Gavin W. Stephens
Director of Portfolio Management
Director of Portfolio Management
Most institutions rely on their investment portfolios to fund their budgets. From tuition assistance to basic operational assistance, these institutions have drawn on their investment funds to fulfill their missions. Within this context, investment committee members often find themselves focused on their investment policies and strategies—asset allocation, expected returns, manager selection, and so on. And while sound investment policy is undoubtedly critical to helping an institution achieve its mission, equally—if not more important—is having a sound spending policy to accompany investment policy.
According to a recent study of institutional endowments, over the last 10 years the majority of endowments have lost long-term purchasing power by failing to earn investment returns above their annual spending rates plus inflation.1 This dynamic is becoming even more critical as expected returns from fixed-income investments, which have served as anchors in institutional portfolios, drop to historic lows. As a result, the expected returns of a traditional portfolio (i.e., with 60% allocated to equities and 40% to fixed income) have declined as interest rates have declined. And while institutional portfolios have, in response, increased allocations to equities and other non-traditional asset classes, that reallocation has helped drive valuations of non-fixed-income asset classes higher and thereby their expected returns lower. The result is an investment environment of lower expected returns and an unchanging, and many times growing, reliance on investment portfolios for institutions to fulfill their critical missions.
It is within this context that spending policy becomes even more crucial. Though investors have limited control over investment returns, they have significant input over their spending. With a sound spending policy, investment committees can help ensure that their investment portfolios are best positioned to support their organizations for the long term. In this paper, we discuss several approaches to spending policy—ranging from the straightforward to the more complex—to help committee members make this important decision. We conclude with a summary of the tradeoffs among these policies to help committee members determine a spending policy that supports both current and future needs.
Spending policies range widely in their complexity. The most straight-forward policies are those that determine spending on a simple calculation made somewhat independently of the consideration of the underlying value of the investment portfolio. For example, an income-based spending rule would create a spending level that reflects only the income generated by a portfolio’s interest and dividend payments; the principal of the underlying portfolio holdings would remain untouched. Though less frequently used than some policies listed below, income-based spending policies have been adopted by institutions that have a strong desire to leave the principal of their portfolios intact and to retain the flexibility to have spending waver with changing levels of interest rates and dividend payments. Other examples of straight-forward spending rules include determining an appropriate spend rate at the beginning of the year and spending a pre-specified percentage of market value (such as 5% for private foundations). These methods all have the benefit of being easily understood and responsive to the immediate budgetary needs of a given institution. However, as discussed in greater detail later, these straight-forward policies can also introduce heightened levels of spending volatility that can hamper an institution’s ability to achieve its mission.
A more commonly adopted spending policy is to incorporate a smoothing rule, or a policy based on moving averages of the portfolio’s ending market value over a period of previous years. Indeed, the moving average-method is used among 75% of institutions with endowments of all sizes.2 Implicit in the adoption of a smoothing rule is the desire to limit the volatility of spending from year to year and thus maintain a consistent level of budgetary support. Investment committees typically apply smoothing rules over three to five year periods; a smoothing-rule spending policy, for example, could equal 5% of the average ending balance of the portfolio over the past five years. Such a policy should create reasonably stable spending from year-to-year and, in periods of market increases or declines, help committees adjust spending in line with portfolio performance. After a year of poor market returns, spending would decrease; after a year of strong market returns, spending would increase. Such automatic spending adjustments, while limited in scope via the averaging method, would also help preserve portfolio principal by forcing automatic spending adjustments based on market performance.
Other committees may choose a spending rule that aims to maintain a consistent level of purchasing power—i.e., a policy that ensures that endowment funding will keep up with the increasing costs of the services it supports. A simple example of such a policy is an inflation protected spending rule that would adjust the previous year’s spending—typically expressed as the dollar amount of last year’s spending—by the rate of inflation as measured by the Consumer Price Index (CPI).3 Such a rule effectively severs the spending decision from the market value of the portfolio and can establish a more stable level of budget support from the investment portfolio. Using an inflation-based rule can effectively refashion an investment portfolio into a rainy-day fund—that is, spending would remain stable while the market value of the portfolio would fluctuate. In downturns, this would result in increasing levels of spending as a percentage of the portfolio’s market value.
