Key takeaways

  • Effective endowment management requires balancing immediate needs with long-term sustainability.
  • A well-crafted spending policy is crucial for aligning operations with mission and values.
  • Diversification and smoothing techniques can enhance distribution stability and preserve purchasing power.

Contributors

Jeffrey Kuhlman, CFA

Executive Director

Nonprofits and private foundations face the dual responsibility of addressing immediate community needs while ensuring sustainable support for the future. For board members and investors, understanding how to balance these objectives is essential for achieving long-term success.

Developing an endowment spending policy

A spending policy serves as a strategic plan for how and when funds will be allocated to support the organization's goals. Typically expressed as a percentage of the endowment's asset value, an effective policy ensures alignment with the mission and values. Investors must weigh two critical goals: preserving purchasing power and maintaining spend rate stability.

Preserving an endowment’s purchasing power

James Tobin, a renowned Yale economist, emphasized the importance of preserving equity among generations. For endowments, this means achieving a sustainable return rate above inflation. Foundations must distribute funds in a way that supports current missions while allowing portfolios to grow for future funding.

Intergenerational equity ensures that future capital remains comparable to current support on an inflation-adjusted basis. Maintaining the inflation-adjusted value of a portfolio is challenging, requiring growth at a rate equal to or greater than the spend rate plus inflation and operational costs. Empirical evidence shows that most endowments struggle to achieve this balance.

Beneficiaries rely on stable short-term support from endowments. For instance, scholarship recipients expect consistent funding throughout their education. Volatile distributions create uncertainty, complicating planning efforts.

Endowments can enhance distribution stability through diversified allocation and smoothing techniques.

Asset allocation

Diversifying stock and asset-class-specific risks helps manage portfolio volatility. While diversification can reduce specific risks, different asset allocations exhibit various risk profiles. Greater equity allocations can lead to significant portfolio drawdowns. Diversifying into less volatile asset classes like cash and investment-grade bonds can mitigate this risk, though it may reduce return potential.

Bar chart showing purposes of endowments across different school sizes, focusing on two key responses: Financial Aid and General Operating Support.

Endowment smoothing techniques

Endowments use smoothing techniques to manage market volatility. Institutions typically employ one of three methods to improve annual distribution consistency:

  • Fixed target percentage of portfolio's moving average year-end value: Establishes a target percentage applied to the portfolio's average value over several years, smoothing annual distributions.
  • Fixed dollar amount (inflation-linked) with bounded target percentage: Sets a fixed dollar amount for payouts, adjusted annually based on inflation and within a target percentage range.
  • Hybrid method: Combines elements of the previous methods, balancing stability with purchasing power preservation.

The bottom line

For board members involved in nonprofits or private foundations, effective endowment management requires balancing spend rate stability with long-term purchasing power preservation. By focusing on controllable elements like asset allocation, spend rate and investment management costs, organizations can improve their chances of maintaining a portfolio that supports their mission over time.

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