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.

How a spending policy or distribution policy is developed and implemented can significantly impact the ability of an investment program to achieve its goal(s).
 
In this paper, we discuss four best practices for decision-makers with regard to spending policies. Specifically, we focus on understanding the relationship with a return goal, picking the right type of rule relative to the distribution’s use, understanding the impact of the rule on portfolio outcomes, and setting up a plan for periodic review.

 

Understanding the Relationship with a Return Goal

 
In a 2020 survey of 188 nonprofit organizations (survey respondents), we asked, “Which of these best describes your organization’s return objective for the endowment/foundation?” The three answer options were focused on contributing to the operating budget or funding obligations, growing the assets, or having the return match or surpass an index.
 
Chart 1: Which of these best describes your organization’s return objective for the endowment/foundation? (As of 8/31/20)

Source: PNC; Numbers may not add up to 100% due to rounding.
 
View accessible version of this chart.
 
We view it as a best practice for nonprofit organizations to focus on the return objective in the context of their investment program’s purpose. In our survey, most respondents chose option one, which related the investment return to the spending policy, and a combined 52% chose the two answers that focused on growing the assets or beating a benchmark. While those two answers might be appropriate for a certain few organizations’ objectives, they might not be the most appropriate way to think about the investment program for most nonprofit organizations.
 
As an investment manager, one of the first things PNC discusses with a new client is their return objective. In framing this discussion, we start with asking the client what their distribution or spending policy will be. Implicit in this are two parts: the distribution itself (i.e., 4.25% of the end-of-period market value) and the length of time during which this distribution will be made. While the first part, the rate, will vary, most nonprofit organizations will answer the second part with the response: in perpetuity. The result is that in order to preserve purchasing power, inflation and fees have to be incorporated on top of the distribution/spending policy rate to calculate a minimum return objective that will achieve this goal. In the example, you can see how this return objective can be calculated.[1]
 
Table 1: Return Objective Calculation Example
                               
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%
 
From an investment perspective, this calculation becomes an important part of balancing the investment program’s required rate of return and risk tolerance objectives. Using the 6.75% return objective example, an investment manager could use risk optimization to help minimize risk against the return objective of 6.75%, allowing the portfolio to meet its investment goal efficiently and effectively. Without the orientation of the portfolio set on a required rate of return, the portfolio (specifically, the asset allocation) could be geared to return too much or too little. In the case of returning too much, a portfolio created with too high of a return target would be taking significantly more risk than required to meet the goal. In the case of returning too little, a portfolio created with too low of a return target would be taking less risk than is required to meet the goal, and consequently would likely fail to meet the return requirement.
 

Picking the Right Type of Rule

 
There are a number of different spending rules that are commonly used by nonprofit organizations. The differences tend to revolve around three key variables:
  1. Will the distribution be a percentage of portfolio market value or a set amount?
  2. How is the “portfolio market value” determined? (At a point in time, an average of periods, etc.)
  3. Is there an “increase” determined year to year, and if so, how is it determined?
We list five common spending rules in Table 2. It is important to note that there is no one “best rule.” Rather, the “best” rule for a given investment program is dependent on what rule is the best fit for an organization’s goals and objectives. Some organizations only target a set amount each year for maintenance or upkeep expenses. Other organizations aren’t very reliant on this distribution and aren’t very concerned if it is volatile. Yet other organizations derive a large portion of their budget from this distribution and thus need a stable distribution.
 
Table 2: Five Common Spending Rules

Policy Definition
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.

Chart 2: Which of the following statements best describes your organization’s spending policy for the endowment/foundation? (As of 8/31/20)

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

Assuming positive average returns over the long term and all else equal, a portfolio with more money (i.e., from making smaller distributions) is going to end up with a larger market value over time than a portfolio with less money (i.e., from making larger distributions). This should not come as a surprise: Compound interest is one of the fundamental theories underpinning the value proposition of the financial markets. Table 3 shows two examples that start with $100; each has a 6% return, and one has a $2 annual distribution and the other has a $5 annual distribution.

Table 3: Distribution Size
 
  Starting Year 1 Year 2 Year 3
$2 Distribution $100.00 $104.00 $108.24 $112.73
$5 Distribution $100.00 $101.00 $102.06 $103.18
Difference $0.00 $3.00 $6.18 $9.55
 
Over just three years, even a small difference in the size of the annual distribution has a noticeable effect on the portfolio’s ending value. This difference would only become more pronounced over 10 years, 20 years, or more. Picking an appropriate size for the distribution is important in terms of balancing current needs with future needs.

Frequency of the Distribution

The 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 Distribution

In 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?”

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 of 8/31/20)
 

Source: PNC; Numbers may not add up to 100% due to rounding.

View accessible version of this chart.
 
The clear majority of respondents answered that they would decrease liquidity to meet their return objectives; however, less liquidity can create its own problems with being able to make more frequent periodic distributions (e.g., quarterly or semi-annually) relative to less frequent periodic distributions (e.g., annually). Specifically, higher return targets can necessitate greater risk and less liquidity in the portfolio, which in turn can make frequent distributions more difficult without increasing the likelihood of having to sell assets at a discount to market value to make a given distribution.

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


Lastly, we would recommend reviewing how your organization will maintain the spending or distribution policy. Things change over time: Whether it is your organization’s financial picture/objectives, the broader investment markets, or anything in between, we recommend periodically making sure that your spending policy remains appropriate. In Chart 4, we asked the question, “Approximately how often does your organization reevaluate its spending policy for the endowment/foundation?”

Chart 4: Approximately how often does your organization reevaluate its spending policy for the endowment/foundation? (As of 8/31/20)
 


Source: PNC; Numbers may not add up to 100% due to rounding.
 
View accessible version of this chart.
 
A best practice is to reevaluate annually, which is supported by the majority of respondents. The operative word to emphasize here is “reevaluate.” This doesn’t necessarily mean “change”; rather, it means to check in and evaluate whether the spending policy remains appropriate relative to the goals and objectives of the investment program and/or the overall financial picture of the nonprofit organization.

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.

 

Conclusion


Investment programs play an important role as a funding source for nonprofit organizations. For the investment program to be sustainable as a funding source, it is important for decision-makers to think strategically about their spending or distribution policy. With the proper attention to detail in its construction and maintenance, a nonprofit organization can increase the likelihood its investment program is successful in providing financial support to the organization’s mission.

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.

For more information, please see our report Spending Policy: Development and Implementation or reach out to your PNC Investment Advisor.
 

Accessible Version of Charts

Chart 1: Which of these best describes your organization’s return objective for the endowment/foundation?

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%

Chart 2: Which of the following statements best describes your organization’s spending policy for the endowment/foundation?

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?

Not Likely 7%
Somewhat Likely 38%
Very Likely 54%

Chart 4: Approximately how often does your organization reevaluate its spending policy for the endowment/foundation?

Annually 62%
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%