Endowments and Foundations

Transcription

1 OCTOBER 2003 Endowments and Foundations Linking Spending Policy and Asset Allocation

2 2 In order to effectively manage an endowment or foundation, a trustee must first understand the special requirements of the fund, namely, its need for immediate income and its need to increase assets for future endeavors. Maintenance of the spending goals of an endowment or foundation can, in part, depend on the link between its spending policy and asset allocation mix. This paper will outline a simple, yet often misunderstood, formula that can assist in the management of an endowment or foundation. Let s first review the types of endowments and foundations. Endowments Schools Hospitals Churches Cemeteries Museums Societies Foundations Corporate Community Family A common goal for all types of endowments or foundations is to exceed the set spending policy by careful investment without exposing the fund to excessive risk. An endowment or foundation should be managed as a business with a logical, orderly strategic plan. Before an investment plan is executed, a written investment policy statement should be established, which prioritizes the general investment goals and objectives of the fund, with specific risk parameters. While this can provide the necessary investment blueprint for the fund, it also helps the trustee meet his or her fiduciary responsibilities. General goals usually include: Preservation of purchasing power Taking advantage of the long-term investment horizon Preserving the independence of the institution Maintaining/increasing contributions to operating budget Investment results that can offset the effects of inflation Once you have written down the investment goals and objectives of your endowment or foundation and understand portfolio volatility, you can begin to execute the following plan. The plan 1. Develop a targeted spending goal. 2. Understand the importance of asset allocation. 3. Link the targeted spending goal with the asset mix. 4. Develop a manager structure based on the asset mix.

3 3 1. Develop a targeted spending goal In setting up the fund s spending goal, a trustee must consider how the effects of inflation may factor into the overall investment results as the trustee seeks to provide at least the same level of support to future generations that the current beneficiaries enjoy while keeping pace with inflation. Keeping this in mind, an annual transfer from the endowment or foundation to the operating budget must keep pace with inflation. For example, a donor who endows a $1 million chair is not interested in providing $50,000 a year in support, but rather in paying the salary of the professor who holds the chair. Assuming 3% annual salary increases, the endowment must supply $50,000, $51,500, $53,000, etc. Trustees also have the responsibility of protecting the corpus of the endowment or foundation. This is interpreted to mean that the corpus must also keep pace with inflation. For example, assuming 3% inflation, a $10 million endowment is not being preserved unless the value increases to $10.3 million, $10.6 million, $10.9 million, etc. These examples stress the need to factor inflation into your spending policy. Therefore an endowment or foundation s available spending rate is defined as follows: Available Spending Rate = Total Return Inflation The math is not difficult to understand. Assumption: 7% Available Spending Rate = 10% Total Return 3% Inflation In this case, 3% is reinvested in the corpus, which preserves its value in real terms. Spending formulas Now we need to look at the different ways endowments spend their money. One formula is to spend the dividends and interest earned on the investment. In other words, spend all current income. This spending approach, in order to provide a potentially stable stream of income to the operating budget, favors a heavy concentration in fixed income securities, which generally yield lower returns but typically are associated with less risk than other types of investments. Another approach is to spend a percentage of the market value of the fund. A prespecified percentage of the market value is marked for spending. Based on this method, applying a trailing three- or five-year average market value may help to achieve a more consistent spending amount from year to year than by simply using the most recent ending one-year market value. For example, the ending market value for the previous year may be $10 million, and a 5% spending percentage would be $500,000. The average annual ending market value for the past five years, however, may be $8 million, and a 5% spending percentage would equal $400,000. This hypothetical example is provided for informational purposes only. It is not intended to represent any specific investment, and is not indicative of past, present, or future performance. A third approach is to spend last year s spending plus inflation, providing a very stable transfer to budget; however, this spending approach may invade the corpus during falling markets. You may be able to avoid this by setting a maximum percentage that can be transferred. Example: spend last year s spending, plus inflation, subject to a maximum transfer of 6% of market value.

