Senior Director | CAPTRUST Consulting Research Group
Manager | CAPTRUST Consulting Research Group
The Uniform Prudent Management of Institutional Funds Act (UPMIFA) suggests that charitable organizations must find an appropriate balance between investment returns and spending to fulfill their charitable intent. But what does that mean in today’s capital markets environment, with bond yields at all-time lows, stagnant earnings, and an aging bull market in U.S. stocks?
While fiduciaries can control how much risk they take, they do not control the direction of capital markets. Since Internal Revenue Service-defined payout rules define minimum required spending policies, private foundations harbor a natural desire for assets to out-earn required distributions to maintain their corpus of capital. However, these foundations often spend well over the requirements defined by the IRS reducing the potential for future expenditures. One main contributing factor is the lack of communication between the board members responsible for spending and those responsible for investment outcomes.
With board and committee membership in constant rotation and limited resources, how do you balance spending with the need for long-term sustainability of assets to support a philanthropic mission? One word sums up the answer to this question: Governance.
Assets Return over the Next 5 to 7 Years
Our most recent capital market assumptions released in January of 2016 portray a challenging investment environment over the next 5 to 7 years. CAPTRUST Chief Investment Officer Eric Freedman explained how this inelegant truth for investors already frustrated by the low returns of diversified portfolios may play out in the coming years.
A combination of the following factors drives this forecast:
- Persistently low interest rates;
- Stagnant or falling corporate earnings; and
- Somewhat lofty valuations for U.S. stocks driven by a lengthy bull market since 2009.
Portfolio returns result from the asset allocation and volatility (or risk) level a fiduciary committee chooses to take in its investment portfolio. Both of these decisions vary widely among philanthropic organizations. Small private foundations tend to rely on traditional asset classes like bonds and stocks. Large pools often have significant allocations to alternatives and illiquid asset classes. This concept is referred to as the endowment model, a term originating from David Swensen’s work as chief investment officer of Yale University’s endowment.
In Figure One, we test a variety of allocations, including both of these models, using our capital market forecast. Recognizing that our capital market forecasts could be wrong, this exercise suggests that earning more than 5 or 6 percent will be a challenge—even with significant allocations to illiquid investments (which are often impractical for smaller private foundations).
Figure One: Asset Allocations and Risk and Return Forecasts (based upon current CAPTRUST capital market assumptions)
This challenging return environment, a stark contrast to the 1990s and early 2000s, will put more focus on spending over the next several years. Whether the time horizon is 5 to 7 years or perpetuity, fiduciary committees should regularly evaluate their asset allocation in light of their return goals, risk tolerance, liquidity, tax constraints, and time horizon.
Spending Policy Considerations
Tax rules vary by organization, but the IRS requires most private foundations to pay out approximately 5 percent of their charitable asset pool each year (based on the 12-month average fair market value in a given tax year). These distributions must generally be paid out within 12 months after tax-year end, although there is some flexibility to carry over the excess for up to 5 years if a foundation exceeds the 5 percent payout in a given year.
Across our client base, we see many private foundations pay out more than the required 5 percent. The average private foundation paid out 7.6 percent in 2014, with smaller foundations (less than $1 million of assets) paying out 13.2%. Clearly, this level of distribution is not sustainable in light of the expected return environment—without the luxury of significant new capital contributions.
Many of our clients seem comfortable spending more than the 5 percent requirement when investment returns are high and they can afford to support more activities—only to turn around and spend more than 5 percent when asset performance is poor. Perceived philanthropic needs are often highest in times of economic stress. Unfortunately, this can force organizations to sell assets when prices are low, which locks in investment losses.
To illustrate the impact of spending policy on investment outcome, we evaluated the expected growth (or decline) of foundation assets over a 10-year period (with a starting value of $10,000,000) using four differing spending policies. We ran 5,000 simulations for each spending policy using the expected return and volatility characteristics of the endowment model, the highest-return model based on our capital market assumptions. The spending policies we tested included:
- Required Minimum (Spending Policy 1)—A spending policy of 5 percent of assets per year, the minimum required for tax purposes, regardless of market return.
- More than Required Minimum (Spending Policy 2)—A spending policy of 7.6 percent of assets per year, the average payout rate for private foundations in 2014, regardless of market return.
