A mathematical model for better managing portfolios of endowments and foundations has been developed by Phil Dybvig, the Boatmen's Bancshares Professor of Banking and Finance at the John M. Olin School of Business at Washington University, St. Louis.
The model, which optimizes income from investments, merges both planning for the management of assets and planning for spending. His prescription for better management includes: determining committed expenses to make sure they are covered by income from risk-free investments and other sources; investing the remainder of the endowment in a mix of various assets; and, as the value of the fund increases, raising committed expenditures and setting a new base level of expenses to be covered by income from risk-free securities.
"Basically, you're trading off how much you like making profits in the stock market against a smooth consumption path. ... The advantage of starting with a well-crafted theoretical model is that it gives us an objective way of analyzing the trade-offs we need to make."
"There needs to be a link between investment policy and what's going on in expenses," Mr. Dybvig said. But usually, managing assets and budgeting are decided separately. Schools commonly allocate assets under fixed proportions or within a range of acceptable proportions. Then they spend something such as a fixed proportion of a five-year average of the portfolio's market value.
When budgeting and investment decisions are made separately, it's more difficult to determine how much to keep in risk-free investments.