Endowment Spending Policy Essentials for Long-Term Success

A well-crafted endowment spending policy is crucial for long-term success. The policy should be designed to balance the need to support the organization's mission with the need to preserve the endowment's value for future generations.

Endowments with a larger asset base can afford to spend a higher percentage of their annual returns, typically in the range of 4-6%. This is because the larger asset base provides a cushion against market fluctuations.

However, endowments with a smaller asset base may need to be more conservative, spending only 3-4% of their annual returns. This is to ensure that the endowment's value is preserved and can continue to support the organization's mission.

A key consideration when determining the spending rate is the endowment's investment return. Endowments with a high investment return can afford to spend a higher percentage of their returns.

There are two distinct approaches to developing endowment spending policies: the Implied Spending Method and the Required Return Method. Each has its own characteristics and implications.

The Required Return Spending Policy Method begins with a goal spending rate and adds expected inflation and costs, then subtracts or adds other relevant variables to determine the required investment return.

Both methods are simplified for illustrative purposes and exclude important potential additional variables, relying on hypothetical numbers.

The Uniform Prudent Management of Institutional Funds Act (UPMIFA) plays a crucial role in guiding endowment spending policies. It's the current regulatory framework for endowments, adopted by most US states.

UPMIFA establishes seven key factors to consider when developing a spending policy for endowments. These factors include preserving the fund, understanding the purpose of the endowment, and considering the expected total return from investments.

Preserving the fund is a top priority, and costs related to managing and maintaining an endowment are also part of fiduciary responsibility. These costs should be factored into a spending policy analysis and monitored to ensure they remain reasonable.

To develop a comprehensive spending policy, non-profit entities must carefully weigh these seven factors and consider their specific circumstances.

Here are the seven factors to consider when developing a spending policy:

The spending policy approach you choose can have a significant impact on the long-term sustainability of your endowment fund. Most organizations use one of three primary methods: moving average, inflation-based, or hybrids.

A moving average method involves applying a spending policy rate to a moving average of beginning-period market values over a defined historical period, typically three to five years or 12 to 20 quarters. This tends to "smooth" the overall spending rate and reduce the impact of a single year's increase or decrease in your portfolio's value.

Inflation-based methods are calculated using the previous year's spending, and inflating it by an applicable inflation index, such as the Consumer Price Index. Some organizations also impose upper and lower bands on spending, like a lower band of 3% and an upper band of 6%.

Hybrids use a weighted average of both the inflation-based calculation and the moving average calculation. This approach can provide a more nuanced view of your endowment's spending needs.

A spending policy should be aligned with your organization's overall mission, risk tolerance, and investment strategy to ensure the long-term sustainability of the endowment fund. By using a spending policy analysis process and applying a spending smoothing rule, you can make investment policy decisions easier and reduce the chance of corpus erosion.

An income-only approach to spending from an endowment fund may seem like a good idea, but it's actually a complication that can lead to under- or over-spending.

This approach was once considered a best-practice, but it can cause well-meaning fiduciaries to design an investment portfolio that maximizes income, often at the cost of expected return reduction and increased risk.

Donors may require that money only be spent from income, but this approach can be problematic, as it may not align with the organization's overall mission, risk tolerance, and investment strategy.

In fact, the current best-practice is to use a prudent spending policy that utilizes a total portfolio return approach within the spending policy analysis, rather than relying solely on income.

This approach helps to ensure the long-term sustainability of the endowment fund, and is associated with a specific expected return, which is connected to a specific stock/bond mix.

Traveling to a new destination can be overwhelming, especially when it comes to budgeting. One approach to consider is the pay-as-you-go method, which involves paying for expenses as they arise, rather than setting aside a lump sum in advance.

This approach can help alleviate the financial burden of traveling, as seen in the case study of a family who saved only $500 for a two-week trip to Europe, yet managed to stay within budget.

Accommodation costs can be a significant expense for travelers, with hostels and budget hotels often being the most affordable options. In fact, a study found that staying in a hostel can be up to 50% cheaper than booking a hotel room.

For those who prefer to plan ahead, setting a daily budget can be a helpful tool in managing expenses. By allocating a specific amount for each day, travelers can avoid overspending and stay on track.

Research has shown that travelers who plan their expenses in advance tend to spend less than those who don't, with some studies suggesting a savings rate of up to 20%.

A well-crafted spending policy can simplify investment decisions by making the probability of prudent spending more likely. This is because a spending policy analysis process helps fiduciaries make informed decisions.

Proper spending policies reduce the risk of corpus erosion, which is a significant concern for endowment funds. Corpus erosion occurs when the endowment's assets decrease over time.

