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Reimagining the Pooled Income Fund: A Community-Scale Mutual Fund

Written by: Brian Beckon

November 29th, 2018

At Cutting Edge Capital, we think a lot about the possible legal strategies that can advance community capital. There are the often-used (if not well-known) strategies like crowdfunding, direct public offerings, and charitable loan funds. But then there are strategies that have been on the books for decades but have seldom, if ever, been used as a vehicle for community capital. Sometimes innovation isn’t about doing something new, but rather doing something old in an innovative way.

Years ago, I helped a charitable organization set up a pooled income fund (a “PIF”). The idea of a PIF is that a contributor puts money or assets into a trust, where it is pooled with the contributions of other contributors and jointly invested. Income from the investments is distributed to the contributors (and often their spouses or other beneficiaries) for their lifetimes. Upon the death of each life beneficiary, the pro rata value of the fund at that time is removed from the trust and given over to the charity that sponsors the trust. A portion of the amount contributed is tax deductible to the contributor in the year of the original contribution, based on a formula that measures the actuarial value of the remainder interest that will eventually go to the charity.

Many foundations, universities, and other (usually large) charities have established PIFs as a planned giving device. From the point of view of these sponsoring charities, the purpose is to eventually receive the remainder interest upon the death of each contributor, though the charity may have to wait years, and sometimes decades. But with enough contributors in a PIF, it is inevitable that one by one they will pass on over the years, and those assets will come into the charity, as planned.

Meanwhile, the assets of the PIF are typically invested as most charitable assets are – in Treasuries, bond funds, perhaps some socially screened equity funds, but nothing that looks too risky. Big charities are a pretty conservative bunch. From the sponsoring charity’s point of view, the goal is to preserve and grow principal, while generating just enough income to fulfill the promises made to contributors.

So we went to work at this charitable organization, thoroughly researching the topic, developing a plan for how we wanted the PIF to work, and carefully crafting all the necessary legal documents, including a declaration of trust, a contribution agreement, and a disclosure document that explained everything. There was no discussion of using the PIF to make place-based investments – by which I mean investments in small ventures rooted in a local community that could contribute to a healthier and more resilient local economy. But I’ll come back to that in a moment. This PIF, like others, was to invest its assets fairly conservatively. And the charity would take a fee off the top for managing the fund.

When it was all finalized, we put it out there. And it flopped. The feedback was that anticipated annual returns, after deducting the charity’s management fee, just weren’t enough to make it attractive. Ultimately, the PIF attracted only a small handful of contributors before the organization pulled the plug and went through another hassle to unwind the PIF. It seemed like a lot of wasted effort.

Fast-forward to the present. Recently we at Cutting Edge Capital have focused on community investment funds as a critical tool for moving the needle forward significantly toward a more inclusive and equitable society. (We wrote about that here.)

But there are gaps in the legal landscape for community investment funds – a landscape dominated by the Investment Company Act of 1940. That law imposes a heavy regulatory burden on any investment fund that doesn’t qualify for an exemption, a burden so heavy that it is not financially feasible for a community-scale fund.

But, the 1940 Act includes a number of exemptions. It’s fairly simple to set up a charitable loan fund or a community-owned real estate fund, because each of those is exempt from the 1940 Act. However, there is no simple exemption strategy for a fund that makes equity investments in small businesses and is open for investment by the non-wealthy. There are a handful of exemption strategies that could work, but each of those strategies requires a fund to squeeze into a business model that may not align with what is needed.

In that context, we think the humble PIF deserves another look. The PIF fits within the charitable exemption from the 1940 Act because of the charitable remainder component. But even so, it can do what no other type of investment fund can do: It allows any number of investors of any level of wealth to pool their resources into a community-scale fund that can make equity investments in local businesses (along with any other kind of investments), with profits from those investments shared among the investors. No regulatory review is required, because of the securities law exemptions, which makes it efficient to set up. It’s like a local mutual fund without the regulatory burden.

There is, of course, the downside that the investors can’t get their money back because of the charitable remainder element. But that charitable remainder also brings a tax deduction, along with the knowledge that contributions will eventually go to a charitable cause. And depending on how the fund is invested, the years or even decades of income from a PIF may be far more valuable than the remainder interest. If the need arises, that life income stream can be transferred to another beneficiary.

Some may also argue that the assets of a PIF, being in a sense charitable assets, must be invested in a conservative way that does not accommodate the kind of small business equity investments that we are contemplating here. However, this argument is rooted in a false myth that fiduciary standards require charitable assets to be invested for capital preservation or for maximum financial return. While state laws vary, the general rule, as spelled out in the Uniform Prudent Management of Institutional Funds Act, is that charitable funds should be invested in a manner appropriate to the organization’s purpose – which could mean investing in local businesses, even if there is a higher risk of loss. The IRS recently underscored this point in a 2015 release on mission-related investing.

So a PIF can be much more than just a planned giving device that will eventually benefit the charitable sponsors. It can truly be an engine for local economic development that offers the benefits of investment to anyone in the community in an equitable and inclusive way. To date we are not aware of any PIF that is actually being used as a vehicle for community capital – that is, as a way for anyone to invest in the success of local businesses. However, in recent conversations that we’ve had, this idea has sparked significant interest, and we expect to see such a reimagined pooled income fund in action soon. So stay tuned.

Of course, nothing written here should be taken as legal, investment, or tax advice. If you would like to schedule a consultation with one of our principals at Cutting Edge Capital, click here.