4 4 2. Understand the importance of asset allocation Once the spending formula is established, you need to look closely at the possible combinations of asset classes you wish to invest in. A study by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower 1 determined that 93% of the variability of returns an investor experiences is attributed to the asset allocation decisions (or class selection). Even more specifically, William F. Sharpe, 2 in his development of asset class factor models, illustrates that within just the equity portion of the mix, manager style selection may be attributable to 90% of the portfolio s variation in return. Major Asset Classes (Gary P. Brinson Study) Security Selection 7% Equity Asset Class (William F. Sharpe Study) Security Selection 10% Class Selection 93% Style Selection 90% Keep in mind that past performance is not indicative of future results. Below is a look at historical returns for the basic asset classes. Annualized Asset Class Returns U.S. Large-Cap Stocks 10.2% Long-Term Corporate Bonds 5.9% Cash Equivalents (Treasury bills) 3.8% Inflation 3.1% 1 Determinants of Portfolio Performance," Brinson, Gary P.; Hood, L. Randolph; and Beebower, Gilbert L., Financial Analysts Journal May June Asset Allocation: Management Style and Performance Measurement: An Asset Class Model Can Help Make Order Out of Chaos, Sharpe, William F. Adapted from the O Neil Abbott Distinguished Lecture at the Darden School of the University of Virginia on October 2, Asset class returns are from Ibbotson Associates. Please refer to page 7 for asset class definitions and indexes. The indexes that make up the asset classes are presented to provide you with an understanding of their long-term historical performance, and not the performance of any specific security. Investors cannot directly purchase an index. Stocks represent ownership in a corporation, while government bonds and U.S. Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Stocks offer long-term growth potential, but may fluctuate more, and typically provide less current income than other investments.

5 5 3. Link the targeted spending goal with the asset mix Now, assuming these historical rates of return for various general asset classes, a spending policy would then be linked with the asset mix. Remember: Real Return on a Portfolio = Actual Return Inflation Assumption, based on the historical returns presented in Section 2*: Real Return on Large-Company Stocks approximately 7% (10.2% 3.1%) Real Return on Corporate Bonds equals approximately 3% (5.9% 3.1%) Below is an example of the equation for an assumed 5% targeted spending goal. 7x + 3(1 x) = 5.4% Where x = proportion invested in stocks; 1 x = proportion invested in bonds. Answer: 60% stocks/40% bonds. Applying this formula to the historical returns, the following asset mix guidelines would have been created for the respective targeted spending goals: Targeted Spending Goal Asset Mix Guidelines Stocks/Bonds 7% and above 100%/0% 6% 80%/20% 5% 60%/40% *This example is for illustrative purposes only. This does not reflect the performance of any specific investment. Since historical returns are no guarantee of future performance, there is no assurance that the target rates of return will be attained. Although this is a seemingly simple formula illustrating asset mix guidelines, many endowments or foundations do not apply a spending policy and, therefore, may either be exceeding or falling short of their targeted spending goals as well as their future growth needs. An endowment study from the National Association of Colleges and Universities Business Officers (NACUBO) done in 2000 showed that smaller endowments usually required more spending than larger endowments. Larger endowments are also able to gain more exposure to alternative asset classes such as hedge funds, private equity, and venture capital. Size of Spending by Equity Hedge Fund Endowment Endowment Exposure Exposure $25 million $50 million 5.6% $51 million $100 million 5.6% $101 million $500 million 5.1% $501 million $1 billion 4.7%

