Reserves and risk Kate Sayer 16 September 2016 A step-by-step guide to developing a risk-based reserves policy that complies with SORP 2015

CC guidance – new CC19 Jan 2016 Justifies and explains reasons Plans for continuation of services Reflects risks of unplanned closure from business model Addresses risks of unplanned closure

Purpose of reserves “A charity should hold reserves for only one reason. That is to ensure, as far as is reasonably possible, that the charity’s future expenditure objectives can be met, given certain assumptions made about future income streams.” Andrew Hind, The Governance and Management of Charities 1995 In the extreme case, if the charity has no future expenditure commitments, it needs no reserves. If it has a guaranteed income stream, equivalent to expenditure commitments, it needs no reserves. Alternatively, if the charity has a fixed future expenditure commitment, and no future income stream, its reserves would need to be equivalent to that future expenditure commitment.” Start from the assumption that charities raise funds to spend them. Therefore the objective should be to get them to beneficiaries as quickly as possible. What if a donor challenged you “What happened to that £1 I gave you?”

What are reserves? Unspent unrestricted reserves, excluding designated and funds for fixed assets Restricted funds Unrestricted funds Interactive So how would you define reserves – does anyone have any ideas? Definition of reserves - I have seen many - “Money for a rainy day”; “To fund unexpected expenditure”; “To cover shortfalls in income” “Resources not immediately required to finance operations and which can be freely deployed by trustees to fund future expenditure if required” -Andrew Hind Quantifying reserves This is an area that often causes confusion because of the type of funds held by charities. I will quickly go over them, to make sure you are happy with the types of funds held by the charity Funds = unexpended resources – 2 types. R & UR. Endowment funds Restricted income Designated funds General funds

Why hold reserves? Finance for expansion and new projects Designated funds Provisions for known liabilities e.g. pensions Free reserves Continuity of charitable activity – fluctuation in income The Charity Commission report found that charities gave the following reasons for holding reserves: to ensure continuity in the event of a large variation of income (71%) to spend in emergencies (41%) to pay for specific future projects (40%) to bridge cash flow problems (37%) to cover specific liabilities (29%) to generate income (20%) other (1%)   Holding reserves to generate income is not legitimate. Charity trustees are under a legal duty to apply the charity’s income within a reasonable time of receiving it. Retaining too much unspent income in reserves amounts to accumulating funds or converting it into capital. Charities need specific powers to do this. Charity Commission Annual Report 1992, para 98 Working capital – cashflow profile

What level do we need? How well have we defined the risk or liability? Do we know the probability, timing and amount needed? Provisions for known liabilities e.g. pensions Continuity of charitable activity – fluctuation in income How good is our income forecasting? How diverse is our income? Reliability? Think about changes such as payment by results How well do we match incoming to outgoing resources? Timing of funding Working capital – cashflow profile

Understand your business model Predictable Adjust spend to fit income Use reserves Income Flexible cost base High committed costs Regularly monitor income Danger zone The simple diagram below puts charities into four categories.   Firstly, income will be predictable if it is longer-term, but will include sources such as investment income, legacies and direct mail which may fluctuate, but the source remains. Whereas a charity with unreliable income is more likely to have sources such as one-year funding and fundraising is dependent on events or similar, where the risk of loss of funding is high. Next, costs for many charities are fixed and unavoidable unless they close the service. For example, a care home has to operate with a certain number of staff. Whereas a grant-making foundation can make decisions about its distributions. The most comfortable place to be in a time of change is in the top left of the diagram, where the charity needs to understand what its forecast income will be and flex expenditure to match. Charities with unreliable income and a flexible cost base (bottom left) can do the same, but their task in forecasting income is more difficult. They remain vulnerable if they suffer a significant loss of funding and may have to consider other options such as collaborative working or merger to gain more secure income. Charities with high committed costs and predictable income (top right), such as a care home, should use their reserves to maintain their service levels if income falls temporarily. Clearly if the reduction in income is more permanent, then using reserves is only delaying the inevitable decision and is not a good use of funds. Charities in the bottom right corner are in the danger zone. If income falls, they may be able to use reserves, but may quickly exhaust them as they struggle to reduce costs. They are more likely to have to close services or seek a merger Unreliable

Level of reserves needed Take into account reliability of funding and risk profile on income Consider the level of commitments and how long you are committed for Think about moral obligations as well as contractual commitments Plan cashflow Tool to analyse….. Feed into strategic plan – also consider new funding/activities in same way Any other future risks that may need to considered – any potential liabilities that may crystallise Value Doesn’t have to be one target, Can be a range / can be different for diff times of the year if there is a seasonality to income/expenditure. May be expressed as a ratio of reserves to expenditure i.e. 3 months running costs, equating to _____. The key is to explain rationale May decide to look at similar charities to get a feel for whether you are on the right track – i.e. overseas development agencies – in general have low reserves if responding to urgent needs overseas– aim to convert public donations into charitable expenditure ASAP – therefore may be odd if you have 2 years, whereas similar charities range between 3 & 9 months – that said – unique – as long as can justify and there is sound rationale – ok.

Good practice Holding reserves is a way of managing risk It is not the only way! Case studies showed that charities halved reserves after review Range of risk management strategies in place Reserves just one part If you are managing your risks well – you do not need large reserves. In particular, you do not need to budget for contingencies AND have reserves for them – this is double counting.

Spend or save? Reserves policies should be in this context If you spend more to help more beneficiaries, what is the risk? If you spend more on fundraising, what is the risk? How should you allocate resources?

Conclusions Better risk management can mean that you can have lower reserves Getting funds to beneficiaries more quickly You can make your funds work harder

Further information ‘Beyond Reserves’ published by sector bodies with Sayer Vincent in June 2012 Sayer Vincent made simple guides Reserves Policies Made Simple Risk Management Made Simple CC19 Charities Reserves (Jan 2016)