Strategic Planning – Income Stability vs. Endowment Longevity

• Mission: Spending Policies should reflect the priorities of the charitable mission for any endowment or foundation. While these two objectives are certainly not mutually exclusive, prioritization is imperative to developing the appropriate Spending Policies.
• Analysis: Cash flow analysis of the budgetary expenses – operational and/or support services – dependent on the portfolio will help shape the organization’s Spending Policy.
• Design: Carefully select spending guidelines and calculation methods. Variability in income provided by the Spending Policy can hurt the charitable mission. Minimizing those fluctuations should be a high priority, especially for endowment-dependent institutions.

Spending Calculation Methods

Basic calculation methods for spending:

• Moving Average of Market Valuation Method – typically uses simple averages over 3-5 years, but weighted method calculations are also popular; this method may place greater emphasis on the most recent year, for example.
• Inflation-Adjusted Method– more stable income for current beneficiaries, higher potential impact on investment longevity.
• Hybrid Method – averages the valuation moving average method with the inflation-adjusted method.
• Other Methods – spending all of current income, determining a rate each year, or spending a percentage of a market value at a point in time.

According to the 2012 NCSE report analyzing the investment and governance practices of endowed institutions of higher learning, 75% of those studied utilize some version of a moving average method to smooth the impact of volatile markets on annual distributions*. However, the report goes on to further illustrate a trend in the increasing number of institutions deciding on an appropriate rate each year – likely in response to volatility during the 2008 market.

Smoothing Results

Why is it so important to get this right?

A 2011 study by Alliance Bernstein highlighted the following spending risks to the longevity of an endowment**:

• A traditional 70% stocks/ 30% bonds portfolio with a 5% targeted spending rate has a 34% probability of exhaustion within 40 years when using a simple inflation-adjusted spending policy**.
• Risk of facing an annual distribution decline of greater than 10% (using a 70/30 portfolio, over 30 years and a 5% spending rate): Based on annual market value method = 1 in 8 chance;  Based on 5 year moving average for valuation = 1 in 50 chance

A good Spending Policy must strike the proper balance between providing consistent income for the organization’s charitable mission and insuring longevity of the investment portfolio for future income payments. It takes not only mission and budget analysis, but also a well constructed calculation method best suited for the institution’s specific needs.

We hope these thoughts are helpful in meeting your Spending Policy goals and our investment professionals would be happy to discuss strategic Spending Policy design with you directly.

Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.

Sources:
*NACUBO-Commonfund Study of Endowments (NCSE) 2012 Annual Report.
**AllianceBernstein “Sustainable Spending for Endowments and Public Foundations”-Jan ’11
***Beacon Pointe Institutional Consultants can be contacted at info@bpadvisors.com

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