Endowments and foundations provide financial support to nonprofits doing important work within our communities. Assets from these endowments are distributed using a spending or distribution policy. The success of an investment program is defined by its capability to support the goals and spending needs of an organization. 

Establish an Effective Spending Policy 

Understanding your return objective within the context of your investment program’s purpose is an important part of establishing an effective spending policy. When considering your distribution and spending policy, there are two important parts—the distribution itself and the length of time over which the distribution will be made. 
 
While the distribution and its rate will vary, most nonprofit organizations are looking for their distributions to last in perpetuity. To preserve that purchasing power, inflation and fees have to be incorporated into the distribution/ spending policy rate to calculate a minimum return objective that will achieve this goal. In Figure 1, you can see how this return objective can be calculated. 
 
This calculation is important to balance the investment program’s required rate of return and risk tolerance objectives. Using the return objective example in Table 1, an investment manager could use risk optimization to help minimize risk against the return objective of 6.75%, allowing the portfolio to meet its investment goal efficiently and effectively. Without the orientation of the portfolio set on a required rate of return, the portfolio (specifically,the asset allocation) could be designed to return too much or too little. In the case of returning too much, a portfolio created with too high of a return target would be taking significantly more risk than required to meet the goal. In the case of returning too little, a portfolio created with too low of a return target would be taking less risk than is required to meet the goal, and would likely fail to meet the return requirement.
 
Table 1: Return Objective Calculation Example
                               
Distribution 4.25% of Market Value
Inflation 2.00% over the Long Term
Fees 0.50% of Market Value
Return Objective 4.25% + 2.00% + 0.50% = 6.75%
Source: PNC

Creating Savvy Spending Rules

There are three key variables to consider regarding spending rules:
  • Will the distribution be a percentage of portfolio market value or a set amount? 
  • How is the portfolio market value determined? (e.g. at a point in time, an average of periods, etc.) 
  • Will there be an increase determined year to year, and how will it be determined?

In Table 2 below, five common spending rules are included. It is important to note that there is no one best rule. Rather, the best rule for your investment program is dependent on the organization’s unique goals and objectives. Organizations that derive a large portion of their budget from the distribution will likely need a more stable payout. Organizations that are less reliant on distributions for regular cash flow can tolerate more volatility in distribution and will require a different rule. 

Table 2: Five Common Spending Rules

Policy Definition
Simple Spending Rate   Spending is equal to the specified spending rate multiplied by the beginning period market value. 
Rolling Multi-Period Average of UPMIFA   Spending is equal to the spending rate multiplied by an average of the market values of previous periods. This method reduces the volatility of required distributions year-over-year.
Geometric Spending Rule Spending in the current period is equal to a) previous year’s distribution adjusted for inflation multiplied by a smoothing rate (used to further reduce volatility, i.e., 0.7); plus b) the beginning market value of the portfolio multiplied by the spending rate and the residual of the smoothing rate (i.e., 0.3 = 1 – 0.7).
Inflation-Linked Rule Begins with a set dollar amount (typically determined by a certain percent of trailing market value) and the fixed amount is adjusted each year by an inflation index.
Hybrid Rule
 Part of the annual spending amount is determined by an inflation adjustment of the previous year’s spending while the balance is determined by applying a fixed rate to the portfolio’s market value.  

Given the different needs and objectives of nonprofit organizations, there will be a wide range of rules employed. It is important that rules are not selected for ease or familiarity. Nonprofit organizations should work with their investment advisor to determine the rules that are most appropriate to the founding purpose of their investment program.

Analyze Probable Portfolio Outcomes

The size and frequency of distributions have measurable impacts on portfolio outcomes for investment programs. For a simplified example:

  • A portfolio that starts with $100, earns an average of 5% per year, and distributes 6% per year will eventually run out of funds.
  • A portfolio that starts with $100, earns an average of 6% per year, and distributes 5% per year should be able to maintain this, all else equal, in perpetuity.

There are three key variables in predicting the outcome of distributions: the size of the distribution, the frequency of the distribution, and the return objective of the portfolio.

Size of the Distribution

Assuming positive average returns over the long term and all else equal, a portfolio with more money (from making smaller distributions) is going to end up with a larger market value over time than a portfolio with less money (from making larger distributions).
 
In Table 3, over just three years, even a small difference in the size of the annual distribution has a noticeable effect on the portfolio’s ending value. This difference would only become more pronounced over 10 years, 20 years, or more. Picking an appropriate size for the distribution is important in balancing current needs with future needs.
 
Table 3: Distribution Size
  Starting Year 1 Year 2 Year 3
$2 Distribution $100.00 $104.00 $108.24 $112.73
$5 Distribution $100.00 $101.00 $102.06 $103.18
Difference $0.00 $3.00 $6.18 $9.55
Source: PNC

Frequency of the Distribution

The frequency of the distribution is an important consideration in setting a spending rule and when designing a strategic asset allocation. For example, a portfolio that supports monthly distributions needs to have higher exposures to liquid asset classes, while minimizing excess cash drag (the reduced return that comes with holding investment assets in low-returning cash or near-cash equivalents). While a portfolio that supports an annual distribution might be able to invest in asset classes with potential for higher returns, such as private equity.
 
Predictability is also important. It is easier and more effective to build an asset allocation strategy to support regularly scheduled distributions than it is for one that takes distributions at irregular intervals. 

Return Objective of the Distribution

It is important that your return objective supports your minimum required distribution. It can be tempting to adjust things like liquidity to meet your return objectives, but less liquidity can create new challenges. While your return goal may be met, you could be unable to make frequent distributions without liquid assets. Organizations targeting more frequent distributions might want to consider having a lower percentage distribution for it to be sustainable. Conversely, organizations targeting less frequent distributions might be able to consider having a higher percentage distribution that is sustainable.
 
Size, frequency, and return objective of the distribution are interconnected in determining an appropriate spending policy.

Planning for Periodic Review

Organizations should establish a process to review and maintain the spending or distribution policy on a regular basis. Things change over time, from your organization’s financial objectives to the broader investment markets. Periodically evaluating your spending policy to see that it remains appropriate is best practice, an annual review is generally sufficient.
 
The review is not necessarily a change. Your evaluation should simply check in to see whether the spending policy remains appropriate relative to the goals and objectives of the investment program and/or the overall financial picture of the nonprofit organization.
 
As new board or investment committee members join the organization, they should be given the spending policies as part of their on-boarding. This will help them to understand the current policies, and help the organization keep strategic continuity across leadership succession.
 
As the world continues to change, we would encourage nonprofit leaders to continue to evaluate and reevaluate every aspect of their investment program as part of good governance practices. Including the spending policy in that review can help keep the program running smoothly.

Conclusion

Investment programs play an important role as a funding source for nonprofit organizations. For the investment program to be sustainable as a funding source, decision-makers should understand their return goals, create savvy spending rules, analyze probable portfolio outcomes, and plan for periodic reviews. With the proper construction and maintenance, a nonprofit organization can increase the likelihood its investment program is successful in providing financial support to the organization’s mission.

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