Endowment spending: designing a policy that works

Foundations & Endowments

Saving. Spending. Investing. From the time we’re children until we become adults, we often hear about these personal budgeting terms. Unfortunately, there’s one caveat that’s usually missing from the equation. And that is, ‘with discipline.’ That caveat applies just as much to institutional investing as it does to personal investing.

Nonprofits are continuously under pressure to balance current and future needs when determining the purpose, structure, and governance of your endowment assets. Even when the appropriate strategy and process are in place to align saving and investing with long-term goals, one piece of the puzzle—spending—often takes a back seat.

Applying a disciplined strategy to how your organization spends its endowed resources impacts current budgets, future initiatives, capital projects, investment strategies, and administrative expenses. Disciplined spending can limit volatility and ease organizational strain. So a strong framework for spending success is essential to the long-term sustainability of your endowment assets.

Spending policy analysis: getting from here to there

Your organization’s spending policy should be carefully selected after a thorough evaluation of several key inputs. A qualitative review of the type of organization, time horizon, beneficiaries, purpose of the endowment, sources of funding, institutional resources, applicable donor restrictions, and the investment policy statement should factor into a quantitative analysis that addresses:

  • Annual operating expenses and income
  • Grant-making obligations, if any
  • Capital expenditures
  • Risk tolerance
  • Expected total return from income or capital appreciation
  • Investment-related costs
  • Inflation/Deflation
  • General economic conditions

Objectives: set goals for spending success

The goal of a successful spending policy is to balance predictability and stability with the preservation of capital. The policy should include statements indicating your nonprofit’s position on the:

  • Preservation of purchasing power expressed in a target return or measure greater than inflation
  • Extent to which investment income is needed as a revenue stream to support the organization’s operating budget
  • Possibility of exceptional spending and the prevention of erratic spending
  • Role of inflation and investment-related expenses

Spending rate: choose well

There are numerous ways to determine the endowment spending rate for your nonprofit. Most organizations are familiar with less complex approaches that include spending income, assigning a pre-specified percentage of the beginning market value, simply deciding on a spending rate, and using the IRS minimum required payout of 5% for certain private foundations. In practice, there are three primary methods used today.

Moving average methods: one of the most frequently used approaches, this method tends to ‘smooth’ the overall spending rate and reduce the impact of a single year’s increase or decrease in your portfolio’s value. It involves the application of a spending policy rate (typically 3.5% – 5%) to a moving average of beginning-period market values over a defined historical period (typically three to five years or 12 to 20 quarters).

Inflation-based methods: these are calculated using the previous year’s spending, and inflating it by an applicable inflation index (such as one of the Consumer Price Indexes). Depending on preference, some organizations will then impose upper and lower bands on spending (e.g., a lower band of 3% and an upper band of 6%).

Hybrids: another way to determine the appropriate spending level for your organization is to adopt a hybrid calculation that uses a weighted average of both the inflation-based calculation and the moving average calculation.

Spending rates can be expressed as a maximum, a target, or a range.

Ready, set, govern!

In terms of governance, we believe that many of the same topics addressed by your investment policy statement should also be acknowledged by your spending policy. The spending policy should:

  • Explain the intent or purpose of the endowment spending
  • Define the spending calculation method used
  • Identify the parties authorized to approve or amend the document
  • Outline how to handle exceptional expenses like capital campaign expenses, debt service, operating needs, etc.
  • Receive an annual signed and dated review

How can Truist Foundations and Endowments Specialty Practice help?

If a spending method has been selected by your organization, Truist can compare the spending objectives against our proprietary forward-looking expected return assumptions. We’ll also examine the strategic asset allocation outlined in your investment policy statement to determine if the allocation is appropriate and/or realistic. Based on these findings, we will make recommendations for the spending policy to ensure that the asset allocation outlined in the investment policy statement closely reflects the future liabilities of the organization.

If you haven’t yet selected a spending method, we will undertake a full qualitative and quantitative review of your organization. Using key inputs, we’ll model various spending levels over time that consider endowment income needs, inflation, investment related costs, and risk tolerance. The output of the analysis reveals multiple scenarios that demonstrate the relationship between spending, ending market value, and cumulative spending—both over time and in consideration of multiple investment approaches. We then provide this information to your investment or finance committee to inform the selection of a spending policy.

Spending with discipline

Whether incorporated into the investment policy statement or created as a stand-alone document, we recognize that your organization’s spending policy is critical to long-term sustainability. This document is a fundamental component of the investment decision-making process and, along with the investment policy statement, represent critical resources used by the investment committee to balance current and future spending requirements with maintaining the long-term value of endowment assets.

The following ‘Moving average methods’ policy is provided as an example. Additional sample spending policies are available upon request.

ABC Endowment

General Endowment Spending Policy

ABC Endowment (the “Endowment”) will endeavor to ensure, to the degree reasonably possible, that the endowment funds with which it is entrusted keep pace with inflation so that the original purpose of the endowment fund can be maintained in perpetuity. Toward that end, the Endowment has adopted the following spending policy, which will apply to all endowed funds unless a particular donor has otherwise stipulated spending restrictions.

1.      In adopting this policy, the Endowment seeks an appropriate balance among three goals:

  • To provide current programs with a predictable and stable stream of revenue
  • To ensure that the real value (defined as purchasing power) of the revenue stream does not decline over the long term
  • To ensure that the real value of the endowment assets does not decline over the long term.

2.      Authorized expenditures during the Endowment’s current fiscal year (ending June 30) shall be ______ percent (most non-profits use a number between 3.5% and 5.0%) of the average total market value of the endowment for the trailing three-year period ending ______ (you can use December 31 or March 31 period end market values for this calculation or use the prior 12 quarters).

3.      In making distributions, the Endowment is authorized to use both the Net Income and Net Capital Appreciation (defined as realized and unrealized appreciation in the fair market value of the investments) in excess of the fund’s Historic Dollar Value (i.e. corpus). The Historic Dollar Value shall be determined in accordance with the Uniform Prudent Management of Institutional Funds Act, which defines Historic Dollar Value as “the aggregate fair value in dollars of an endowment at the time it became an endowment, each subsequent donation to the fund at the time it is made, and each accumulation made pursuant to a direction in the applicable gift instrument at the time the accumulation is added to the fund.”

4.      The Endowment’s Executive Committee shall have discretion over whether or not distributions are made. If it is determined that a distribution is not needed in a current fiscal year, the Executive Committee may waive the distribution for the year.

5.      Any exceptions or changes to this spending policy shall be made only upon the written approval of the Endowment’s Board of Directors.

This statement of spending policy is adopted on _______________ _____, _____

About Truist’s Foundations and Endowments Specialty Practice

Truist has more than a century of experience working with not-for-profit organizations. Fiduciary stewardship is the heart of our culture. We’re not just a provider, but an invested partner—sharing responsibility for prudent management of not-for-profit assets. Our client commitment, not-for-profit experience, and fiduciary culture are significant advantages for our clients and set us apart. The Foundations and Endowments Specialty Practice works exclusively with not-for- profit organizations. Our institutional teams include professionals with extensive not-for-profit expertise. These professionals are actively engaged in the not-for profit community and are able to share best practices that are meaningful to their clients. Team members offer guidance and advice tailored to the various subsets of the not-for-profit community, including trade associations and membership organizations. Our Practice delivers comprehensive investment advisory, administration, planned giving, custody, trust and fiduciary services to trade associations, educational institutions, foundations, endowments and other not-for profit clients across the country.

Interested in having a deeper conversation about creating a sustainable spending policy? Contact your Truist relationship manager or investment advisor or call us at 866-223-1499.