The organizations that rely on spending from endowments are all smiles these days.
About three-quarters of endowments employ formulas that use asset values to determine how much money to pay out. A typical spending policy is 5 percent of an endowment’s average market value over the past three or five years. When investment returns are good—and over the past five years they have been very good indeed—spending rises apace.
But a much smaller group of endowments uses a very different approach, and those organizations have kept the champagne and party hats firmly tucked away.
Organizations including the Health Care Foundation of Greater Kansas City and the University of Iowa Foundation decided years ago on a prudent dollar amount to pay out, and each year they increase that spending by the rate of inflation. With inflation averaging around 2 percent in recent years, their spending is inching up rather than jumping.
The upside for these endowments comes when markets drop. The endowments that use a “moving average” of market values will eventually be forced to cut spending, while the inflation-adjusters will boldly keep increasing their spending by the rate of inflation.
“When the downturn comes, as it will, you can reach into that bank that you’ve built and just keep on spending,” says William Jarvis, a managing director at the Commonfund Institute, the research arm of Commonfund, an investment firm specializing in endowments.
One of the main arguments for creating an endowment is to have a cushion for the bad times, so some consultants, including Mr. Jarvis, are puzzled that the inflation-adjusted approach isn’t more popular.
Commonfund’s 2013 study of operating charities found that 78 percent of the 63 participating organizations use an average of market value to determine spending. Only 15 percent use an inflation adjustment to calculate spending.
In October, Mr. Jarvis spoke at a conference where many of the participants calculate endowment spending from the last five years of market value. “The joy in the room was palpable,” he says. The low market values of 2009 dropped out of spending calculations this year, giving payouts a nice boost.
The exuberance made Mr. Jarvis nervous. With the moving-average approach, “as the market reaches a boom peak, you’re probably overspending,” he says. “You’re calculating off of a spendable base that is too high.”
The Health Care Foundation of Greater Kansas City knows that phenomenon all too well—and the lesson came like a punch in the mouth during the 2008-9 financial crisis.
The group’s endowment lost a third of its value as stocks cratered, forcing the group to cut $8-million from its grant-making budget over a two-year period. The cuts in endowment spending came when health charities supported by the foundation were seeing donations and government support drop.
“Operationally, it didn’t make sense,” says Rick Zimmer, the foundation’s chief financial officer. “It’s hard to do strategic planning and long-term grant making when you have a spending policy that’s contingent on the market.”
That’s when he began to research alternative spending methods. The charity’s board chose the current approach, known as “banded inflation.”
The formula can’t rely on inflation alone. The bands require the endowment to pay out a minimum percentage of market value—perhaps 4 percent—and no more than a maximum, often 6 percent. The cap on the high end keeps endowments from spending too much and putting the corpus at risk when markets sink. The minimum payout ensures that spending doesn’t dwindle when markets are good and inflation is tame.
Some big college endowments—including those of Yale and Stanford—use a hybrid approach. They make an inflation adjustment for the majority of their spending calculation but use market value for 20 to 40 percent of the formula. Throwing market value into the mix addresses some of the concerns addressed by the bands.
With markets at a peak, experts say it might be prudent for endowments to at least reevaluate their spending policies. Many investment committees tinker endlessly with asset allocations but rarely revamp spending.
In a move aimed at giving its institution’s deans more stability to help them budget their spending, the University of Iowa Foundation switched to the banded-inflation approach in the 2011 fiscal year, says Jim Bethea, the group’s assistant vice president for investments.
“We were fortunate from a timing perspective,” Mr. Bethea says. “I think it would be harder today.”