Using a spending smoothing rule, rather than relying on guesswork, can make spending and investment policy more effective. This approach helps ensure that the endowment's resources are allocated wisely.

A solid spending policy process should utilize reasonable and defensible expected portfolio return assumptions for different stock/bond mixes. This helps fiduciaries choose an appropriate stock/bond mix that aligns with the endowment's mission and risk tolerance.

By connecting spending policy to investment policy, a spending policy analysis process makes it easier to select a suitable stock/bond mix. This mix is associated with a specific expected return, which is essential for long-term sustainability.

Some endowments have unique spending policies due to their specific circumstances. For example, endowments with restricted assets may require a more conservative spending approach.

A common challenge is navigating the balance between preserving the endowment's principal and meeting its intended purposes. In the case of a university endowment, this might mean allocating funds to support a specific academic program or research initiative.

In situations where the endowment's assets are highly volatile, a more cautious spending policy may be necessary. This was the case for an endowment that invested heavily in the stock market, leading to significant fluctuations in its value.

To mitigate these risks, some endowments adopt a "spendable" or "available" pool approach, setting aside a portion of their assets for discretionary spending. This strategy allows for more flexibility in responding to changing circumstances.

True endowments are funds where donors specifically designate the funds to last into perpetuity, often by labeling them as an endowed gift.

The main difference between true endowments and quasi-endowments is that true endowments have perpetuity requirements and spending restrictions, whereas quasi-endowments do not unless otherwise required.

Quasi-endowments, also known as board-endowed funds, are funds not declared to be "endowed" funds by the donor or endowment fiduciaries. Determining spending levels based on investment income or investment gains is not an appropriate spending method for endowments.

Fiduciaries that treat quasi-endowments like endowments do so to maintain the corpus and inflation-adjusted purchasing power over time.

Spending above a spending policy level can be allowed in certain circumstances, but it's advisable to consult a non-profit/UPMIFA attorney in such cases.

Most states, including California, have adopted the optional UPMIFA provision, which states that spending above 7% of an endowment (using a 3-year average market value) is presumptively imprudent.

Spending policy should be based on a defensible method, such as those outlined by Truist Foundations and Endowments Specialty Practice, which compare spending objectives against their proprietary forward-looking expected return assumptions.

Indirect Impact Restrictions can decrease diversification, which in turn can lower expected return and increase risk. This can have a significant impact on an endowment's overall performance.

Well-meaning donors may establish restrictions that don't directly affect spending policy, but can still cause problems. These restrictions can include things like security types and quality levels.

Such investment restrictions can complicate the work of endowment fiduciaries, making it harder for them to manage the portfolio effectively. This can lead to higher operational or portfolio costs.

Donor education is key to reducing these types of restrictions, which can actually work against the donor's goals. By understanding the potential consequences of their restrictions, donors can make more informed decisions.

Special donor-imposed restrictions can create complications for endowments. These restrictions can override the normal spending policy expectations of UPMIFA, a law that governs endowments.

A donor may require that a specific dollar amount be spent by a certain date. This can be a challenge for organizations to balance the donor's wishes with the need to preserve the fund's corpus.

Particular dollar amounts or percentages may be specified for annual spending. This can lead to conflicts with the donor's expectation that the funds will last into perpetuity.

Organizations with clear and prudent spending policies are better equipped to educate donors about potential conflicts. By doing so, they can manage donor-imposed restrictions effectively.

Truist Foundations and Endowments Specialty Practice can compare a spending method against their proprietary forward-looking expected return assumptions. This analysis will help ensure the asset allocation outlined in the investment policy statement closely reflects the future liabilities of the organization.

They'll also undertake a full qualitative and quantitative review of an organization if a spending method hasn't yet been selected. This review will consider key inputs such as endowment income needs, inflation, investment related costs, and risk tolerance.

Their analysis will provide multiple scenarios that demonstrate the relationship between spending, ending market value, and cumulative spending. This information will be presented to the investment or finance committee to inform the selection of a spending policy.

The Finance and Audit Committee plays a crucial role in establishing the Foundation's spending policy, which is then approved by the Board of Directors.

This committee takes responsibility for recommending the spending policy, which sets the tone for the Foundation's financial decisions.

The spending policy will be implemented by Management or its designate(s) as directed by the Finance and Audit Committee, ensuring a clear chain of command.

This structure provides a clear line of authority, allowing for efficient decision-making and financial management within the Foundation.

Planning for the future can be a daunting task, but it's essential to ensure a comfortable retirement or long-term financial stability. Some endowments or endowment-like funds have ultra-long time frames, which can span decades with a focus on corpus growth and no spending before a spending policy begins.

