At Russell, we see our role as being to help our clients earn the rate of return they require at a level of risk they can survive. For non-profit organizations, the archetypal required rate of return is one that allows a distribution of 5% of assets each year, while also maintaining the real value of the asset base.
In fact, there is more variation between the investment objectives of non-profit organizations than is generally acknowledged. The prevalence of the 5% spending rate in analysis is largely due to the IRS requirement that non-operating private foundations pay out this amount; other types of non-profit organization have more flexibility in choosing how much to spend. Even so, a return of 5% above inflation remains the most common return objective for non-profits¹—a target that rises by another 1% or so when non-qualified spending is taken into account.
The question of whether a 5-6% return above inflation is achievable over the long run is therefore a basic one for this sector, and that’s a question that my colleague Steve Murray revisits every few years. But it’s hard to reach a definitive conclusion. I just asked Steve again if he thought the target was achievable. His response: it’s a “very challenging” target, and “unlikely to be met every year.”
Keep in mind that interest rates remain low compared to the last several decades (the after-inflation yield on a 5-year government TIPS as of May 23 is negative 0.42%—a topsy-turvy state of affairs) which makes return objectives tougher to meet. All of which helps to explain why non-profit organizations have been at the forefront of the search for new sources of return: alternatives, illiquid asset classes, dynamic strategies and so on. As Steve puts it: “organizations that aggressively exploit sources of return and have the patience of a long-term perspective have a reasonable chance” of meeting this goal. So a return objective of 5% above inflation is not obviously unrealistic, but it’s certainly not a sure thing.
And that is before we consider what it means to talk of “a level of risk they can survive” for a non-profit organization. Even if the return objective is achieved over the long run, there will be fairly long periods (like ten or twenty years) where returns will deviate substantially from the long-term average. The flexibility of the spending policy makes a difference here. If variations in spending can absorb some of the fluctuations in investment returns, that can make tough times easier to survive. Space prevents a full discussion of spending policy here but please check out our non-profit asset allocation guidebook for more on that topic.
Looking at the non-profit sector as a whole, this is a community with some of the highest return objectives of any group of investors¹. Those return objectives will not always be met over the short- and medium terms. Even those who ultimately meet their objectives will find it a bumpy path to success.