6 6 4. Develop a manager structure based on the asset mix As illustrated in the pie charts (page 4), asset allocation and manager selection decisions are key to the investment success (or failure) of the endowment or foundation. The development of a manager structure can be best achieved with the help of an investment management consultant. The consultant has the resources and knowledge to help develop an appropriate manager structure based on the specific needs of the endowment or foundation. The consulting process includes: 1. Assistance in developing guidelines for each investment manager type based on your established asset class mix. 2. Assistance in selecting the investment managers for each slot in the manager structure (style selection). 3. Assistance in monitoring the investment managers on an ongoing basis to help ensure that they are within the guidelines and for performance measurement. 4. Review and revision of items 1 3 above, as required. Summary The combined forces of inflation, complicated economic climates, and declining interest rates can prevent many endowments and foundations from meeting their investment goals. Trustees for these funds should first develop a written investment policy for the fund as well as targeted spending goals. Once the endowment spending goals and future growth needs are determined with the help of an investment management consultant, the spending (goal) policy can then be linked with an asset mix formula to help determine a guideline for allocation among the various asset classes. Finally, based on this strategic asset mix guideline, an investment manager structure can be selected and monitored on an ongoing basis. Keep in mind that independent money management may not be suitable for all investors.

7 7 Asset class descriptions Large-Cap Stocks: The large-cap stock total return index is based upon the Standard and Poor s Composite Index from January 1926 to December The S&P 500 is an unmanaged marketweighted index of 500 of the largest stocks (in terms of stock market value) in the United States, providing a broad indicator of price movement. Prior to 1957, it consisted of 90 of the largest stocks. Long-Term Corporate Bonds: Corporate bond total returns are represented by the Salomon Brothers Long-Term High-Grade Corporate Bond Index. The Index includes nearly all Aaa- and Aa-rated bonds with at least 10 years to maturity. If a bond is downgraded during a particular month, its return is included in the Index for that month before removing it from future portfolios : Total returns were calculated by summing the capital appreciation returns and the income returns. For the period , Ibbotson and Sinquefield backdated the Salomon Brothers Index, using Salomon s monthly yield data with a methodology similar to that used for Capital appreciation returns were calculated from yields assuming (at the beginning of each monthly holding period) a 20-year maturity, a bond price equal to APR, and a coupon equal to the beginning-of-period yield : Standard and Poor s monthly high-grade corporate composite yield data were used, assuming a 4% coupon and a 20-year maturity. The conventional present-value formula for bond prices was used for the beginning- and end-of-month prices. The monthly income return was assumed to be one-twelfth of the coupon. Long-Term Government Bonds: The total returns on long-term government bonds from 1977 to 2002 are constructed with data from The Wall Street Journal. Over , data is obtained from the government s file at the Center for Research in Security Prices (CRSP), Graduate School of Business, University of Chicago. Each year, a one-year bond portfolio with a term of approximately 20 years and a reasonably current coupon and whose returns did not reflect potential tax benefits, impaired negotiability, or special redemption or call privileges, was used. Where callable bonds had to be used, the term of the bond was assumed to be a simple average of the maturity and first call dates minus the current date. The bond was held for the calendar year and returns were computed. Treasury Bills: For the U.S. Treasury Bill Index, data from The Wall Street Journal are used from 1977 to 2002; the CRSP U.S. Government Bond File is the source until Each month, a one-bill portfolio containing the shortest-term bill having not less than one month to maturity is constructed. To measure holding period returns for the one-bill portfolio, the bill is priced as of the last trading day of the current month. Inflation: The Consumer Price Index for all Urban Consumers (CPI-U), not seasonally adjusted, is used to measure inflation, which is the rate of change of consumer goods prices. All of the security returns are measured from one month-end to the next month-end. CPI commodity returns are collected during the month. Thus, measured inflation rates lag the other series by about a halfmonth. Prior to January 1978, the CPI (as compared with CPI-U) was used. Both inflation measures are constructed by the U.S. Department of Labor, Bureau of Labor Statistics.

8 Information herein should not be construed as legal advice. Our financial professionals are not legal advisers. You should consult your legal adviser for counsel on these matters. Wachovia Securities LLC, member NYSE and SIPC. A MAC327W Ed. 10/03