A glidepath approach to investing may be suitable for these types of situations, starting with a higher stock, higher volatility portfolio to maximize growth. This dynamic asset allocation approach can be done programmatically until the year spending is projected to begin.

The glidepath approach involves gradually reducing the stock allocation and increasing the bond allocation over time, allowing for a smooth transition to a more conservative investment mix.

Should policies adapt to short-term markets? Prolonged periods of higher or lower returns compared to long-term return projections may tempt endowment fiduciaries to make temporary adjustments to spending policies.

In some cases, short-term spending reductions may be advisable when markets experience prolonged downturns. This is particularly true for private endowments with a minimum legally mandated 5% minimum spending rule.

However, public endowments are not limited to spending less than their normal spending policy unless a donor has specified a particular spending rate. Fiduciaries should be cautious not to over-spend in a way that fails to recognize market returns tend to revert to the mean over time.

To avoid corpus erosion, it's essential to treat excess investment returns as banked excess unrestricted funds, rather than increasing spending. This approach helps to mitigate the risk of unintentionally increasing corpus erosion in the future.

Fiduciaries should also be aware that UPMIFA provides for spending above normal spending policy levels in some cases, when sufficiently justified. In such cases, documentation of the rationale relative to UPMIFA-allowable exceptions is crucial, and the guidance of an attorney is advisable to avoid fiduciary and/or corpus risk.

Truist Foundations and Endowments Specialty Practice can help by comparing your organization's spending objectives against their proprietary forward-looking expected return assumptions.

They'll examine the strategic asset allocation outlined in your investment policy statement to determine if it's appropriate and realistic. This will help ensure that your asset allocation closely reflects your future liabilities.

If you haven't selected a spending method, they'll undertake a full qualitative and quantitative review of your organization. This review will consider key inputs like endowment income needs, inflation, investment-related costs, and risk tolerance.

They'll model various spending levels over time and provide multiple scenarios that demonstrate the relationship between spending, ending market value, and cumulative spending. This information will help inform the selection of a spending policy for your investment or finance committee.

Adapting to changing circumstances is crucial in endowment management, and recognizing the importance of endowment spending policy is a vital step in this process.

Investment committees should devote more time to endowment spending policy, as it's a vital tool for institutions of higher education seeking intergenerational success.

Fiduciaries may choose to spend larger lump sums from unrestricted or spendable endowment assets to further their missions, rather than growing the corpus and following a spending policy.

Maintaining separate portfolios with different time frames can minimize the impact of volatility on assets with shorter time frames.

A long-term fund, medium-term fund, short-term fund, and ultra-short-term fund can be used to address spending timing and optimize return while minimizing risk.

As you consider your endowment spending policy, it's essential to recognize its importance in positioning your institution for intergenerational success.

Investment committees should devote more time to endowment spending policy to ensure it's a vital tool in their strategic planning.

It's crucial to bring a more comprehensive approach to endowment management, and the guidance provided here can help you achieve that.

Spending policy is often overlooked in endowment management, but it's a critical component that should be revisited as frequently as asset allocation.

Most institutions use the rolling average spending method, which has performed well in the past decade due to favorable capital market and philanthropic conditions. However, this method may not be optimal for all institutions.

According to the 2021 NACUBO-TIAA Study of Endowments, 74 percent of responding higher education institutions used the moving average methodology.

The time is now to explore whether your endowment is using an optimal spending calculation, especially given the recent market fluctuations.

An optimal spending policy should offer a combination of the following: providing a consistent and growing level of annual support, offering sufficient long-term support while leaving enough capital, allowing for prudent risk-taking, and sticking to a long-term allocation plan.

Here are the key characteristics of an optimal spending policy:

For many, the most pertinent risk related to the endowment is not portfolio volatility, but spending volatility and/or drawdown. This is because historically, portfolio risk has been defined as volatility or standard deviation, but the more relevant risk for an endowment is periods of drawdown relative to a real return objective.

The standard deviation of the annual spend, also known as spending volatility, is a key metric for measuring spending risk. A reasonable goal is to ensure this metric is lower than the investment volatility of the portfolio.

A significant challenge for colleges and universities is the high percentage of negative spend years. In fact, many institutions are plagued by this issue.

The hybrid 80/20 policy has proven to be the most favorable from a spending risk perspective. It has the fewest negative spend years and the second-lowest average annual negative spend decline.

Calculating and explaining this policy to donors can be more challenging, but it's a worthwhile investment for a consistent and stable stream of support.