How to Set Endowment Spending Rates

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How to Set Endowment Spending Rates

Non-profits seeking to establish endowment spending rates may find the task as difficult as the fundraising itself. Setting spending policy remains a balancing act between protecting purchasing power and providing for the needs of the institution. Ultimately, the tightrope act becomes a question of inter-generational equity: Do we sacrifice the needs of the current generation to that of future generations, or visa versa?

Endowment spending rates can prove a catalyst for fulfilling or killing the life of the organization itself. Years with negligible or negative investment returns only magnify the importance of having a well-developed spending policy which can see the organization through thick and thin.

As part of their fiduciary duty, trustees and board members of non-profits must develop a spending formula consistent with the stated goals of the foundation or charity. Although private foundations are required to spend 5% of net investments, other non-profit organizations such as public charities and university endowments maintain greater flexibility in determining withdrawal rates. However, just what constitutes the ideal spending rate remains a controversial issue.

Four factors determine an endowment’s total value: market returns, time horizon, asset allocation, and spending. Because the first two cannot be controlled, the importance of asset allocation and spending policies become all the more essential to maintaining and increasing endowment funds.

Endowment spending rates typically fall into one of the following five profiles.

Income-oriented – Spending policies based on income yields spend all or a predetermined percentage of the returns generated by the endowment each year. For budget planning purposes, this strategy is highly unpredictable, especially when net returns are negative.

Further, income-oriented spending policies encourage investment committees to overweight income-generating securities. Investing heavily in income-oriented securities may actually compromise the overall health of the endowment.

Market-value oriented – By far, the market-value approach is the most popular spending formula among non-profit institutions. In a market-value scenario, spending is based on a percentage of the total market-value of the assets. To help smooth the rate of withdrawal, spending is typically based on a three-year rolling average of the market value.

The market-value model has received criticism since the boom and bust of the tech bubble in the late ’90s. Endowments which adopted this model, despite poor returns in the 2001-2003 window, were still spending at extraordinarily high rates due to the three-year rolling average. As a result, spending remained high even in years of negative returns.

Budget-oriented – Budget-oriented spending policies (also known as “constant-growth” policies) increase spending incrementally, usually at the rate of inflation. Popular among organizations which rely heavily on endowment funds to prop up operating budgets, budget-oriented policies provide a much needed measure of predictability.

Using this model, if last year’s endowment spending was set at $100,000, this year’s spending would be equal to last year’s spending, adjusted for inflation. If inflation is 2.5% then, this year’s spending would be $102,500. To guard against over- or under-spending, a “band” or “collar” may be added which sets minimum and maximum yearly withdrawal rates.

Hybrids – Increasing in popularity, investment management committees are turning to hybrid models which blend market-value with budget-oriented spending policies. Yale University employs this model, determining withdrawal rates based the fund’s market value and on a weighted average of last year’s spending adjusted for inflation.

Indeterminate – Some foundations adopt no spending discipline at all. Similar to a family without a monthly budget, there is no overarching plan year-to-year governing how funds are spent. Failing to articulate a spending discipline leads to eroding principal as funds are invariably overspent.

Developing a spending policy congruent with foundation principles plays a big role in whether an organization has the continuing resources to fulfill its mission. However, no amount of double-digit returns can ultimately answer the question of who deserves the benefits of the endowment more: present or future generations.

The original version of this article was published May 22, 2006. Photo used here under Flickr Creative Commons.

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Wealth Manager, CFA, CFP®

Beth Nedelisky is part of the Investment Committee at Marotta Wealth Management and specializes in trust and endowment management. Born in Africa, raised in Europe and married in the USA, Beth understands world markets first hand.