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Picture this: it is the late 1990s, and the recently formed American Registry for Internet Numbers, Chantilly, Virginia, finds itself at the center of the technology boom. Revenues are steady, and growth must be able to keep up with the industry that ARIN serves. Moreover, reserves must keep up with the association's budget growth. But what percentage of the annual operating budget should be maintained in reserve? How are the board's and staff's responsibilities in managing the reserve pool to be divided? When can the reserves be used? Should the reserves be invested in technology companies or, in doing so, would there be an appearance of a conflict of interest? While most associations understand the need for reserves, many have not taken the time to answer such questions--questions ARIN's board of trustees eventually realized should be addressed in a formal reserve policy.

We recognized that associations and other nonprofit organizations--whether they serve an expansive and volatile industry or not--have a fiduciary responsibility to minimize the risk of financial problems, and reserves generally act as insurance against potential cash flow problems affecting operations. Particularly in today's financial climate, nonprofit organizations face difficult financial decisions in terms of managing the money they may have saved or plan to save.

Simply possessing reserves raises its own set of risks for an organization, such as the possibility of making bad investment decisions, having insufficient levels of reserves to operate during times of revenue shortfalls, and even suffering from fraudulent use of reserve funds. Yet, according to the Operating Ratio Report, 11th Edition (2000, ASAE), only about 50 percent of associations have reserve policies.

At ARIN, we've learned that a reserve policy also serves as a guide for staff leaders and governing boards, differentiating the responsibilities of each in handling money and controlling risk. It also outlines how, why, and in what financial instruments to invest reserve funds. Embedded within an overall reserve policy is an investment policy, which guides asset allocation. (For information on developing a reserve investment policy, see sidebar "Risk and Asset Allocation in Investment Policies.")

Developing the reserve policy of ARIN was an evolutionary experience, beginning with the establishment of a reserve goal amount followed by the gradual recognition that a formal reserve policy was in order. This relatively new organization, which experienced rapid growth while at the center of the notoriously volatile technology and Internet sectors, offers a noteworthy case study of how one association came to invest its reserves and develop a formalized reserve policy.

Realizing a need
With most of its members being Internet service providers that request and register Internet protocol (IP) addresses through ARIN, the association's mission is central to the development and expansion of the Internet. Our goal is to help the Internet to continue to grow, while conserving addresses to ensure responsible growth and operational longevity. The numerical IP addresses, which we keep in our public database, are what lie behind the URLs and e-mail addresses that your computer uses to navigate the Internet.

From the beginning, the board of trustees gave management the task of keeping at least one year's worth of operating revenue in reserve. As one can imagine, ARIN's budget has grown quickly and substantially during its short lifetime, creating a need for an ever-increasing reserve level to meet any future revenue shortfalls. Beginning operations in December 1997, ARIN's revenues have increased from $2.5 million in 1998 to approximately $7.2 million in 2002, and expenses have grown from $2 million to approximately $6.3 million during that time.

Because the board did not give guidance on what types of investments in which to hold the reserve funds, management was keeping the money in one of the most conservative investments possible: the bank. A substantial, conservatively invested reserve was deemed appropriate particularly because at the time of the organization's beginnings, many Internet legal issues still had not been resolved. Consequently, we wanted to be prepared should ARIN be forced to become involved in a lawsuit.

In mid-2000, with its operating budget (and reserve level) up to $4.8 million, ARIN was holding its reserves in both money market mutual funds and an interest-bearing checking account. Because the Federal Deposit Insurance Corporation (FDIC) only insures up to $100,000 per customer per banking institution, management felt that the time had come to diversify the portfolio. ARIN's reserves were at risk if the bank that held the majority of its reserves should declare bankruptcy. While the odds of this happening were quite low, it nevertheless was time to make some asset allocation decisions and develop a plan to diversify the investments. With required reserve levels continuing to rise with the operating budget, ARIN began to look into developing both reserve and investment policies--realizing that they go hand in hand.

Learning from the experts
Significantly, the need to develop an investment policy--that is, a policy to guide reserve asset allocation--spurred the creation of a broader reserve policy. Initially, ARIN decided to seek out assistance in developing its investment policy from a knowledgeable professional with experience handling investments for associations. After I, as ARIN's director of business, made contacts with several financial services firms, candidates were narrowed down to three--two full-service financial services firms and one independent broker-dealer--each of whom were asked to submit proposals. ARIN's board of trustees set up an investment subcommittee consisting of three board members. Once the process of choosing a financial consultant got under way, we soon learned that what we really needed was a formal reserve policy as an overarching plan that included guidelines for diversifying investments.

Working with the investment subcommittee, the three firms then developed their proposals based on the issues raised in individual, face-to-face meetings. Largely through a survey administered by one of the three firms, ARIN gave the vendors guidance on such reserve policy issues as how much risk the organization wanted to undertake and how soon the money might be needed in the event ARIN's operations required additional funding. Based on our answers to this same survey, we realized that we were in the very conservative camp in terms of risk we wanted to undertake, and that we did not want to put more than 33 percent of our reserves in high-risk (that is, equity) positions. The extensive survey requested information ranging from sources of revenue to ranking of investment priorities (preservation of capital, optimize return, and so on).

While we had no formal written request for proposal (RFP), it is now apparent that it would have been better to have a short written document to avoid having to re-explain the requirements to each firm and to clarify exactly what services we were seeking. Once the meetings were concluded, we relied primarily on e-mail to discuss further details of the proposals, so we left a good audit trail that tracked the process of proposal development.

The three firms each did presentations to the investment subcommittee in March 2001, one year into the steady decline of the stock market. As one would expect, market prices for the stocks of ARIN's members were some of the worst hit. In this climate, the investment committee felt that a more conservative investment approach with an emphasis on safety should play heavily into the choice of vendor and plan.

