EVALUATING AND EXECUTING CHANGES TO SPENDING POLICY

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1 NACUBO: 2015 ENDOWMENT A N D DEBT MANAGEMENT FORU M 2014 FEG INVESTMENT FORUM GAME ON: Producing Results in an Unpredictable World EVALUATING AND EXECUTING CHANGES TO SPENDING POLICY Nolan M. Bean, CFA, CAIA Fund Evaluation Group, LLC Managing Principal Rip Mecherle, CFA University of Tennessee Executive Director of Investments

2 AGENDA I. Impact of Spending Policy II. Selecting the Right Spending Policy Methodology III. Case Study: University of Tennessee IV. Considerations for a Low Return Environment V. Conclusion 2

3 Impact of Spending Policy 3

4 SPENDING POLICY CONSIDERATIONS ENTERPRISE MANAGEMENT Spending Policy Governance/ Structure Endowment Support of Budgets (i.e., Univ., Fdn.) Foundation & Development Support Endowment Management 4

5 SPENDING IS ONLY PART OF THE EQUATION Long Term Return > Target Spending Rate + Administrative Costs + Inflation 4.5% + 1.0% + 2.5% = 8.0% Spending Fees Inflation Primary Objective CONSIDERATIONS: Spending needs should not unduly influence asset allocation decisions Higher spending needs could lead to overly aggressive asset allocation Lower spending needs could lead to overly conservative asset allocation 5

6 SPENDING AND ASSET ALLOCATION POLICY SHOULD ALIGN RETURNS VS. OBJECTIVE 60/40 Equity/Bond Portfolio, 10 Year Rolling Return Return 18% 16% 14% 12% 10% 8% 6% 4% 2% Rolling 10 year Return 8% Return Objective 60/40 achieved an 8% return ~50% of the time 0% Data Sources: Ibbotson Associates and Barclays Capital; Data as of 12/31/

7 Selecting the Right Spending Policy Methodology 7

8 SPENDING POLICY METHODOLOGIES MOVING AVERAGE Spend a fixed percentage of the average market value over a set time period CONSTANT GROWTH Increase spending each year by a constant growth rate or inflation CONSTANT GROWTH W/BANDS Spending is contained within a range +/ a percentage of previous year s market value GEOMETRIC Weight given to inflation adjusted spending and target spending of market value HYBRID Custom combination of spending rules to meet the specific needs of an institution 8

9 SPENDING POLICY METHODOLOGIES MOVING AVERAGE 5% spending rate using a 3 year moving average 5% x (1/3) [ Ending market value t 1 + Ending market value t 2 + Ending market value t 3 ] = Spending t ADVANTAGES DISADVANTAGES Smooths spending more than if ending market value used x All market values all given same level of significance Simple to implement and explain x Spending is highly correlated to market value fluctuations t: time. 9

10 SPENDING METHODOLOGY COMPARISON YoY CHANGE IN SPEND ($) , Standard Deviations AVERAGE SPEND (%) Yr. 5 Yr. 7 Yr. MA MA MA Data Source: Lipper; Data as of 12/31/2013. YoY: Year over Year; MA: Moving Average Yr. 5 Yr. 7 Yr. MA MA MA

11 SPENDING POLICY METHODOLOGIES CONSTANT GROWTH Spending t 1 x (1 + Consumer Price Index YoY % change ) = Spending t ADVANTAGES DISADVANTAGES Smooths spending x Judgment in setting annual increase Higher probability spending increases over previous year x Does not consider endowment market value t: time; YoY: Year over Year. 11

12 SPENDING POLICY METHODOLOGIES CONSTANT GROWTH WITH BANDS Spending t 1 x (1 + Consumer Price Index YoY % change ) = Spending t If spending is < floor, spending = floor If spending is > cap, spending = cap ADVANTAGES DISADVANTAGES Increases endowment value during strong markets x Moderated spending amount during strong markets More predictable spending x Spending higher during prolonged bear markets t: time; YoY: Year over Year. 12

13 SPENDING POLICY METHODOLOGIES CONSTANT GROWTH WITH BANDS Hypothetical 3 Year Scenario Beginning Market Value Y0=$100m, Y1=$125m, Y2=$150m Spending Y0=5% Inflation Y2=2.0%, Y3=3.5% 4 7% Band Steps: 1. Calculate the Bands 2. Calculate the $ Spending 3. Verify Spending Falls within Band For illustrative purposes only. 13

