No matter how conservative or aggressive an endowment or foundation portfolio was positioned over the past 30 years, its returns probably exceeded the historically low inflation rate, which made maintaining distributions almost effortless. Going forward, however, fiduciaries must consider the possibility of higher inflation and lower returns, which makes meeting distribution rates nearly impossible with current plan designs. How can endowment and foundation fiduciaries plan for long-term success given short-term market disruptions? It starts with designing an appropriate strategic asset allocation policy.
Strategize for the long term
A strategic allocation policy must establish the total return necessary to satisfy withdrawals or distributions, while considering the expected life of the fund and the ability to weather a sustained drawdown. For many organizations that means maintaining the principal value of their portfolio after inflation while meeting a 3%–5% annual distribution rate into perpetuity.
Strategic allocation sets a long-range plan, but should also account for various possible market conditions, like the possibility of lower returns or higher inflation in the future. Organizations have three choices to address a change to return expectations that may impact distributions: obtain revenue from other sources, change withdrawals, or shift asset allocation.
Soliciting charitable donations
Obtaining additional revenue is not an easy task. Fundraising generally requires a dedicated team and usually takes time and effort to payoff. While we do not rule out raising more funds as a way to compensate for shortfalls, it often is very difficult to find steady revenue streams, particularly when externalities, like changes to tax laws, impact giving incentives. Unlike sourcing additional revenue, changing distribution rates and shifting asset allocation are within the control of fiduciaries, and can address gaps in return expectations.
Spend less today to spend more tomorrow
However, even when faced with a shortfall, reducing distributions for many organizations is often not possible. In fact, many non-profits would like to spend more. But withdrawing more today generally lowers the likelihood of maintaining distributions over time. That’s because the combination of inflation and higher spending will cut into the principal value each year. In contrast, by withdrawing less today, eventually more is available for the future. (Display*)
For example, in the display above, the 4% spending rate represents lower annual distributions initially, but gradually the gap between this rate and 5% annual distributions closes. At year 10, the difference is just 13%, and by year 20, it falls to only 4%. Once the crossover point is reached, the 4% policy will distribute more annually and still provide the organization with higher remaining assets.
Unfortunately, unlike endowments, which have the flexibility to change distribution rates, especially during periods of lower market returns, private foundations are required to distribute at least 5% each year. So, if the intention is to last into perpetuity, both endowments and private foundations need to consider ways to increase returns to meet these withdrawal needs.
Changing the mix
A common way to boost returns is to increase the allocation to return-seeking assets like stocks. Stocks generally perform well over the long term and offer a better hedge against rising inflation, but they can be quite volatile over shorter time periods. Conversely, high-quality intermediate bonds, which are normally used to offset equity volatility, have returns which are historically lower than stocks.
Another option is diversifying strategies, which tend to have a low correlation to both stocks and bonds. These strategies, often referred to as alternatives, include securities related to “real” or nonfinancial assets, such as real estate and commodities, as well as hedge funds, private equity, and private credit.
Many organizations shy away from using alternatives because they can add a layer of complexity, and fees tend to be higher than for traditional investments. It also means accepting more illiquidity. But the benefits can be substantial: Illiquid strategies often provide strong returns, dampen volatility, and provide a source of returns that has a low correlation to the other liquid portions of the portfolio.
Navigating periods of uncertainty
Even the most well-designed strategic policy faces challenges, particularly during periods of heightened volatility and uncertainty in the markets. At those times, tactical maneuvering makes sense. How should an organization balance the structure of a strategic allocation with the flexibility to make tactical changes?
A well-worded Investment Policy Statement (IPS) can address tactical changes. It should be flexible enough to grant an investment manager the freedom to move around target allocations without seeking approval. These shifts should be geared toward managing short-term portfolio risks and mitigating the effect of extreme outcomes.
The big picture
With the short-term trials present in any investment environment, it’s easy to lose sight of the importance of establishing and revisiting your long-term strategic asset allocation. In the short term, optimizing for risk and return through tactical allocation can add value, but setting a proper, long-term strategic allocation that considers a mix of asset classes and management approaches will provide the backbone to sustain an organization and meet its distribution goals over the long haul.
Today, that may mean moving beyond a traditional stock and bond portfolio, to one that uses diversifying, illiquid assets to enhance returns while continuing to effectively manage risks. It also means a focus on measuring outcomes, with the ultimate goal of achieving your mission.
*Notes to Bernstein Wealth Forecasting System
For more on timely topics for nonprofits, explore “Inspired Investing”, a new Bernstein podcast series that covers investing, spending, policy and more for Endowments & Foundations, and for additional thought leadership, check out the related blogs here.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.