A Delicate
Balance
introduc tion author

Setting Foundation and Nonprofit norman e. nabhan, cima

Spending Policy in a Volatile

Managing Director — Investments
Institutional Consulting Director

Market Environment Graystone Consulting

 
Norm Nabhan is a Managing Director and
The rising stock market of the 1990’s led some critics of not-for-profit a member of Graystone Consulting based
organizations to call for greater spending levels based on gains in Houston, Texas. He has more than
thirty-five years of experience helping
realized on endowed portfolios. Some critics called for the raise of the institutional investors design spending and
investment policy, develop asset allocation
annual payout requirement for private foundations from the currently strategies, select appropriate investment
mandated 5% to 6%, 7% or even 8% of assets. Unfortunately, the days management firms and conduct regular
rebalancing and portfolio reviews.
of outsized performance results could not be sustained indefinitely. Mr. Nabhan graduated from Purdue
Recent capital market results and conditions have shown, in retrospect, University with a B.A. His professional
associations include the Investment Man-
that such spending targets could have posed a formidable challenge agement Consultants Association, where
he served on the Board of Directors for
for organizations seeking to protect their foundations from serious eight years and two years as President.
erosion — or spending into extinction. He is also former Chairman of the
Certification Committee.
This paper is intended to help foundation and not-for-profit managers Mr. Nabhan is Past President of the
understand the spending and investment choices they face. It describes Association of Professional Investment
Consultants. He has served on the Advisory
the components of an effective planning process and explains how effective Boards of the Boston College Center for
Wealth and Philanthropy and the Purdue
portfolio management can help trustees and directors prudently manage University Endowment.
both their current and future needs — particularly through periods of
market volatility.

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a delicate balance
The Balance Between Spending
and Investment Policy
In theory, a successful financial man-
agement plan for a foundation or non-
profit organization has one main goal:
to maximize the resources available
to support the organization’s mission.
These charitable endeavors may be
targeted at programs such as museums,
schools or libraries, grants to other
nonprofit groups, scholarships or any
number of charitable gifts designed
to help individuals, organizations
and communities.
The charitable planning process
requires officials to balance the ex-
pected life of the programs to be funded
against the desired life of the founda-
tion or organization. This involves the
management of two broad trade-offs:
between current spending and future
spending on the one hand, and between
investment risk and return on the other.
The law requires that private foun-
dations spend an amount equal to at
least 5% of their prior year’s invest-
ment assets each year, subject to cer-
tain adjustments (Figure 2). Failure
to meet this target can result in a tax
equal to 15% of the unspent amount.
Additional excise taxes (100 percent
of undistributed income) are imposed
on any undistributed income of the
pertinent taxable year remaining at the
close of the correction period. Spending
in excess of the minimum can be car-
ried forward and applied to later years,
up to a maximum of five years. Many
nonprofits receive financial support
Figure 3: Liquidation Math
Future Purchasing Power
100%
86%
80
60
40
20
0 issue and to attempt to reduce over-
5 years
Source: Graystone Consulting
2 morgan stanley
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from a related foundation or from the
investment income or gains from their Figure 1: Sustained High
reserve funds. Spending Rates Eat Into
Trustees must understand the im- Future Purchasing Power
pact that spending decisions can have
on their investment policies. A high rate Spending Policy and Inflation
of spending may require a relatively Nominal Return 8.0%
aggressive-and-riskier-portfolio strate- Inflation 2.5%
gy to support that spending. Conversely,
Investment Expenses 0.5%
trustees who prefer a more conserva-
= Real Return 5.0%
tive investment approach may need to
Payout Rate 8.5%
reduce spending (Figure 3).
Effective Liquidation -3.0%
The stakes are high: trustees who
craft incompatible spending and invest- The real value of the portfolio is
diminished by inflation over time.
ment policies may jeopardize the future
of their institution and violate their
fiduciary duty to manage charitable Figure 2: Spending Policy
assets wisely and effectively (Figure 1). Based on Single-Year
The Role of Spending Policy
Portfolio Balances
Developing an appropriate spending 2011 Year-end
$10,000,000
policy is one of the hardest steps in the Portfolio Balance
nonprofit planning process. Only after Spending Rate at 5% $500,000
the spending policy is defined can the
However, if the fund loses 20% during the
fund’s asset allocation policy be deter- year, the year-end balance and spending
mined. If a fund must spend 5% per amount of the 2012 fiscal year would be
annum, and inflation is projected to be impacted as follows:
2.5%, then a fund must earn at least 7.5% 2012 Year-end
$8,000,000
to “break even” on an after-inflation Portfolio Balance
basis. The fund must also account for Spending Rate at 5% $400,000
the impact that investment and admin- The chart above represents a series of
istrative expenses have on plan assets. broadly diversified portfolios.
The Role of Asset Allocation 1999, the U.S. stock market, as mea-
As we’ve learned from the market cor- sured by the S&P 500 Index, posted an
rection of 2008, outsized performance average annualized return of about 15%
returns are not the norm. The market after inflation — more than double the
gains of the 1990s were spectacular — 7.1% average annualized return of the
but far from normal. From 1990 through past 80 years from 1931 to 2011. It was
unlikely that this trend could continue.
In all likelihood, the severe correction
that took place in the last decade was
The real value of a portfolio and of future
grants is diminished by inflation over time. a normal “regression to the mean” in
Impact of 3% per year inflation. long-term stock returns.
A thorough understanding of the
relationship between risk and return
is central to the investment process.
74% High returns typically cannot be
realized without higher volatility.
48%
Trustees must decide their tolerance
for investment risk. To address this
10 years 25 years all portfolio volatility, many trustees
turn to the theory of asset allocation.
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 a delicate balance

