Non–profit fiduciaries seek to balance the needs of their communities today with the desire to maintain and expand support for their communities in the future. The spending policy they select plays a key role in managing current distributions and planning for future ones. An effective spending policy can provide a steady anchor for non–profit investors to guide their actions in today’s uncertain, evolving markets. Creating a clear and well–defined spending policy not only helps ensure strategic alignment with an organization’s mission—it is also an important means of creating fiscal discipline and consistency across diverse market environments.
The spending policy consists of two components, the spending rate and the spending methodology, and is explored in further detail in “Non-profit spending policy options” (Kaake, Lato, Santo-Walter, Wang, 2018). The spending rate dictates the overall level of expected spending over time, while the spending methodology is the framework for setting annual spending and dictates the extent to which the annual spending is responsive to changes in the value of assets.
Non–profit fiduciaries use the spending rate and spending methodology together to set an overall spending policy that determines how the organization chooses to balance the interests of current beneficiaries with those of future beneficiaries. The spending policy is under increased focus by non–profit fiduciaries as expected investment returns have decreased relative to historical levels, leaving fiduciaries less certain that they will be able to support their spending with investment returns going forward. This dilemma requires that fiduciaries re–consider their spending policy as part of their overall objective–setting.
Spending rate: A tug-of-war between current and future beneficiaries
As fiduciaries determine the trade–offs they wish to make between current and future beneficiaries, the largest lever they have at their disposal is the spending rate. Fiduciaries must continue to consider the tug of war between the desires of current and future beneficiaries. Current beneficiaries may desire more money to help fund or expand their programs and services today, which leads to a preference for a higher spending rate. An increase in current spending would result in fewer assets to invest for the future, and could hamper the organization’s ability to maintain the real value of its assets over time. Future beneficiaries, however, seek greater future spending, which leads to a preference for a lower current spending rate and higher future spending—potentially at the expense of today’s beneficiaries.
A spending rate that is equal to the portfolio expected real return, net of all expenses, would balance the support provided to both current and future beneficiaries. However, many fiduciaries targeted this balance when capital market valuations were lower and expected returns were higher. This favorable market environment allowed fiduciaries to assume they could support higher spending rates while maintaining equity between current and future beneficiaries. As expected real returns have decreased over time, fiduciaries are left questioning whether they should reduce the spending rate or expect to provide a diminished level of support to future beneficiaries. Additional levers for fiduciaries facing this conundrum are explored in “Are 5% distributions an achievable hurdle for foundations? Were they ever?” (Lato, Murray, 2016).
Spending methodology and market volatility
While setting the overall spending policy, fiduciaries often focus on the spending rate due to its relatively higher impact. However, it is also important to consider the impact of the spending methodology and then consistently follow the chosen method. Not considering and following a spending methodology can create governance risks, as the chosen amount of spending in any given year may be driven by external factors that are separate from the organization’s long-term objectives. The spending methodology determines the extent to which market volatility and asset drawdowns impact an organization’s ability to spend today versus in the future.
The most common spending methodology1 used by endowments is the percentage of moving average assets methodology2, while the hybrid rule3 is often discussed due to its use by large endowments such as Yale, but not nearly as commonly adopted. The extent to which these methodologies allow for spending to react to changes in the asset value depends on the parameters chosen. The moving average assets methodology utilizing an asset value that is averaged over a long number of years will lead to more stable spending than one utilizing an asset value that is averaged over a shorter time horizon.
The more reactive the spending methodology is to changes in the asset base, the greater the ability to protect the asset base in down markets. That reactivity will also create organizational planning risks, as the actual annual spending becomes more volatile and the organization cannot rely on receiving a set level of funds annually to serve their beneficiaries. Fiduciaries must carefully weigh this decision as to how they want to balance the stability of the asset base relative to the stability of spending in volatile markets. Organizations with high fixed costs that are funded from the non-profit asset pool may have less flexibility and require a spending methodology that leads to stable spending through time.
The spending policy can be a powerful tool in times of volatility and uncertainty. However, in order to wield it effectively in today’s evolving markets, it is important to truly understand its various components and effectively design a policy that does not unintentionally favor one group of beneficiaries over the other. This will allow non-profit fiduciaries to balance their more immediate objectives while also supporting their communities going forward.
Spending rate vs. spending methodology: What should non-profit fiduciaries consider when designing a spending policy?Click to tweet
1 Source: NACUBO-Commonfund Study of Endowments, 2017
2 Spending a fixed percentage of the average asset value over a determined number of years.
3 Spending based on a blended weighting of last year’s spending and a percentage of current assets.