Feature
Endowment and Foundation
Spending Guidelines
By John Ameriks, Ph.D. | Vanguard
Endowments and foundations face many challenges when deciding how to allocate their
resources. One of the most difficult is choosing a spending policy that will best balance their
two competing goals: maintaining the level of current spending, and growing or preserving
the endowment in order to support future spending. This report discusses several common
spending policies along with the factors to be considered in making this important decision.
Common spending policies
•
Dollar amount grown by inflation.
•
Percentage of portfolio with a smoothing term.
This policy aims to provide a stable amount of inflation-adjusted
spending each year. If all goes well, this spending pattern can
greatly assist with budgeting over time. However, while such
policies typically produce stable year-to-year spending levels
in the short term, difficulties can arise over the long term. The
policy makes no provision for adjusting spending downward when
market returns have been poor. This means that all potentially
necessary reductions in spending must occur in the future, rather
than the present.
•
Percentage of portfolio with a ceiling and a floor.
Percentage of portfolio with smoothing term
•
Hybrid—a combination of dollar amount grown by inflation
and one of the percentage of portfolio policies.
Dollar amount grown by inflation
As the name implies, a percentage of portfolio policy bases
annual spending on a stated portion of the portfolio value at
the end of the prior year. A smoothing term modifies this to a
percentage of the average ending balances over a number of
years. For example, if the smoothing term is three years, each
year’s spending is equal to a percentage of the average ending
balance for the prior three years.
Under the dollar amount grown by inflation policy, a dollar
amount of spending is calculated in the initial year on the basis
of need or other criteria. (The amount is usually expressed as a
percentage of the initial portfolio value.) The spending amount for
each subsequent year is then determined by multiplying the prior
year’s spending by an inflation factor— typically the change in
the Consumer Price Index (CPI) or another cost inflation index.
As a result, spending levels vary based on investment returns.
This can make budgeting more difficult in the short run (although
the existence of a smoothing term can dampen the volatility
somewhat). On the other hand, spending is automatically cut
back when the markets have been doing poorly, and automatically
increased after periods when the markets have done well. Thus,
poor investment returns are at least partially offset by reductions
Some institutions are required by law to spend a certain amount
annually, such as 5% of the portfolio balance; others have more
discretion in selecting a spending policy. Many such policies have
been devised, but this report focuses on four of the most common:
The following article provides brief descriptions of these
policies, followed by a case study that illustrates their application.
22 | SPRING 2015