Endowments and Foundations: How Should You Spend a Windfall?

Brian D. Wodar

Brian D. Wodar and Ashley E. Velategui

If your endowment or foundation received an unexpected bequest, would you spend more now or would you hold spending steady in order to retain more income and boost your future capacity to spend?  

The implications of either choice may not be what you expect. To help you understand them, let’s look at the case of Uptown Community Foundation (UCF), a fictional entity with a $10 million endowment that has received a $2.5 million bequest. In a recent article, we explained why UCF might prefer to retain its moderate 60/40 stock/bond asset allocation while diversifying more broadly. But what about its spending policy?

Let’s assume that UCF’s board—like most we’ve met–would like to offer larger grants to current recipients, but is reluctant to take steps that could lead to instability in grant size if market returns are poor. The board knows how damaging a sudden drop in support can be for a small or midsize nonprofit. The board is also eager to expand its future grantmaking capacity and protect its capital against the possible inroads of inflation. How should it pursue these multiple—and sometimes conflicting—goals?

UCF currently spends 4.5% of its $10 million portfolio on grants and operations. If it keeps this distribution rate, the added capital from the windfall will push its dollar spending much higher in the next few years. But if it reduces its distribution rate to 3.6%, its dollar spending will remain relatively stable in the short term at $450,000, and its capital will grow faster. Another alternative would be for it to take a middle course and cut its spending rate to 4.0%.

No matter what the board decides, the bequest will lead to higher distributions over time (Display 1). Without the windfall, cumulative distributions would have been $24.1 million over the next 30 years, but they will now range from $26.0 million at the 3.6% spending rate to $28.6 million at the current 4.5% rate.



 

Perhaps surprisingly, our Wealth Forecasting Analysis shows that the annual amount distributed under the 3.6% regime will likely catch up to and eventually surpass the amount spent under the 4.0% and 4.5% policies. In other words, less spending now means more spending later. Assuming that UCF was established to exist in perpetuity, its board should weigh current priorities against future priorities.

Keeping Payouts Steady

UCF’s board would like to increase payouts over time with little risk of short-term cuts, but these goals are not completely compatible. As Display 2 shows, boosting the equity allocation improves the odds that payouts will grow, but also increases the chance that a short-term market loss will lead to cutbacks in grants of 5% or more in any one year.

Display 2 also shows that a lower spending rate can moderate the payout instability.  As highlighted in the chart, a 60/40 asset allocation combined with a 3.6% or 4.0% spending rate strikes a reasonable balance between the two goals. Many foundation boards would opt for this sweet spot.



Mitigating Inflation Risk

Inflation is another key consideration. Boards generally want to maintain not just the nominal size of their foundation’s portfolio but also its real value—its spending power. As Display 3 indicates, the spending rate affects the foundation’s susceptibility to inflation: the lower the spending rate, the greater the chance that its portfolio will retain its real value 30 years hence.



With these findings before it, a board in UCF’s situation should define its top priority and implement steps to attain it. If it’s very concerned about future grantmaking capacity in real (inflation-adjusted) terms, it might decide to cut its distribution policy from 4.5% to 3.6%. But if the board wants to step up its support for current grantees and is willing to tolerate slightly more inflation risk, it could cut spending from 4.5% to 4.0%. If it takes the latter course, UCF would now be spending $500,000 a year rather than the $450,000 budgeted before the windfall.

The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Brian D. Wodar is National Director, Bernstein Nonprofit Advisory Services, and Ashley E. Velategui, CFA, is a Senior Investment Planning Analyst, both at Bernstein Global Wealth Management, a unit of AllianceBernstein.

One comment

  1. Thomas Rekdal

    These are very interesting observations, since a $10 million family portfolio that aims to operate in perpetuity faces tradeoffs that are similar to those of an endowment of about the same size.

    I am not sure why a 60/40 portfolio with a spend rate of 3.6% stands a slightly better chance (91% vs 90%) of preserving its purchasing power after thirty years than an 80/20 portfolio. That seems counter-intuitive to me. Can you explain that?

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