The importance of asset allocation — or
portfolio diversification — was first il-
lustrated by Harry Markowitz in 1952
and has been employed by successful
investors for more than half a century.1
Put simply, the goal of asset allocation,
is to identify the mix of assets — such as
stocks, bonds, cash and possibly, depend-
ing on investor requirements and suit-
ability, alternative investments — that
can potentially produce the highest pos-
sible return for a specified level of risk.
The proper blending of these different
types of securities requires a statistical
analysis of the historical returns and
volatility of each asset class based on
normalized and realistic assumptions
for expected returns for each class.
Back to Spending Policy
In addition to building a highly diversi-
fied portfolio of low correlated assets,
there are several options that can help
an organization build an appropriate
spending policy. One possible method
is to use a set number based on, for
example, 5% of the portfolio’s balance
at the end of the last fiscal year.
The drop in spending from $500,000
to $400,000 equates to a 20% drop in
spending to support the organization’s
mission. This drop could have disas-
trous consequences for an organiza-
tion with multiyear needs or one that
is funding multiyear programs that
need continuity of support.
Fortunately, there is another, sec-
ond option. Instead of basing spending
rates on a single year’s ending portfolio
balance, the organization may base its
spending on the average of three or even
five years of account balances (Figure 4).
This may help to “smooth” the overall
spending rate and reduce the impact of
a single year’s decline in value. As asset
values fall, the decrease in spending is
muted by using average year-end bal-
ances. Conversely, as the fund’s value
rises, spending does not climb as rapidly.
It is important to note that regard-
less of whether the organization
adopts a payout rate based on an av-
erage of the trailing three- or five-year
account balances, it still must satisfy
the 5% minimum annual payout.
Conclusion
Private Foundations and nonprofit or-
ganizations face special challenges in
setting their spending policy. Federal
tax laws that apply to private founda-
tions require a minimum annual payout
of 5% per year. While this target may
seem conservative, it could prove dif-
ficult to meet if the U.S. capital markets
experience a lengthy period of poor
performance. Setting spending policy
Single-Year and Three-Year Average Withdrawal at 5%
���� Thousand Single-Year at �%
��� Three-Year Average at �%
���
���
���
���
���
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’01 ’02
*Assumes $10,000,000 portfolio invested in 60 S&P 500/40 Barclays Aggregate
Source: Graystone Consulting
in excess of 5% greatly increases the risk
that a foundation will suffer a significant
decline in real asset value over time.
Ultimately, this could lead to sharply
lower spending levels.
Effective portfolio diversification
may help endowments manage invest-
ment risk while boosting long-term re-
turns. This can allow for higher levels of
charitable spending, without a decline
in future values.
For charitable trustees and directors,
balancing current and future spend-
ing can involve difficult, even painful,
tradeoffs. There are no easy answers.
But with careful financial analysis and
planning, trustees and directors can
seek the best possible terms for those
tradeoffs, and the best possible outcome
for their organizations and the chari-
table causes they support. Calculating
spending rates based on an average of
the trailing three- or five-year balances
will smooth out spending and reduce
the effects of a volatile market.
’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

Figure 4: Spending Policy Based on Three-Year Average Portfolio Balances

Single Year 2007 2008 2009 2010 2011
Year-End Asset Value $10,000,000.00 $10,105,667.47 $7,674,928.3 $8,478,105.13 $9,037,351.51

Spending Rate at 5% $473,541.23 $500,000.00 $505,283.37 $383,746.42 $423,905.26

Three-Year Average
Year-End Asset Value $10,000,000.00 $10,107,937.39 $7,690,194.45 $8,511,214.72 $8,985,494.34
Three-Year Average Spending Rate $471,401.41 $483,163.35 $492,549.871 $463,302.20 $438,489.11

*Assumes $10,000,000 portfolio invested in 60% S&P 500 40% Barclays Aggregate Bond indices
Source: Graystone Consulting

morgan stanley 3

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1 Harry Markowitz first published his formal model in The Journal of Finance
(Vol. 7, No. 1, March 1952, pp. 77-91).His further work on this subject earned him
the award of a Nobel Prize in 1990.
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