Feature
grown by inflation policy, then for 5%/ceiling and floor, and then
for the hybrid policy. But the 5%/smoothing term policy was able
to maintain some level of spending throughout the entire 45 years.
Figure 3 shows the range of downside spending volatility
displayed by each policy over all 45 return paths.2 As you can see,
the dollar amount grown by inflation policy shows the highest
range of downside volatility: Average deviation below the target
over the 45 paths ranged from a high of $1.52 million to a low of
$0 (along a fortunate path in which spending levels never had to
change). The average deviation below target across all time paths
was $530,000 (0.53 in Figure 3).
In contrast to this, the 5%/smoothing term spending policy provided
the tightest range of deviations below target and the second-lowest
level of average shortfalls (0.38). As Figure 3 shows, none of the
strategies eliminated the potential for downside volatility in the
set of scenarios examined.
Each endowment and foundation must determine the extent to
which it can accept volatility in its nearterm spending. This decision
should take into account many factors, such as the level of annual
contributions, the accessibility of additional funds, the degree
of flexibility in annual commitments, and overall risk tolerance.
Case study
The following case study illustrates the four spending policies.
Table 2 on page 19 lists the assumptions for the study.
We analyzed each policy along 45 historical return paths using
data from 1960 through 2004 (“looping” returns when reaching
the end of available data). Because limiting spending volatility is
important to endowments and foundations, we identified a “best
case” and a “worst case” return path for each policy. The “best
case” was the path with the lowest average deviation in spending
below the initial spending target (which was $2.5 million, or 5% of
the endowment). The “worst case” was the path with the greatest
average spending deviation below the initial target. Figures 1 and
2 chart the results (in real dollars).
Among the “best case” scenarios, the greatest spending stability
was provided by the dollar amount grown by inflation policy,
which produced a constant level of $2.5 million (in real terms) a
year. The next most stable spending was provided by 5%/ceiling
and floor. The most volatile “best case” was produced by the
5%/smoothing term policy. On the other hand, the results for the
“worst case” scenario were almost exactly the opposite. Spending
dropped to zero first (in less than 20 years) for the dollar amount
Assuming a level of spending that generates the possibility of exhaustion. Almost all spending rates currently in use produce some chance that, given certain circumstances, withdrawals
will not be sustainable. Based on the historical data we used, initial spending rates as low as 3.25% of the starting balance could not be maintained in all 45 historical paths.
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