really tough economic climate for the past few years and this has prompted many finance professionals to challenge these traditional views as they’ve encountered reluctance to spend reserves or confusion on how best to use them.

“CFG encourages senior managers and trustee boards to question how they can be more dynamic in their approach to managing reserves."

Some charities had been covering risks through their strategy, for example by diversifying their income, while also holding back funds in reserve. They were effectively providing double cover for the same risk.

Ken Moon, director of finance, planning and operations at Sightsavers, notes the focus on trustee liability leads to short-term thinking. He suggests that taking a longer-term view of funding, with plans stretching over a decade rather than just a year or two, would lead to better planning, greater and effectiveness.

Kevin Geeson, chief executive of Dyslexia Action, points out that while businesses focus on their balance sheets and will not allow cash to sit around doing nothing, many charity trustees do not have the same appetite for risk.

Reserves cost
The British Red Cross carried out a review of its reserve policy and decided to reduce reserves from £35million to £15million. This is equivalent to a £20million investment in the charity.

Rohan Hewavisenti, the charity’s director of finance, pointed out the importance of the opportunity cost of reserves. “You need to remember that £1 today is worth more than £1 in five years’ time, therefore, the impact that you could make with £1 today could largely outweigh the impact in the future.

“There may be more efficient uses of reserves and organisations need to understand their internal cost of capital, as this should inform the level and form for holding reserves."

Despite going through the worst recession since the Great Depression, many charities have not had to significantly reduce their reserves. If reserves have not been needed over the last four challenging years it makes sense to ask why they are there in the first place.

Traditionally, the finance team has had sole responsibility for handling reserves, but a more holistic approach is becoming more common which sees finance working with other teams to develop a clear strategy.

Mark Astarita, director of fundraising at British Red Cross, said the link between fundraising and finance is crucial. Larger organisations with easily predictable income need lower levels of reserves.

Money generated by investing in fundraising is likely to outweigh that from conventional methods of investment although the delayed nature of income generation by fundraising adds risk.

Almost half (47 per cent) of the charities taking part in Baker Tilly’s Funding Challenge survey said that government funding had decreased over the last 12 months reflecting the prolonged period of austerity, and almost two thirds (63 per cent) said that sourcing new funding streams was their biggest challenge. Forty-five per cent said they expect reserves to decrease next year.

Therefore a strategic approach should be taken to reserves. Kate Sayer, partner, Sayer Vincent, comments: “It is important for charities to have a strategic approach to their reserves, rather than holding on to funds for a rainy day. Charities must move beyond this thinking and look at all the ways in which they can manage risks, with financial reserves as a last resort.”

The sector still has a lot of work to do to make sure charities and their beneficiaries get the maximum value from the reserves they hold but gradually practices are improving and organisations are learning to be more strategic with this valuable asset.

Maurice Mcleod is a freelance journalist

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