As a society, we are fortunate to have many endowments and foundations whose assets support important work in our communities. These assets are most commonly distributed using a spending or distribution policy. Consequently, the success of an investment program is commonly defined by its capability to support this spending or distribution policy while preserving purchasing power and allowing for the modest growth of real wealth.
Understanding the Relationship with a Return Goal
|Distribution||4.25% of Market Value|
|Inflation||2.00% over the Long Term|
|Fees||0.50% of Market Value|
|Return Objective||4.25% + 2.00% + 0.50% = 6.75%|
Picking the Right Type of Rule
- Will the distribution be a percentage of portfolio market value or a set amount?
- How is the “portfolio market value” determined? (At a point in time, an average of periods, etc.)
- Is there an “increase” determined year to year, and if so, how is it determined?
|Simple Spending Rate||Spending is equal to the specified spending rate multiplied by the beginning period market value.|
|Rolling Multi-Period Average or “UPMIFA”||Spending is equal to the spending rate multiplied by an average of the market values of previous periods. This method reduces the volatility of required distributions from year to year.|
|Geometric Spending Rule||Spending in the current period is equal to a) Previous year’s distribution adjusted for inflation times a smoothing rate (used to further reduce volatility, i.e., 0.7); plus b) the beginning market value of the portfolio times the spending rate and the residual of the smoothing rate (i.e., 0.3 = 1 – 0.7).|
|Inflation-Linked Rule||Begins with a set dollar amount (typically determined by a certain percent of trailing market value) and the fixed amount is adjusted each year by an inflation index.|
|Hybrid Rule||Part of the annual spending amount is determined by an inflation adjustment of the previous year’s spending, while the balance is determined by applying a fixed rate to the portfolio’s market value.|
We asked the question “Which of the following statements best describes your organization’s spending policy for the endowment/foundation?” to our survey respondents. In Chart 2, it is apparent that there is no clear consensus between the different types of rules. We think this is largely appropriate: Given the different needs and objectives of different nonprofit organizations, there should be a wide range of rules employed. With that said, it is important that the rule is not selected for ease or familiarity. Instead, we recommend that nonprofit organizations work with their investment advisor to determine the rule that is most appropriate to the founding purpose of the investment program governing the assets making the distribution and, to the extent appropriate, to their organization’s financial needs.
Source: PNC; Numbers may not add up to 100% due to rounding.
View accessible version of this chart.
Understanding the Impact on Portfolio Outcomes
It should be obvious that the size and frequency of distributions have measurable impacts on portfolio outcomes for investment programs. Take two easy examples:
- A portfolio that starts with $100, earns an average of 5% per year, and distributes 6% per year will eventually run out of funds.
- A portfolio that starts with $100, earns an average of 6% per year, and distributes 5% per year should be able to maintain this, all else equal, in perpetuity.
Implicit in predicting the outcome for each of the examples above are three key variables: the size of the distribution, the frequency of the distribution, and the return objective of the portfolio.
Size of the Distribution
Table 3: Distribution Size
|Starting||Year 1||Year 2||Year 3|
Frequency of the DistributionThe frequency of the distribution is another important consideration, both when setting a spending rule and when designing a strategic asset allocation. For example, a portfolio that needs to support monthly distributions is going to need to have higher exposures to liquid asset classes (i.e., that could be sold quickly) to meet these distribution requirements without having excess cash drag (i.e., the reduced return that comes with holding investment assets in [low-returning] cash or near-cash equivalents). Conversely, a portfolio that only needs to support an annual distribution might be able to invest more in less liquid asset classes (such as private equity) that have the potential for higher return expectations.
The other consideration worth mentioning in this category is predictability. It is easier and more effective to build an asset allocation strategy to support regularly scheduled distributions than it is for one that takes distributions at irregular intervals.
Return Objective of the DistributionIn Chart 3, we asked survey respondents, “Given your organization’s current objectives and risk tolerance, how likely are you to decrease the liquidity of your portfolio in order to improve the probability of meeting return objectives?”
Source: PNC; Numbers may not add up to 100% due to rounding.
As a result, it is important to understand that a given level of distribution (as a percentage of assets) necessitates a minimum return objective to preserve purchasing power. Organizations targeting more frequent distributions might want to consider having a lower percentage distribution in order for it to be sustainable. Conversely, organizations targeting less frequent distributions might be able to consider having a higher percentage distribution in a sustainable way.
Taken as a whole, this emphasizes the point that size, frequency, and return objective of the distribution are significantly connected factors in determining an appropriate spending policy.
Planning for Periodic Review
Additionally, we recommend sharing the current spending policy (and other investment program policies) with new board or investment committee members as they come on board. This will help them to understand the current policies, and help the organization keep strategic continuity across leadership succession.
As the world continues to change, we would encourage nonprofit leaders to continue to evaluate and reevaluate every aspect of their investment program as part of good governance practices. Including the spending policy in that review can help keep the program running smoothly.
Special Note: We know 2020 was a tough year for nonprofit organizations. For those considering making a special distribution beyond normal spending policy, we recommend our report Understanding Special Distributions from Long-Term Asset Pools to help be cognizant of the potential impacts of such a strategy.
Accessible Version of Charts
|Generate enough return in dollars to cover the organization’s operating budget or funding obligations, plus inflation||47%|
|Grow the assets by a specific, fixed percentage over a defined period of time||36%|
|Have the return percentage match or surpass an index or market-based benchmark||16%|
|Based on a percentage of the invested asset pool||35%|
|Based on the money spent during a previous timeframe and only adjusted for inflation||23%|
|A hybrid of the first two options listed above||42%|
|We do not have a formal spending policy||0%|
Chart 3: Given your organization’s current objectives and risk tolerance, how likely are you to decrease the liquidity of your portfolio in order to improve the probability of meeting return objectives?
|As needed, but has not been done in the past 12 months||7%|
|As needed, and has been done at least once in the past 12 months||31%|