PART ONE: 

ESTABLISHING A HOLISTIC CONTEXT

Financial responsibility and stewardship should be a key focus for every investment firm. This is also true for boards and investment committees, which have oversight responsibilities for the management of the organization’s financial assets. Donors and beneficiaries of charitable organizations and pensions are increasingly interested and involved in this oversight process. As a result, stewards are now examining their guiding principles, governance practices and goals, with a focus on advancing the mission of clients and beneficiaries. A key component of this approach is a multi-faceted and holistic view of risk management.

This white paper is the first in a series that explains how a broader understanding of risk from a client’s perspective and how it is essential to every organization’s success. Toward that goal, we will offer our perspectives on:

• Fiduciary responsibility and risk with respect to regulatory issues and operations
• Investment responsibilities, contrasting a typical view of investment risk (focusing on products) with a true client-centered view that focuses on fulfilling the organization’s mission
• A holistic approach to investing that incorporates high standards of fiduciary oversight and rigorous investment practices within client-centered measures of both risk and success.
  
  

MEASURING RISK MEANINGFULLY

Much has been written about investment risk over the years, and investment managers have developed methods to identify various statistical measures of risk. These are used to construct portfolios that are expected to outperform a relevant asset benchmark. (A popular example is a 60/40 mix of stocks and bonds.) Investment firms use these measures of risk to evaluate the success of their strategies.

But what about the view of risk from the perspective of the organization and its beneficiaries? Do these participants see risk in the same way as investment managers?

We believe that the answer is “no.”

While investment managers view risk numerically within their own competitive environment, organizations typically view risk in terms of monetary outcomes relative to their financial goals. Clients don’t see the investment portfolio as an end in itself. Rather, they see it as a means to supporting their mission - and  risk is measured in terms of accomplishing their mission.

And because they operate under intense regulatory scrutiny, organizations must first consider the risk to their reputation - if they do not comply with the laws, rules and guidelines that pertain to them. As a result, we see a hierarchy of risk emerging, starting with reputation and mission. This is the context in which investment risk must be developed and evaluated.

A GOALS-BASED APPROACH TO RISK

We recognize that many organizations (and individual clients) invest to meet dual financial goals: withdrawing an adequate amount of money while preserving the remainder to support future withdrawals. This is a challenge that involves investing within uncertain markets, while balancing the competing claims of current and future needs.

A “goals-based” approach to investment management provides a more robust and realistic method for evaluating risk and explaining it in ways that are relevant and understandable. In this context, risk is multifaceted, incorporating both qualitative and quantitative aspects. We also believe that risk means different things to different organizations, and that appropriate investment decisions are rooted in viewing risk through the eyes of each client. This begins by seeing the investment process through a fiduciary lens, focusing first on stewardship.

FULFILLING FIDUCIARY RESPONSIBILITIES BY MANAGING FIDUCIARY RISK FIRST

Every organization is headed by a board of directors, who provide leadership, stewardship and oversight to carry out the mission. Each board member is a fiduciary of the organization, entrusted with responsibility for all of the organization’s assets - its legacy and good name, its beneficial purpose and all of its financial assets. This relationship of trust encompasses a variety of responsibilities and their accompanying risks.

Fiduciary responsibility has three duties: loyalty, prudence and care.

• Loyalty involves placing the interests of the organization ahead of personal interest, and eliminating conflicts of interest. This begins with understanding the mission of the organization.
• Prudence requires understanding and complying with applicable laws. It also requires having the knowledge and experience to carry out one’s responsibilities. When this knowledge is lacking, responsibilities should be delegated to those having the required knowledge and expertise.
• Care demands diligence in executing all responsibilities, including documentation of all procedures, decisions and actions taken on behalf of the organization.

A fiduciary approach involves every decision made on behalf of the organization. It also involves understanding the hierarchy of responsibilities: organization, mission, goals and financing.

UNDERSTANDING FIDUCIARY GUIDLINES

Fiduciaries face a trend of ever-higher standards of prudence, expertise and transparency. Current regulation now includes the Uniform Prudent Management of Institutional Funds Act (UPMIFA) and the Pension Protection Act (PPA) that was added to existing pension law under ERISA regulations.