In the end, we selected Legg Mason, Inc., Baltimore, a pioneer in investing for nonprofit organizations (having operated the ASAE Association Investment Program since 1992, when it first developed its nonprofit program), and it showed. (For information on the program, go to www.leggmason.com/AIP.) For example, the company's representatives explained that ARIN could invest in mutual funds that had interests in its member companies without having to be concerned over any appearance of a conflict of interest, since ARIN would have no input into specific investment decisions. Besides this sort of expertise, the company is a smaller financial institution that serviced association clients; thus, we are not such a small fish in a big pond.

In addition, without our first having to commit to a contract, the company volunteered to outline a plan for a recommended reserve policy. Working with Legg Mason to develop the plan helped us organize our thinking and further assess how much risk we were willing to take. We learned that a reserve policy is far more than just investing money.
Synthesized from our answers to the extensive survey, the initial policy was drafted, addressing a broad range of issues much farther reaching than we had anticipated when we had begun the process.

Clarifying board and staff responsibilities
We learned that a well-crafted reserve policy sets out the board's oversight authority and staff hands-on responsibilities for managing the portfolio. Performance reports need to be submitted to designated board members and staff, and an individual--in ARIN's case, myself--must be given authority for serving as the contact to the investment adviser for such tasks as moving money among various reserve funds. A key provision is direction on how to handle the deposit and withdrawal of money in relation to the portfolio. ARIN's finances designate that the treasurer has ultimate fiduciary responsibility for the organization's finances, and the policy reflects that fact.

In addressing these policies, ARIN decided to have the performance reports go directly to the finance committee as well as to staff on a quarterly basis. Investment performance is reviewed on an annual basis to ensure that it is meeting predetermined expectations and is meeting or exceeding market performance. If quarterly performance should fall short of either of these gauges, we discuss and assess the reasons and make adjustments without having to wait for the annual review.

Any withdrawals require approval by the finance committee, which also directs any additional investments into the various funds from surplus revenues. The treasurer is designated to give the annual report on the plan to the full board. I am the main contact with the investment adviser and take care of the normal maintenance decisions such as reinvesting the maturing CDs and rebalancing the portfolio. The finance committee meets annually to go over all of ARIN's finances, including the reserve investments.

Determining fund uses and investment guidelines
The plan provided ARIN with guidance on how to allocate and manage the funds, what the allocation structure should be, and what types of instruments to use. Based on the recommendations of our adviser, who had evaluated our survey responses, the investment committee decided to split our reserves into three pools or funds.

Long-term fund. This is our true reserve, in that we do not plan to use the money in the near future, and only in a fiscal emergency. All of the equity investments are part of the long-term fund. Naturally, bond investments in this fund are longer-term as well.

Capital expenditure fund. Because ARIN is technology-oriented, it requires some capital expenditures for software and hardware in any given year. This fund is designed so that the money can be used within a five-year time span. We can pull money out of it, if needed, to fund capital purchases and then replace the funds from operations revenue. If operations do not generate sufficient cash to replace the funds, we can transfer money out of our long-term fund.

Short-term (one-year) fund. This pool is intended as operations backup. If we run short of operating funds, we can withdraw from this fund, paying a minimum penalty on the withdrawal.

If our bank account holding our operating funds exceeds a certain percent of our budget, we reinvest the surplus amount into the reserve funds. Conversely, we tap the reserves, starting with the short-term fund, if our bank account falls below a certain percent of the budget.

The next step was deciding the percentage that each of the pools or funds should represent of the total portfolio. ARIN decided to invest a significant majority in the long-term fund with the rest equally divided between the short-term and medium-term funds. These percentages were derived by analyzing what our cash needs might be during the short- or one-year term, the medium- or five-year term, and the long- or more than five-year term.

Based on our plan, we conservatively decided that we would maintain less than 35 percent of the overall portfolio in equities. The rest would be in bonds and CDs, with a large amount committed to bond mutual funds. The short- and medium-term funds we mainly committed to bank CDs. Because the FDIC treats CDs as bank deposits, we invest a maximum of $100,000 per bank to be fully insured. We also ladder the CDs to minimize the interest-rate risk, meaning that we purchase an equal amount of CDs, with differing maturities so that if interest rates rise, we inevitably have a portion of the portfolio maturing to buy more CDs at the higher interest rate.

Establishing security in checks and balances
With a formalized reserve policy comes increased security. At the center of that security, and key to the policy, is reporting and control. With a reserve policy that calls for periodic review of investment results, the board has a better handle on the investments, and it maintains the final say on the use of the funds. And since the reserve policy contains a written investment policy, our investment company has clear direction as to the kinds of investments that it can make.

Now that we have achieved our goal of maintaining one year's operating budget in reserve, we aim to maintain the fund's purchasing power by taking on a certain level of investment risk. Further, we are aware that our operating budget will probably continue to increase each year going forward, commensurate with inflation, requiring our reserves to rise along with it. The fact that this requirement itself is a part of our reserve policy illustrates the policy's value in ensuring the financial health of the organization.

We look at our reserves as a store of value, and our reserve policy reflects this viewpoint in terms of our acceptance of some investment risk and our detailed guidelines for the proper use of the funds. We do not factor any income from these investments into our operating budget. However, in addition to providing us protection against financial hardship, our detailed reserve policy allows us to tap the funds to offset capital equipment expenditures or other extraordinary planned purchases if needed. Nevertheless, in the final analysis, we view our reserves as rainy-day funds, and we are secure in knowing that they are truly available should we need them.

Bob Stratton is director of business at the American Registry for Internet Numbers, Chantilly, Virginia. E-mail: bobs@arin.net.

Related Sidebar:

Risk and Asset Allocation in Investment Policies

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