For decades, most endowments and foundations have lived by the 5% payout rule, safe in knowing that such prudent spending safeguarded their financial health. However, with markets changing, many endowments find adhering to a government rule that demands how much of a portfolio must be spent annually to maintain tax-exempt status no longer makes sense.
The 5% payout guideline was instituted in 1981 by the IRS. While it applies only to private foundations, it was broadly adopted by most non-profit organizations as a sensible baseline for spending. Now, it is the most widely used spending percentage by institutional investors today, setting the return they must exceed annually to ensure the endowment grows.
Employing a 5% spending policy means an organization must achieve a return of 5% plus the rate of inflation to preserve the portfolio's purchasing power and support the organization in perpetuity. Over much of the past 90 years, this has not typically been an issue. A decade ago, when cash was valuable, the 5% rule made sense. Endowments could make 4% annually on cash and use those funds as collateral for trading, making another 4% from investments such as U.S. Treasuries, top-rated municipal bonds and A-list dividend stocks. That conservative formula was a low-risk strategy to generate annual returns of 8% with ease. However, with the return on cash near zero for years, if an endowment generates only 4% profit from trading, it would shrink if spending stayed at 5%.
Market conditions now make the 5% rule problematic. According to the Wilshire Trust Universe Comparison Service, on average, U.S. endowments returned -0.74% for the year ended June 30, after returns of 2.8% for the 12 months ended June 30, 2015. While this fiscal year has definitely started off much better through Feb. 28, the three-year returns will be a far cry from the double-digit gains of the recent, post-recession, past.
Many experts believe strong stock market returns have been inflated for the past seven years by low interest rates and the quantitative easing policies of global central banks. However, due to a number of factors — including current equity market valuations, current long-term interest rate levels and the likelihood that the U.S. Federal Reserve will have a more normalized interest rate policy in the future — many experts expect lower returns on stocks over the coming decade and weak returns for bonds and cash equivalents. That means the sensible move for most endowments is to budget appropriately for the realistic rate of return that can be earned on assets at this point in the market cycle.