How Endowments & Foundations Have Been Affected by the Financial Dip By: Gabriel PotterMBA, AIFA®

Long Term Goals vs. Short Term Market Pressure

A charity’s balance sheet inflows are subject to two basic factors: external contributions (i.e. donations) and market actions, either through capital appreciation, or dividends & income. As an investment and fiduciary consultant, we often spend more of our time focusing on the inputs, rather than the spending side – the outflows. However, the 2008 financial crisis and associated market downturn put sufficient pressure on charitable organizations’ health such that their spending policies were similarly affected.

In broad terms, there is nothing wrong with lowering your spending when your income goes down. Everyone has to make compensations during times of stress. However, since the need for charity often gets stronger during market downturns, it is in everyone’s interest, at a bare minimum, to set expectations for charitable spending during market downturns. 

Market downturns are inevitable. As the pessimistic adage goes, the only sure things in life are death and taxes. To expand upon this cheery thought, let us add market downturns to this list. In the financial industry, most advisors have been well trained to avoid making promises or guarantees for the future. We will make an exception here: we guarantee that markets will, at least occasionally, be terrible. Given this certainty, it behooves an investment committee to have a plan of action. 

Spending: the 5% Problem

We often consider tactical reallocations, donor outreach, investment changes as part of managing market stress. For this article, let us focus instead on the spending behavior of a charitable organization. 

There are several laws which impact investment and spending guidelines - UMIFA (Uniform Management of Institutional Funds), UPIA (Uniform Prudent Investor Act), NYPMIFA, etc. Perhaps the most important standard, however, is federal tax law which mandates a 5% annual payout for family foundations and similar private foundations. 

This 5% payout level is the eleemosynary standard widely adopted by endowments and more flexible foundations. 

A 5% payout seems like a manageable rate of return to target, but 5% is only the start of the hurdle. First, consider the 5% payout is net of fees – investment management fees, consultant fees, and trading fees. We have known widely-known wirehouse brokers add a full percentage point of fees, or more, to the cost of investing, thus pushing the 5% initial hurdle to over 6%.

Next, there is inflation. Most endowments and foundations are intended to exist forever, so they try to maintain the principal’s buying power. In the long term, inflation averages in the US between 2% and 3%. Therefore, the +6% net of fees hurdle now looks closer to 9% nominal return, to maintain real purchasing power.

We aren’t done; there are extra costs. The foundation may be a lean, cost-effective non-profit, but there may be a few people on staff. Are there miscellaneous taxes? Do you hire an accountancy firm full time or hire a Chief Financial Officer to take care of it? Does the foundation need the services of an attorney? Are there marketing personnel or community outreach staffers? Do you maintain an office? These costs may add another percentage point to the bottom line requirement.

After fees, inflation, and other expenses, the charity may actually need a target rate of return closer to 10%, rather than the presumed 5% target. A 10% target is pretty high under the best of market circumstances. Making matters worse, the current market environment has unprecedented low interest rates. As a result, most fixed income portfolios have yields which are several percentage points below their historical averages. Therefore, to generate a high average rate of return upward of 10%, some foundations may need to allocate their portfolios heavily into equities and similarly aggressive, volatile asset classes. This, in turn, increases the probability of having significant depreciation during inevitable market downturns.

Going Forward

Here are some action items you, or your committee, can take to ensure transparency in your operations and for your community network of donors, staff, and volunteers:
• Set the criteria for spending behavior within your investment policy statement. 
• Set the expectations for spending projects when they are adopted. If spending targets are contingent upon market behavior, set expectation with those project managers. 
• Smooth out your spending targets based on 3-year or 5-year rolling performance. You can still be sensitive to market pressures without wild swings in spending levels.
• Clearly establish your priority - which is either maintaining the current spending levels or protecting the perpetuity of the portfolio. You sometimes can’t have both. Of course, this assumes you have a choice in the matter. The 5% payout is a requirement for tax favored status for certain foundations.
• Some donors specifically require their donation to maintain its nominal value. Naturally, these restrictions will significantly influence the types of investment permitted and spending policy against those assets.
• If spending targets are immune to market downturns (i.e. – you have committed spending), consider separating these earmarked funds into separately managed accounts. For example, if you’ve committed to spending $100K per year for 3 years, then establishing a separate corresponding bond ladder to match that commitment may be the best option.
• Similarly, isolating restricted and unrestricted investments into separate portfolios is prudent.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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