Over the past 18 months, there has been increased criticism of payout rates at foundations and endowments. Outside observers have called for mandatory disbursement rates that could drive return requirements into the double digits. Some of this criticism has been driven by the recent performance success of foundations and endowments, where universe median results have been higher than 10% for fiscal year 2014 and fiscal year 2013. However, results were not as strong the past fiscal year (ended June 2015), ranging from 2.5% to 3.5% depending on the universe. And that is important, as it is very challenging to meet return objectives year after year. 1
Underlying these proposals is a claim that foundations and university and college endowments hold onto cash that could be disbursed for society's benefit. In many cases, there seems to be a basic misunderstanding of the return required to maintain a foundation or endowment without a new infusion of donations. Russell Investments has conducted a number of studies on endowments at universities and other non-profit organizations. The results consistently show it is highly unlikely that a portfolio can grow in perpetuity if required to spend 5% or greater per year. The average payout rate (or spending rate) for the fiscal year ended June 2014 was 4.4%, with a range of 4.1% to 4.6% for university and college endowments, according to the NACUBO Commonfund survey, released in January. Private foundations are required to spend 5% per year, which might potentially put them at risk of depleting their assets.
The most basic calculation for determining required return is as follows: amount of spending + inflation rate + administrative costs = required return.
Let's consider one recent proposal that universities spend at least 8% of their endowments annually. If your spending rate is 8% and inflation is 2.5% and administrative costs are 1% (which is the common average used for university endowments), then an 11.5% return is required to maintain the endowment.
The average endowment return is far from the 11.5% that would be needed to grow perpetually in this scenario. Recent studies show the average endowment has seen returns around 6% to 8% over the past 10 years. Depending on market conditions, an 8% spending rate on an endowment portfolio with a typical allocation — including U.S. equities, developed and emerging markets equities, hedge funds, private equity, real estate, commodities and fixed income — could diminish the inflation-adjusted asset base by up to 33% in just 10 years.
While more aggressive asset allocation can bolster expected return and potentially support a higher payout rate, those changes also introduce added risk and volatility into the investment portfolio. Yes, the highs may be higher, but also the lows may be lower, which makes it much more difficult for institutions to plan for a consistent level of spending over time.
Prior to the 2008-2009 global financial crisis, there had been similar conversations among some to require a certain level of payout from endowments. Those voices were quieted as the markets collapsed and many foundation and endowment portfolios lost a significant amount of their value. In 2009, for example, the median annual investment return among U.S. colleges and universities was -19%2. For our hypothetical endowment with an 11.5% return requirement, a 19% loss would mean a return gap of 30.5 percentage points. It has taken many years of hard work and careful management to return to pre-crisis asset levels. Increasing payouts could undo those gains.
There are times when a large spending rate will not be as detrimental to a foundation or endowment portfolio. During the current U.S. bull market, many foundations and endowments have experienced strong returns and healthy fundraising. As a result, some have had the freedom to exceed their usual spending targets.
Assuming bull-market conditions are average, however, is a huge mistake. Over the long term through multiple market cycles, being required to spend 5% or greater is detrimental. This is why we frequently recommend that our foundation and endowment clients limit the annual spending rate if there is flexibility to do so. In general, we encourage our clients to payout no more than 4.5% per year.
There is widespread agreement that foundations and endowments play a critical role in our society, and excessive spending could leave us with no support at all from these institutions. n
Notes:
1 Foundations and endowments of more than $1 billion from BNY Mellon U.S. Master Trust Universes. 2 “2014 NACUBO—Commonfund Study of Endowments,” released Jan. 29, 2015, http://www.nacubo.org/Documents/EndowmentFiles/2014_NCSE_Public_ Tables_Annual_Rates_of_Return.pdf