Broadly speaking, the founding purpose of most endowment or foundation assets is to support a spending or distribution policy. Investment program success is commonly defined as an investment program’s capability to support this spending or distribution policy while preserving purchasing power and allowing for the modest growth of real wealth.

With that said, how a spending policy or distribution policy is developed and defined can have a significant impact on an investment program’s ability to generate the returns necessary to support the above goal.

Here we outline why a spending rule is important, detail several commonly used policies, and consider the implications of different policies on both the investment portfolio and distribution outcomes.

Why Have a Spending Rule?

One reason to have a formal spending rule is to comply with the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been adopted by many states and applies to the board of trustees or board of directors of the organization. UPMIFA was recently updated to include new language on how an organization’s board should prudently consider spending institutional funds, such as endowments.[1]

The new language outlines seven guidelines for organizations to use when determining annual expenditures. In our opinion, it is prudent for nonprofit organization boards to implement a formal policy to address these guidelines. It should be noted that UPMIFA generally does not apply to funds held by a financial institution as a trustee, and further, funds held in a trust may be subject to additional spending limitations based on the terms of the trust and applicable state law.

Regardless of whether an organization follows the UPMIFA guidelines, our experience working with nonprofit organizations has shown us that having a firmly defined spending rule can help instill discipline into the budgeting and financial management process from an oversight perspective.

As an example, consider the difference between going into the grocery store with a budget in mind and a shopping list and going into the grocery store with no predetermined budget or list. In the former case, the outcome is fairly predictable and based on a disciplined process that typically results in spending what you intended and getting the items on your list. Conversely, in the latter case, chances are you could spend more than you intended and leave with both unintended items and missing ones.

Carrying the example over to a nonprofit organization, a spending rule can help define the budget (or at least the assets’ contribution to a budget) which, in turn, can help determine what operations, purchases, or other considerations can be added to the “shopping list.” This can help keep an organization from overspending in a given year, something that could potentially cause impairment to the purchasing power of the investment assets if they are used to cover the extra spending.

From an investment perspective, a spending rule can assist the board of directors and investment committee in determining the investment program’s required rate of return and risk tolerance objectives. For example, if the spending policy is set at 4%, and using 2% for long-term inflation and 0.5% for management and overhead fees, simple math would put the required rate of return at 6.5%. An investment manager could then use risk optimization to minimize risk against the return objective of 6.5%, 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 too much, a portfolio created with too high of a return target would be taking significantly more risk than required to meet the goal of 6.5%; in the case of too little, a portfolio created with too low of a return target would be taking less risk than is required to meet the goal of 6.5%, and consequently would likely fail to meet the return requirement. In our view, the key takeaway from this is that setting a spending policy can help an organization determine an absolute benchmark to serve as a measurement of investment program success.

Given its importance to budgeting, financial management, and portfolio management, we recommend that a nonprofit entity clearly define a spending rule as part of the organization’s investment policy statement (IPS). We include a discussion of how to create a clearly defined spending rule as part of a nonprofit investment program in our white paper The Discipline to Succeed.

For more information, please contact Henri Cancio-Fitzgerald at 704-551-2843 or