While some institutions may view this dynamic as a true expression of the portfolio’s purpose—i.e., to provide institutional support in periods of market stress—others may view the increased level of relative spending as a threat to the portfolio’s long-term sustainability. To address this concern, committees have established bandedinflation- based rules that determine spending based on previous spending levels adjusted for inflation, yet restrict total spending to a certain range of the portfolio’s value. A banded-inflation based rule, for example, may require inflation-adjusted spending to be no less than 3% and no more than 6% of the portfolio’s previous year-end market value. The aim of such a rule would be to provide relatively stable levels of spending with limited need to draw on the corpus of investment principal.
A fourth approach to spending policy combines a smoothing approach with an inflation-based approach. First introduced by Stanford University, the hybridspending rule is more commonly used among large institutions that are endowment dependent.4 This hybrid spending policy would weigh the smoothing and inflationbased approaches in a way that emphasizes the particular concerns of the institution. For example, for an institution that relies heavily on its investment portfolio to fund its budget, the inflation-based approach would carry a larger weight than the moving-average approach in establishing a spending rule. This same institution might determine spending by combining 60% of the prior year’s spending increased by inflation with 40% of an amount determined by a percentage of the portfolio’s last three-year ending values. Such an approach emphasizes the importance of providing stable spending values (by overweighting the inflation-based method) without ignoring the changes in market values of the underlying portfolio. The inclusion of a smoothing rule would, in effect, cause spending to decrease when markets decline and increase with market rise; the changes in spending, however, would be more moderate than spending changes from a moving-average rule alone.
Although the spending policies described above differ, no spending policy alone is the right one. Rather, the most suitable spending policy is the one that best aligns with the institutional needs and the role of the investment portfolio in fulfilling them. In addition, investment committee members should carefully consider the tradeoffs involved when choosing one policy over another. Below we review these tradeoffs.
Each spending policy differs in its ability to provide stable levels of spending from year to year. For organizations that require significant support from their investment funds, a more stable spending policy may be preferable to one that would produce more varied levels of spending from year to year. Inflation-based rules may be preferable in these contexts: by beginning with last year’s spending in dollar amounts, the projected spending over the subsequent years would be relatively stable with adjustments limited only to increases in inflation. On the other hand, a straight-forward spending rule, such as a given % of portfolio assets, can result in spending levels that vary widely with changes in the underlying value of the investment portfolio. An institution that relies less on its investments for operating support may find such a rule more suitable to its needs.
Seeking a middle ground between these two options, many institutions have implemented smoothing rules to mitigate spending volatility while ensuring that spending levels are responsive to changes in the market value of the underlying portfolio. Hybrid approaches follow a similar strategy, seeking to generate a relatively stable level of spending via an inflation-based rule while remaining sensitive to the market value of the portfolio via the incorporation of a smoothing rule.
The chart above illustrates the expected relative stability of spending produced by each approach. However, when choosing a policy, committee members should also consider carefully the anticipated effect each policy may have on the long-term stability of the underlying investment corpus.
Each spending policy described above poses a different degree of risk to drawing down the assets of the underlying investment portfolio. An approach that provides the most stable levels of spending, such as an inflation-based approach, also risks drawing from investment principal after periods of market declines to meet an organization’s spending needs. Organizations that rely heavily on their investment portfolios for operating budgets may be willing to assume such risk to ensure that immediate mission-critical needs are met, while acknowledging the heightened possibility that spending levels could require increasingly significant draws on portfolio principal.
Other organizations may place greater emphasis on preserving the investment corpus for generations to come. In such cases, a spending rule that places less risk on dipping into portfolio principal may be preferable. The income-only approach represents the extreme example of this approach; a smoothing rule is a much more common approach that adjusts spending levels in response to market fluctuations and thus provides a mechanism for limiting draws on the investment corpus. Hybrid approaches are also intended to lessen the risk of drawing excessively on portfolio principal, while maintaining a reasonably stable level of spending.
As the table above illustrates, each method requires a tradeoff between predictable levels of spending and potential stability of the underlying portfolio principal.
An appropriate spending policy is as important as a sound investment policy in the ability of an institution to reach its investment goals. The framework outlined above is intended to help investment committee members navigate between the need for spending stability and the importance of protecting investment principal. Combined with a sound investment policy and strategic development plan, a suitable spending approach will best position institutions to achieve their immediate and future goals.
1 National Association of College and University Business Officers and Teachers Insurance and Annuity Association of America. 2018 NACUBO-TIAA Study of Endowments, 21.
2 2018 NACUBO-TIAA Study of Endowments, 23.
3 Other measures of inflation include the PCE (Personal Consumption Index) and HEPI (Higher Education Price Index). The choice of inflation-related index should be specific to the underlying needs of the institution.
4 2018 NACUBO-TIAA Study of Endowments, 26.
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