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In this Executive Update Special Section feature article, Tony Keane - interim executive director of the Construction Specifications Institute - provides an outline and options for associations in terms of updating or rethinking their investment policies.  If you are an association CEO or CFO, then this article is a must read.

Associations, like most organizations (and people) in the United States today, have been hit hard with at least two years of investment losses and declining interest income. As of December 5, 2002, the year-to-date returns on the DOW Industrials was a negative 13.95% - not quite as bad as 2001, but it appears 2002 will be another year of losses.

Many associations rely on investment earnings to support operating expenses, capital improvements, new initiatives, and new technology. According to the American Society of Association Executives Operating Ratio Report, 11th Edition, the average dividends and interest income reported on the IRS Form 990 was 3.4% of total revenues, which doesn't sound like much, but with average net profitability at 4.8% it means that 71% of the average net surplus is a result of investment earnings.

According to the same report, 23.1% on average of total assets were invested in securities, which make investments one of the largest association asset categories. However, these statistics were when times were good, as the report is based upon 990s filed during 1999. If the same report were updated with today's statistics, we would see a significant decline in asset values and investment income.

Since that time, realized and unrealized losses on investments have forced many associations to post deficits for the past two years. The current status of the investment markets and interest-rate declines are old news: We have been living in this investment roller coaster environment for the past two years. Most people involved in association finance would like to see this ride quickly come to an end. The fun left when the negative impact on association balance sheets hit the significant stage, and financial forecasting for this activity became next to impossible. So how do associations cope with this business atmosphere?

Staying Alive
Financial planning is critical to an association's survival. In many associations, budgets govern spending programs very tightly, and variances from revenue projections are not tolerated well. How should an association budget for investment returns?

As with many accounting questions the answer to the above question is, "It depends." I have found that there are three general approaches to budgeting for investment income. The first model pertains to the association that relies on the investment income to support a level of operations. These associations include the revenue line as part of the net operating results. The second model relates to the association that includes investment income as a "below-the-line" item. These associations include the investment income after the net results from operations are calculated. The third model is a hybrid model, whereby the association accounts for dividends and interest income as part of operations, and gains and losses, both realized and unrealized, are accounted as a "below-the-line" item.

There also is a variation of the third model, which is when the investment earnings from working capital are included as part of operations, while the investment earnings from reserve or restricted funds are not included in net results from operations. Each model will impact the forecasting methodology and possibly the investment policy.

The first model, which includes the investment income as part of operations, has the potential for serious ramifications if projected investment results are higher than the actual investment earnings. This is due to the fact that program spending relies on the investment revenue for support. If these are ongoing programs, it is highly recommended that the types of investments used in the portfolio be heavily weighted to fixed-income securities.

Fixed-income securities will minimize investment losses and will make it easier to forecast earnings. An association can budget for a fixed-income portfolio by looking at the interest rates locked in on owned securities and the maturity dates. A very specific forecast can be made from this approach. If certain securities will mature in the fiscal year, then look to current rates and interest futures to estimate the potential interest rate that will be earned on the replacement security. Investment portfolios heavily weighted to equities will yield much variability in the operating results if this model is used. Results from operations will be distorted either positively or negatively based upon gains and losses in the equity account.

The second model, which includes investment income as a "below-the-line" item, affords some short-term relief from budgeting investment returns. A quick survey of several associations revealed that 50% of the associations using this model do not budget for the investment gains or losses. Due to the variability of gains and losses, the actual earnings are not compared to a budget amount in the financial statements.

However, the investment results are compared to several benchmarks in accordance with investment policies. For organizations using this method, budgeting for investment income has not been a problem. For the other 50% that budget for investment earnings, they typically have used a historical return rate based upon the types of investments included in their investment policies. Many associations use a rate between three and ten percent for the historical rate. When using this second model, an association can afford to take more risk in the investment portfolio due to the longer term outlook.

The third model and its variation, reflecting the hybrid approach, is in my observation the most widely used by associations. The reason for widespread usage is twofold. First, dividends and interest income are easier to predict, and therefore can be reasonably included in operating budgets as in the first model. Second, many associations look to the appreciation of securities to increase the value of their special-use or reserve-type funds.

Due to variability, gains and losses are difficult to forecast; therefore, this method works well since the equity investment results are captured "below the line." The theory behind this model is that working capital is used for operating purposes, so any returns on working capital should be part of operating net results. The investment portfolio is to provide long-term stability and fund capital-intensive projects - thus, returns should not be included in operations but tracked separately.

An investment policy for associations using the third model should be comprehensive. It should cover not only the special-use or reserve-type funds but also the working capital funds. Usually, associations using this model would have a balanced approach to investing with 50 to 75 percent of the funds invested in securities. The actual percentage should be based upon the capital needs, the association's capacity to handle risk, and the recommendations of an investment consultant.

Strategies for Success
What to do, though, when interest rates have declined so significantly that they do not even come close to matching historical rates? What to do when investment returns are negative instead of close to or exceeding historical averages? What to do when returns fluctuate significantly on a regular basis? Here are some items to consider.

1. Refine your budget model to either the second or third model - remove the variability from operations.
2. Change your investment budget to reflect more of a worst case scenario: Be conservative.
3. Stabilize investment earnings and revise your investment policy to reflect an increase in fixed-income securities; this may come at the cost of lower investment earnings in the future.
4. If regular operating income from investments is a necessity, then consider setting up a portion of the portfolio in an annuity format to level out the cash flow for program spending. This may periodically require dipping into principal to support operations.
5. Use a flexible budget for the programs that rely on investment earnings: Control spending based upon earnings instead of spending (and then hoping that the investment income will be adequate to cover the program expenses).
6. Be prepared to reduce expenditures in programs that have reduced funding. Remember, just because it is in the budget does not mean it has to be spent.
7. Plan future net surpluses to replenish funds that have decreased significantly due to economic conditions. It is important to replenish funds to provide for the future stability of the association.
8. Do nothing if the association has adequate working capital and reserves. The association will have to accept years of deficit spending until the economy recovers.
9. If the investment environment changes mid-year, then consider a contingency budget or mid-year update. Be prepared to react to changes in the business environment.
10. Change the investment policy to reflect target ranges to provide opportunities to increase or decrease the amounts invested in cash, fixed-income, or equity securities when the markets are not performing as planned.
11. Remember: No one is able to accurately predict the stock market returns and interest-rate changes on a regular basis; associations should not expect to either.

Patching (or Preventing) the Leaks
These are uncertain times. Budgeting and forecasting are difficult enough tasks in normal times. When constant fluctuations and significant losses are introduced into the picture, it can become a nightmare.

For example, my association, the Construction Specifications Institute (CSI), budgets for investment income only on working capital funds. The budget document includes cash flow projections for the invested reserve funds, which are reflected in the projected balance sheets. During these uncertain times, CSI has implemented the following to address lower returns and to help minimize the impact of reduced investment values.

1. Reduced earning expectations.
2. Reduced new initiatives spending due to losses in the reserve funds.
3. Revised the investment policy to provide increased flexibility.
4. Brought a fresh outlook to the investments by changing investment advisors.
5. Implemented contingency budgets due to changing economy in the middle of the fiscal year.
6. Reduced operating expenses due to lower interest income.

Each association is slightly different, and what may work for one may not be possible for another. The important aspect of budgeting for investment results in today's uncertain economy is to be flexible and to manage the operations accordingly. Investing is a long-term view that will continue to be similar to a roller coaster ride. Associations need to make sure that their types of investments match the short- and long-term needs of the organization. Keeping expectations reasonable will make the ride much smoother and will keep the impacts of the ups and downs at a minimum.

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