AAOS Bulletin - February, 2006

Special report: AAOS investment fund philosophy

By Edward A. Toriello, MD, and Rich Stewart

Edward A. Toriello, MD
AAOS Treasurer

As my term as AAOS treasurer draws to a close, I think it is a good time for Rich Stewart, the Academy’s chief financial officer, and me to report on the state of our investments. We also want to ensure that you understand the rationale behind the recently revised AAOS Investment Policy (see the end of this article for Investment Policy Highlights).

Investment policy

The AAOS runs much like our offices. Money comes in and is used to pay for the cost of operating our business. If we have more revenues than expenses at the end of the year (profit), then we place that money into our investment funds. On the other hand, if we show a loss at year’s end, then the money in our investment portfolio can be used to balance our books.

The AAOS investments are in a single portfolio, but are composed of two separate funds, each with a Board-designated mission.

The purpose of the Permanent Fund is to provide enough money for the AAOS to continue functioning for six months in the event of a financial disaster that significantly impacts our revenue stream. Although such an event is unlikely, Hurricane Katrina demonstrated how real this scenario could become.

Most nonprofit organizations and medical associations have a Permanent Fund—often described as a “rainy-day fund.” Although the most common target balance is six months of operating expenses (or 50 percent of the annual expense budget), many organizations are increasing their permanent fund’s target balance to reflect a full year’s operating expenses (or longer). However, the AAOS Board believes that a six-month reserve is adequate. The AAOS 2006 expense budget is $49.3 million; thus a fully funded Permanent Fund would total approximately $25 million.

The Project Fund is designed to give the Board the money necessary to fund large projects and acquire large capital assets. The Board “borrows” the money from the Project Fund and must develop a repayment plan covering a limited term at a specific rate. This ensures that the Fund will continue to be available for future Boards. A formula is used to determine the appropriate amount for this Fund; as of December 31, 2005, a fully funded Project Fund would include about $16 million.

Taken together, the Permanent Fund and the Project Fund would require a balance of $41 million as of December 31, 2005 to be fully funded. In comparison, the AAOS Investment Fund—which has grown solely because of investment earnings—now amounts to $40 million, or about $1 million short of the total target balance. Because we are well on our way to being fully funded in the near future, the Finance Committee has recommended that the Board designate up to 4.5 percent of the money in the Investment Fund to help close the original $2.7 million budget gap for 2006.

Fund Type

Dollar Value




Target Range

Large Cap – U.S.




Mid-Cap – U.S.




Small Cap – U.S.




Total U.S Equities



45% - 55%

Large Cap – Int’l.




Small Cap – Int’l.




Total Int’l. Equities



12% - 18%

Fixed Income



30% - 40%

Total Fund




The 2006 budget

Since 1998, AAOS revenues—from dues, the Annual Meeting, courses, publications and grants—have increased from $33.1 million to $44.3 million (through November 2005). On the other side of the ledger, expenses have kept pace by rising from $31.7 million in 1998 to $39.1 million in 2005 (through November). This is the direct result of a dramatic increase in the number of activities that the AAOS performs—347, up from 290 in 1998.

Some new activities with significant costs are the Expert Witness/Professional Compliance Program, the Medical Liability Reform effort and membership benefits, such as the shift to a monthly Journal of the AAOS and the member benefit subscription to the Journal of Bone and Joint Surgery. In addition, the Academy’s business plans include significant involvement in the government’s “Pay for Performance” initiative as well as a respected presence in the many other health care discussions taking place at both national and local levels.

The initial $2.7 million gap in the 2006 budget noted above has been narrowed significantly by cutbacks in budgeted expenditures. Nonetheless, total spending is forecast at $49.3 million while revenues are projected to reach $47.7 million. Rather than raise dues or cut back further on programs, we will use up to 4.5 percent of our investments—about $1.8 million—to make up this difference.


To my knowledge, the AAOS has never been in a better position to use investments to fund operations. This gives the Board more flexibility when moving forward with major projects such as Patient-Centered Care, Pay-for-Performance and Medical Liability Reform. With this flexibility comes additional challenges for future Boards.

Currently, each new project—no matter how critical and without deference to its source—is subject to critical review by the Finance Committee before consideration by the full Board. Each project sponsor must provide a multiyear financial analysis and submit annual measures of success that will be used to evaluate the program and determine whether it is fulfilling its expectations. Programs that do not meet expectations will be modified or terminated.

In a similar manner, any program that costs the AAOS more than $75,000 per year is subject to a semiannual review by the Leadership Review Group (LRG). The LRG—which is composed of the first vice president as chair, the second vice president, the immediate past president and the treasurer—looks at whether the program is meeting its measures of success. If it is not, it is either modified or terminated.

Using investments to fund operations is an extremely viable option in “bull” markets. However, this practice becomes a slightly risky proposition in a normal “bear” market, and an extremely risky proposition in a significant economic downturn such as the one we experienced in 2001-2002. The AAOS has been fortunate in that our recent investments have yielded ample returns, and sufficient funds are available to cover the expected shortfall in 2006.

I am confident that future Boards will remain vigilant and will not allow the ready availability of investment funds to lull us into a state of relaxed standards for the performance of AAOS products and services. I am also certain that the Board will continue to demand that every program, product or service add value for the resources that are expended to maintain it.

Future options

The AAOS’s investments exist solely for the long-term benefit of the Academy and its members. They provide the AAOS with security and flexibility and need to be treated with proper respect. Speaking from my experience as the AAOS treasurer for the past three years, I believe that the Board’s plan to use a limited amount of our investments to fund operations in 2006 is appropriate and constitutes a prudent use of these funds, which have grown by an annual average return of 12 percent during the past three years.

I know that William L. Healy, MD, the incoming treasurer, will be extremely diligent in protecting all the assets of the AAOS and will do his best to ensure that the Board has the information it needs to make prudent decisions on the use of our investment funds. When used wisely, the investment funds can help maintain the vitality of our organization without our having to resort to drastic and unpopular measures such as increasing dues or curtailing important programs and services.

I want to thank you for your support over the past three years. I believe that I am leaving at a time when the AAOS has a solid financial foundation to continue performing at the peak level that you, the members, deserve. If you have any questions, please feel free to contact us at stewart@aaos.org

Edward A. Toriello, MD, is the AAOS treasurer; Rich Stewart is chief financial officer for the Academy.

AAOS investment policy highlights

The AAOS Board of Directors recognizes its responsibility to manage the Investment Fund assets:

• for the exclusive benefit of the Academy;

• prudently and in full compliance with all policies, applicable laws and regulations and

• to enhance long-term returns within certain risk parameters.

The Board has delegated operational authority—the buying and selling of securities within Board-approved target ranges—of the Investment Fund to the Finance Committee. In carrying out these responsibilities, the Finance Committee is assisted by the Academy’s chief financial officer and an outside investment advisor.

The Board recognizes that the primary investment objective is relatively conservative: to achieve optimal, long-term, real (after inflation) investment returns with manageable volatility and minimum negative impact on the principal while allowing for up to a 4.5 percent annual withdrawal to fund current operations. To manage volatility, the Investment Fund assets are to be diversified (through investment funds in various asset classes such as domestic equities, international equities and fixed income).

To minimize the impact on principal, the Finance Committee reviews investment returns monthly and the investment managers’ performance quarterly. However, the Investment Fund has a long-term performance horizon, so short-term declines in market value (and a slight reduction in principal) may be tolerated to achieve potentially higher long-term investment returns.

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