- Increased Spending in Strong Markets (Spending Policy 3)—Spending of 7.6 percent of assets when returns are greater than the portfolio’s 5.7 percent expected return and 3 percent spending when returns are below 5.7 percent. This represents a foundation that spends more when times are good and less during times of stress.
- Increased Spending in Times of Stress (Spending Policy 4)—A 5 percent spending policy when asset returns are positive and 7.6 percent spending policy when returns are negative.
The results shown in Figure Two are straightforward. Consistently spending more than 5 percent creates a significant potential for declining asset values over the period. However, if an organization spends more than the required 5 percent, aligning spending with asset returns (i.e. spending more when returns are strong and less when returns are weak) provides expected results similar to a consistent 5 percent spending policy—with a more predictable outcome. While tying spending decisions to asset performance has overall benefits, this dynamic budgeting practice requires coordination to implement.
Figure Two: Impact of Spending Policies on Projected 10-Year Asset Values
Meanwhile, spending more in times of stress is better than consistently elevated spending levels, but can also lead to a high probability for declining asset values over the period.
Appropriate spending policies will vary by organization based on goals, objectives, risk tolerance, tax considerations, regulatory concerns, and philanthropic mission. However, organizations should evaluate the impact of spending patterns in a range of market scenarios and make informed decisions. Spending policies followed and monitored relative to investment results will ensure better alignment of results with organizational objectives and support long-term stability.
Why is Governance the Answer?
In our experience, private foundations face several key challenges. Volunteer board members of most private foundations serve short and rotating terms. They often serve without training or meaningful documentation of predecessor decisions and supporting rationale. To compound matters, the organizations they represent often have few resources to create board continuity over time.
Many private foundations govern by committee. We often find that two different committees guide the investment process and spending decisions. This means that the people with insight into investment objectives and outcomes do not make spending decisions. Conversely, those determining philanthropic expenditures may not be aware of the long-term challenges created by consistent overspending. In these cases, clear communication created through sound governance can ensure that organizations consider and integrate both perspectives in the decision-making process.
Organizations should track the spending-versus-earnings dynamic as part of their quarterly review process. For example, former Harvard University President Lawrence Summers thinks the time has come to revisit the university’s endowment’s spending policy. “If it makes sense for Harvard University to pay out 5 percent of its endowment in 1999 when the real interest rate was 4 percent, it’s quite unlikely that it makes sense to pay out 5 percent of its endowment in 2016 when the real interest rate is zero,” said Summers in a recent Bloomberg interview.
We agree and encourage foundations to ask some tough questions in light of current investment conditions:
- Do you have a charter (or similar document) that defines roles and responsibilities for the board and committee members?
- Do you have a documented spending policy? A formal investment policy?
- Do you tie the two together when making spending and investment policy decisions?
- How often do you revisit your spending policy? Is it tied to long-term asset allocation decisions?
- How do these decisions tie to your asset pool’s liquidity needs?
- Does your investment policy define the responsibilities of the board, committee, staff, and outside vendors such as investment managers, investment advisors, and custodians?
- Do you have regular meetings? Are minutes taken to document decisions and define follow-up accountability?
- Do you have a formal process for training new board and committee members? How do you ensure they understand the historical context of predecessors’ decisions?
While there is no perfect answer to these challenging questions, organizations with sound governance practices will be in a much better position to make proactive decisions aligned with their goals and objectives.
Foundations should consider realistic expectations for asset performance relative to asset allocation, risk tolerance, and spending policy—and make informed decisions based upon their understanding of these issues. Today’s likely low-return capital markets environment makes these decisions even more critical, and the stakes are simply too high to assume that capital markets history will repeat itself.
1 Representative asset allocation based upon the All Foundation Allocation Table in Foundation Source’s 2015 Annual Report on Private Foundations.
2 Representative asset allocation based upon the 2015 NACUBO–Commonfund Study of Endowments Detailed Asset Allocations for Fiscal Year 2015.
3 2015 Annual Report on Private Foundations, Foundation Source.
4 “Ex-Harvard Head Summers Suggests School Curb Endowment Payout”. Bloomberg. Accessed April 25, 2016. http://www.bloomberg.com/news/articles/2016-04-18/ex-harvard-head-summers-suggests-school-curb-endowment-payout.