These laws provide guidance on both the investment of assets and expenditures of investment funds. Failure to meet these regulatory standards can result in sanctions, fines and potential loss of reputation.

Meeting these requirements and the many legitimate requests for information from so many interested parties can be a daunting task, and many boards are finding that managing fiduciary risk is not only a key responsibility, but perhaps their greatest challenge.

BALANCING CURRENT AND FUTURE OBLIGATIONS

The board must ensure that there is a vision for the organization’s future. Many organizations are meant to last in perpetuity, and so the board must maintain the organization’s purpose over successive generations. This requires the flexibility to remain relevant in the face of changes in the society, economy and technology. At the same time, the board must ensure that the organization remains true to its purpose.

To do this, the board must establish and confirm the organization’s values and adopt a mission statement that (a) identifies the organization’s beneficiaries, (b) defines the general business of the organization and (c) defines the end result from their efforts. This provides clarity and direction, allowing the organization to establish and adopt both short-term and long-term goals and to monitor the progress of the plan. This careful approach increases the likelihood of success in preserving the legacy of the organization.

The two components of preserving the organization’s legacy

Each organization’s legacy consists of two components:

• Its reputation, as defined by its purpose

• Its ability to maintain its presence in society by continuing to provide support for its mission.

Reputation: Boards must understand that it is not enough simply to do good. It is critical that the organization is recognized for providing significant good to its constituents, while maintaining high standards of ethics, prudence and effectiveness.

Continued support of mission: The second component of an organization’s legacy is financial in nature, since the organization must preserve the value of its assets if it expects to continue providing the same level of support over successive generations. The investment portfolio is an important source of funding these financial obligations; for some organizations, it may be the only source of support for the mission.

A SOLID FOUNDATION OF GOVERNANCE

The board’s primary responsibility is to outline and define the types of risk and the levels of risk that are appropriate for the organization and its investment portfolio. As a rule, the board must decide which types of risk should be borne by the organization vs. engaging capable third parties to further their charitable purpose. Once these appropriate risks have been identified, they may then be managed effectively, subject to the organization’s governance, compliance and oversight systems.

While most organizations feel that they have adequate controls and resources in place for corporate governance, many face tremendous challenges in this area. Sadly, we see a steady supply of news stories involving credible organizations that experienced major corporate governance failings.

INSTANCES OF FAILED CORPORATE GOVERNANCE

No organization is perfect, but thankfully we have regulations and governance structures that are designed to prevent and correct errors that might cause reputational and financial harm to the organization and its beneficiaries. The board is responsible for ensuring that adequate compliance systems are in place - and for providing the necessary oversight to ensure that these procedures are followed.

Board members may not understand that they are personally liable for bad decisions that are the result of imprudence, malfeasance or the lack of adequate due diligence. The Ponzi scheme run by Bernard Madoff resulted in financial losses for its investors – and then fines were levied against these organizations and their board members for failing to provide adequate operational controls and due diligence.

Here are a few more examples of inadequate corporate governance:

• A private university whose chief investment executive was fired for self-dealing
• A public charity whose board members regularly flew first class to meetings held at posh resorts
• A private foundation whose family board members engaged in business dealings with the foundation that were not arms-length transactions
• A faith-based charity whose chief executive was indicted for inflating expenses and colluding with vendors to rebate overcharges in the form of political campaign contributions and kickbacks

CLIENT-CENTERED RISK STARTS WITH THE CLIENT

• Risk is a multi-faceted concept that requires a holistic approach
  
• Each participant has a unique view of risk, rooted in their unique contributions and needs
  
• A fiduciary approach to risk is a hierarchy:
  • organization
  • mission
  • financing goals
  • investments
    
• Stewardship brings risk analysis into the proper context for effectiveness and client success

COMING UP NEXT

Having established a foundation of fiduciary responsibility and risk from the client’s perspective, the next paper in this series will examine establishing the organization’s mission and goals.  This is where its purpose is identified and described in practical terms, focusing on its beneficiaries and the expectations of financial support to be provided.

Written in partnership with Stephen Campisi