W. Scott Simon
Among other kinds of clients (e.g., retirement plans such as 401(k) plans and individuals), my investment advisory firm invests and manages money for non- profits. When we are retained by fiduciaries responsible for a non-profit pool of money to replace an existing investment advisor, it never ceases to amaze me what outright awful (and costly and underdiversified) portfolios the advisor had foisted on the hapless fiduciaries.
A recent example concerns a non-profit that employed a national broker-dealer as its investment advisor. The advisor broker-dealer had an alliance with a local community foundation whereby the advisor supplied the investments through which the donors could make donations to the foundation. Correction: The advisor didn’t actually make the investments itself. Instead, it handed off that task to a third- party “wrap manager” that invested the portfolio in a mishmash of individual stocks and mutual funds. As a result, the non-profit portfolio was burdened with the broker-dealer’s fee, the third-party wrap manager’s fee and (let’s not forget) the community foundation’s fee for a total annual fee of 4% to 5% of the value of the portfolio. The Web site of the advisor broker-dealer that quarterbacked this wonderful (for the advisor) arrangement, of course, assures all that its fees are “reasonable.”
Marion Fremont-Smith, a legend in the field of nonprofit law and regulation with over a half-century of experience working with non-profits of all kinds, noted in an interview recently that “one of the strengths of the nonprofit sector, the reason that we revere it and support it, is its ability to respond.to society’s problems.” The word “respond” in the preceding sentence is a code word for “giving” (another important word in the non-profit world), and giving largely means giving money.
But when the total investment fees involved in placing a non-profit in an awful (or, for that matter, even a stellar) portfolio can reach 5% annually–the same minimum percentage of principal which must be distributed (that is, “given”) annually from a non-profit’s portfolio to charitable causes–something is rotten in Denmark. In cases such as this, sometimes you have to pay dearly for bad advice.
Welcome Inside the World of Non-Profits
Non-profits are a major component of the U.S. economy. This trillion-dollar industry has addressed implications of Sarbanes-Oxley voluntarily and maintains an ongoing dialogue with Congress and the Internal Revenue Service. Non-profits have been successful historically in raising money and have continued to perfect their development models. The way in which those dollars have been invested, though, has all too often been done in an imprudent and haphazard way.
I will assume that any trustee or other fiduciary of a non-profit cares deeply about its charitable mission. Call me crazy, but I cannot imagine that anyone associated with a non-profit in any position of authority would want to do anything other than what’s best for the non-profit. (There are, of course, members of non-profit boards that don’t have any particular passion for nonprofit missions, yet they continue to serve so that they can represent their employers and keep their names prominent in the local media.) There are, nonetheless, a number of real-world factors that keep fiduciaries responsible for non-profit pools of money from doing their best as responsible stewards. Two of these factors are ignorance about fiduciary standards and practices, and blatant conflicts of interest.
Ignorance about Fiduciary Standards and Practices
Many members of nonprofit boards of directors are volunteers with little knowledge of investing. These fiduciaries are often busy people, so board meetings have to be kept relatively short leaving scant (or no) time for education about fiduciary duties. In such cases where this kind of education isn’t regarded as a priority, the inevitable result is widespread ignorance among board members about even the most basic principles involved in overseeing a non-profit investment portfolio. I have seen situations (whether involving a $7 million portfolio or one with $70 million) where a non-profit, for example, had no Investment Policy Statement (IPS) or, where one was present, the IPS was canned and therefore totally inadequate in helping carry out the nonprofit’s mission.
Many investment advisors to boards are all too glad to take advantage of the ignorance shared by many board members. Advisors often attend board meetings, leaving board members with little chance to have an honest dialogue about, for example, the true, all-in costs charged a nonprofit portfolio, an issue that advisors would rather avoid. These advisors generally control the flow of information, and board members—well-meaning but often so uninformed that they don’t even know what issues are involved much less what questions to ask about those issues–sit idly by and rubberstamp whatever the advisors want.
Even in cases where an earnest attempt is made to provide board members with fiduciary education, the results can be inadequate. In one Southern state, for example, three major supporting foundations have set forth “best practices” guidelines for all non-profits in that state.
What’s missing from these guidelines–unbelievably–is any mention of the standards of investment conduct that must be followed by fiduciaries responsible for non-profit pools of money. Such basic standards have been around, in one form or another, since the 11th century in England when trust and fiduciary notions first emerged. Those in charge of these three foundations really should know better, given that the Uniform Prudent Investor Act (UPIA), whose standards “inform” investment fiduciaries of non-profits, was published in 1994 and the Uniform
Prudent Management of Institutional Funds Act, which is derived largely from the UPIA and applies specifically to fiduciaries of non-profits, was just published in July.
Conflicts of Interest
Members of non-profit boards of directors sign a conflict of interest disclosure statement as soon as they begin their tenure. Many of them, however, have conflicts of interest large enough to drive a truck through. Despite this, it seems only right to allow, for example, the local banker (who just happens to sit on the board) the opportunity to invest a non-profit’s assets in proprietary mutual funds, hidden costs and fees notwithstanding. After all, stock brokerage firms, banks, trust companies, insurance companies, and the like are often major donors to nonprofits. Since competition for dollars is so fierce among non-profits, no one wants to upset such entities so they are rarely replaced as board members or investment advisors. (Executive directors and CEOs of non-profits must tread lightly in this area because they are answerable to their boards with their jobs.) Without sufficient knowledge of prudent fiduciary guidelines, many board members simply default their votes to support the “good old boy/gal” network of conflicted interests.
I have received phone calls from members of non-profit boards asking me if I think that a local broker, banker, or trust officer who sits on the board and whose firm invests at least some (if not all) of the non-profit’s portfolio has a conflict of interest. When I give the obvious answer, usually the caller is relieved to find that someone else thinks that something is very wrong.
Yet upon completion of such a call, it’s pretty obvious that the board member can’t (or won’t) do anything about the situation. In my experience, there are only a relatively few hardy board members that will actively buck the conflict-ridden situations they face and speak out against them. They simply refuse to “go along to get along” and for that, they are truly doing the Lord’s work, particularly since the issues they care about involve investing more efficiently and effectively to yield bigger and bigger pies that can be fed in ever bigger slices to beneficiaries of non- profits.
My next column will explore the approach used by most investment advisors in providing investment advice to fiduciaries of non-profits. That approach, which can be thought of as imprudent speculation, unnecessarily leaves investment returns on the table, thereby resulting in smaller pies from which beneficiaries of non-profits get smaller slices.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.