Senior Director | CAPTRUST Defined Benefit Practice Leader
Hunter Brackett, CFA
Senior Manager | CAPTRUST Consulting Research Group
The Uniform Prudent Management of Institutional Funds Act (UPMIFA) of 2006 provides a general fiduciary framework for charitable organizations. It offers two helpful guiding principles. The first principle suggests that assets be “allocated prudently in diversified investments that sought growth as well as income”; the second, that asset appreciation can “prudently be spent for the purposes of any endowment fund held by a charitable institution.”1 While these two principles are not fundamentally at odds, they do suggest that charitable organizations must find an appropriate balance of investment returns and spending to fulfill their charitable intent. Given rising interest rates and declining capital market assumptions—which may generate subdued investment returns in coming years, challenging current spending policies—these organizations may need to reassess their asset allocation strategies, spending policies, or both.
While UPMIFA requires many fiduciary considerations when determining investment policy, it suggests that “investment decisions be made in relation to the overall resources of the institution and its charitable purposes.”2 Any investment policy should consider time horizon, risk tolerance, tax considerations, and liquidity needs.
In addition, the return objective and its building blocks should also be considered:
Spending. Charitable organizations develop spending policies based upon several factors, including Internal Revenue Service (IRS) guidelines, donor limitations, and a number of other objectives and constraints. According to the 2012 NACUBO-Commonfund Study of Endowments, the average annual effective spending rate for endowments was 4.2 percent.3 Private foundations often focus their spending policies on the 5 percent IRS spending requirement. Regardless of the tax, regulatory, and structural differences between charitable organizations, 4–5 percent spending policies are commonplace.
Inflation. For charitable organizations that seek the corpus of assets to support philanthropic efforts in perpetuity, inflation is an important consideration. Inflation, as measured by the Consumer Price Index, has averaged approximately 2.5 percent since 2000.4
Nonqualified expenses. Asset management fees, generally between 0.5 and 1.0 percent, represent the largest nonqualified expense and vary widely based on asset allocation, use of alternatives, asset size, and other factors.
Endowments and foundations have experienced strong investment returns since the financial crisis with the recovery in the capital markets. Figure One provides average net returns for small to midsize endowments and foundations, as reported in annual studies conducted by Commonfund Institute and the Council on Foundations.5
For the latest fiscal year, three-year annualized returns were in the 7–10 percent range, and 10-year annualized returns were in the 6–7 percent range. Five-year returns are biased by the 2008 market sell-off, seen as representing a (hopefully) extreme market event. While the 3- and 10-year returns in Figure One are encouraging, some institutions may have difficulty maintaining that performance given their current asset allocation and our expectations for future capital market returns. Under these circumstances, we believe that now is the time for foundations and endowments to reassess their portfolio return expectations in conjunction with spending policy and make any necessary asset allocation adjustments.
Figure Two shows asset allocations for small and midsize endowments and foundations, based on the two previously cited studies. Expected return and risk are based on CAPTRUST’s capital market assumptions, which cover a five- to seven-year time horizon, historically the length of a full capital market cycle. Our capital market assumptions use standard deviation, defined as the possible divergence of the actual asset class return from its expected return, as a measure of risk.
However, investors also measure risk through other methods, such as permanent capital impairment or loss.6 For further details on our capital market assumptions, please see our April 2013 position paper titled Capital Market Assumptions: Opportunities in a More Challenging Environment.
Based on our proprietary capital market assumptions, we expect endowment and foundation portfolio returns to range between 5.5 and 6.0 percent, which is lower than the historical returns cited in Figure One and the common return objective of 7.5–8.0 percent identified earlier. The primary driver of this performance differential is our expectation of subdued bond returns. While we continue to believe that bonds can perform well during times of economic stress, we are concerned that rising interest rates will pose a headwind for this asset class (since bond prices move in the opposite direction of rates). In contrast, our capital market assumptions maintain a favorable view on traditionally riskier asset classes, such as stocks.
Figure Two also shows two hypothetical portfolios, illustrating the asset allocation changes needed to achieve a return in the 6.5–7.0 percent range. Compared to the actual endowment and foundation portfolios, the hypothetical portfolios contain a higher allocation to stocks, funded from decreased allocations to bonds and cash.
We also advocate for a larger allocation to private equity for those institutions able to access it, as investors can benefit from manager skill and the illiquidity premium associated with this asset class. By increasing allocations to traditionally riskier asset classes, we believe that endowments and foundations will have a better chance to meet their long-term return objectives; however, they must be willing to accept higher portfolio return variance. Our standard deviation assumptions for stocks and private equity are considerably higher than fixed income, thus charitable organizations should incorporate this factor into asset allocation decisions along with liquidity considerations.
Interestingly, the risk-adjusted return — or expected return divided by expected risk (as measured by standard deviation) — of the hypothetical portfolios shown in Figure Two are modestly lower than endowment and foundation allocations currently being employed. And while investors often focus on market risk associated with stocks, other types of risk also merit consideration. In particular, as interest rates rise from historically low levels, interest rate risk related to bonds deserves close attention. The bond market has been in a multi-decade bull market as interest rates declined, but that favorable backdrop is beginning to change. Every asset class contains inherent risks that deserve consideration; therefore, CAPTRUST stands ready to help charitable organization clients sort through this issue and determine which risk factors they are comfortable with in light of the capital markets environment.
Illiquidity and large losses in high-risk asset classes often occur at the same time philanthropic institutions need to spend the most. These organizations face the difficulty of reevaluating the perpetual nature of their commitment, spending too much (a fiduciary concern under UPMIFA), spending too little (failing to meet their philanthropic objectives), or taking on too much risk to support their spending needs.
We believe that charitable organizations should consider a balanced approach of reevaluating current spending policies (where possible), risk tolerance, and return objectives in light of lower forward-looking return assumptions for fixed income. They should also view risk tolerance in a comprehensive context, as opposed to risks that are only measured by standard deviation. While such statistical measures of risk do emphasize the potential downside of return-seeking behavior, they do not necessarily capture shorter-term capital market views or risks of failing to meet long-term objectives. These measures of risk also do not differentiate between permanent capital impairment and temporary market swings. Charitable organizations may find that more risky portfolios (in the traditional sense) and creative asset allocation solutions may be warranted to accomplish long-term objectives.
1 The National Conference of Commissioners on Uniform State Law. “Prudent Management of Institutional Funds Act Summary.” Uniform Law Commission. n.d. http://uniformlaws.org/ActSummary.aspx?title=Prudent Management of Institutional Funds Act. Accessed December 2013
2 2013 National Association of College and University Business Officers and Commonfund Institute. “2012 NACUBO—Commonfund Study of Endowments.” National Association of College and University Business Officers. 2013. http://www.nacubo.org/Documents/research/2012NCSEPublicTablesSpendingRatesFinalJanuary22.pdf. Accessed December 2013
4 US CPI Urban Consumers NSA Year Over Year Percentage. Bloomberg, 2013
5 National Association of College and University Business Officers. “2012 NACUBO—Commonfund Study of Endowments.” National Association of College and University Business Officers. 2013. http://www.nacubo.org/Research/NACUBO—Commonfund_Study_of_Endowments.html. Accessed December 2013
6 Brackett, Hunter. “Capital Market Assumptions: Seeking Opportunities in a More Challenging Environment.” CAPTRUST Financial Advisors. 2013. http://www.captrustadvisors.com/pdf/CAPTRUST_Capital_Market_Assumptions_Position_Paper_April_20132.pdf. Accessed December 2013