Endowment Spending Policy Ultimately, your endowment portfolio will be used to fund the organization in some way. In anticipation of that, you will need to develop a spending policy that will strike a balance between providing for the current sustainability of the organization and the long term sustainability of the portfolio. Even if you are not ready to take a distribution from the portfolio, it is a useful exercise to discuss the issue with your board and determine the formula for how you will ultimately calculate your annual spending amount. If your operating budget needs are modest and you have relatively few decision makers, a simple solution may suffice, and you may be able to quickly make decisions about the distribution amounts for a given year based on prior year market performance and other organizational factors. However, as the number of members on the investment committee grows and the need to get approval from the board for changes in policy becomes more likely, you will want to think through the possible outcomes and build some flexibility into the policy. Spending Calculations The following are some common methodologies for calculating the spending amount: Spending rate selected by board each year Fixed dollar amount based on percent of original asset balance Percent of prior year's ending asset balance or a moving average of asset values Percent of historical asset balance adjusted for inflation Of course there are numerous other methods that could be used in addition to these. Regardless of the method, you must first decide what the spending rate is going to be. Many organizations use 5% or a flexible band around 5% such as 4.75% - 5.25%. Why the magic number of 5%? Most well diversified and balanced portfolios are assumed to have a long term growth rate of 7-8% or better. This would allow for growth of principle in excess of the spending amount, in theory. In reality, we don't know in advance what level of returns each spending period will bring. If the portfolio value declines for several years in a row, it becomes very important how the spending calculation is done. If, as in method 1 above, it is based on a fixed percentage of the original balance, then the portfolio not only risks dipping into principal, but also risks running out of money entirely. If a percentage of the prior year's asset level is used, then the portfolio is not at risk of being depleted but may still run the risk of drawing down the principal if bad markets continue. A secondary issue with using a percent of portfolio balance as the basis for calculation is that it may create excessive volatility of the distributions. For this reason, a smoothing over several years' asset values is preferred by many institutions. In a 2009 study by the Commonfund, the spending policies of 842 institutions were evaluated. 74% of the institutions preferred a percentage of a moving average of asset values. At 9% of the institutions, a set spending policy was not selected, rather, the board decided on the appropriate rate every year on its own. At 6% of the institutions, a combination of a smoothed spending approach and an inflation adjusted spending approach was used. Tobin's Spending Rule The combination asset value and inflation adjustment methodology is the type of policy adopted by the Harvard and Yale endowments and the one that we find most intriguing. James Tobin, a noted American economist who taught at Harvard and Yale, had a part in developing this formula. S(t) = dollars of endowment spent in year t i(t) = rate of inflation in year t V(t)= endowment value in year t x = target (long term) spending rate w = weight on current (year t) endowment value Using this formula, the organization can choose how much emphasis to put on recent asset values and how much to put on an inflation adjustment to the prior year's spending to calculate the current year's spending amount. For example, if the w term were set to 0.25 that would mean that 25% of the spending amount would be related to the year‐end asset value multiplied by the chosen spending rate. 75% of the spending would be determined by last year's spending amount adjusted for inflation. An important point here is that the inflation rate, i, is the rate of inflation most appropriate for the organization. It may be simply the growth rate of the consumer price index, or it may be better approximated in the case of an academic institution as the rate of growth of tuition costs. Another consideration for board members is the establishment of a policy that addresses the implications of spending below the historical dollar value of the endowment. Historically, restricted funds were governed by a law which prohibited such spending. As of 2010, however, the Uniform Prudent Management of Institutional Funds Act (UPMIFA) redefined the requirement as an effort simply to preserve the purchasing power of the principal over the long term. Your choice of how you spend your endowment funds is as critical as the asset allocation of the portfolio over time. We encourage boards to consider not only the issues presented here, but also the makeup of your organization and decision making structure when deciding on a spending policy that is appropriate for you. Kahn, Ronald, Thoughts on Managing Endowment Goals, Spending, and Investment Policy, 2008.