14 SPENDING POLICY METHODOLOGIES 1. Calculate the Bands Floor = Market Value x 4% Cap = Market Value x 7% BEG. MV FLOOR (4%) CAP (7%) Year 0 $100m $100m x 4% = $4.0m $100m x 7% = $7.0m Year 1 $125m $125m x 4% = $5.0m $125m x 7% = $8.8m Year 2 $150m $150m x 4% = $6.0m $150m x 7% = $10.5m For illustrative purposes only. 14

15 SPENDING POLICY METHODOLOGIES 2. Calculate the $ Spending Spending t = Spending t 1 x (1 + Consumer Price Index YoY % change ) BEGINNING SPENDING ($) CPI YoY % CHANGE CONSTANT GROWTH ENDING SPENDING ($) Year 0 $5.0m Year 1 $5.0m 2% =$5.0m x 1.02 $5.1m Year 2 $5.1m 3.5% =5.1m x $5.3m For illustrative purposes only. 15

16 SPENDING POLICY METHODOLOGIES 3. Verify Spending Falls within Band Floor < Spending < Cap FLOOR (4%) ENDING SPENDING CAP (7%) ADJUSTED SPENDING Year 0 $4.0m $5.0m $7.0m $5.0m Year 1 $5.0m $5.1m $8.8m $5.1m Year 2 $6.0m $5.3m $10.5m $6.0m For illustrative purposes only. 16

17 SPENDING POLICY METHODOLOGIES GEOMETRIC Smoothing rate x [Spending t 1 x (1+inflation t 1 ) ] + (1 smoothing rate) x (target spending rate x beginning market value) = Spending t ADVANTAGES DISADVANTAGES Accounts for inflation and market movements Good balance between spending and market value can customize smoothing rate x x Slightly lower endowment values Complex t: time. 17

18 SPENDING POLICY METHODOLOGIES HYBRID Yale Model 1 spending totals 80% of the previous year s spending and 20% of the targeted long term spending rate (5.25%). Spending is adjusted for inflation and constrained between 4.5% and 6.0% of the inflation adjusted market value two years prior. ADVANTAGES DISADVANTAGES Can favor either stable distributions or maintaining purchasing power x Finding and maintaining the right combination of spending rules Spending rules can be customized to fit the specific needs of the institution x Complex Yale Endowment Report: Investments Office for the Yale Corporation Investment Committee. 18

19 SPENDING METHODOLOGY COMPARISON IMPACT ON SPENDING , 70/30 Equity/Bond Portfolio Constant Growth CPI 3Yr MA Geometric Market Value $200 $180 $160 $140 $120 $191m $151m $145m $ Data Source: Lipper; Data as of 12/31/

20 SPENDING METHODOLOGY COMPARISON CUMULATIVE SPENDING $175 $170 VOLATILITY OF SPEND $165 6 $160 5 $155 4 $150 3 $145 2 $140 1 $135 Constant 3 Yr. Growth CPI MA Geometric 0 Constant 3 Yr. Growth CPI MA Geometric Data Source: Lipper; Data as of 12/31/

21 Case Study: University of Tennessee 21

22 BACKDROP Endowment assets of $815m 1 Endowment supports 2% of University Operating Budget Research 13% Other 6% Instruction/ Academic Support 46% Scholarships 35% 1 As of September, Based on UT's current allocation. Information provided by UT. 22

23 CATALYST FOR CHANGE FY 2012 university decided to fund development efforts by shifting 50 bps from spending to fees 5.0% + 0.5% + 2.5% = 8.0% Spending Fees Inflation Primary Objective 50 BPS + 50 BPS 4.5% + 1.0% + 2.5% = 8.0% Spending Fees Inflation Primary Objective Shift in spending distribution, along with post Credit Crisis market returns, created confusion amongst beneficiaries Forgot (underestimated the impact of) shift on distributions Didn t understand the look back impact of rolling average calculation 23

24 OBJECTIVES Volatility and the impact (real/perceived) focused attention on the Spending Formula Lower the year to year volatility in distributions while maintaining the target payout rate Preserve the long term purchasing power of the endowment More closely align spending policy time horizon with that of the investments, which are assessed on a 5/10 year rolling basis 24

25 PROPOSAL Move from 3 Year Moving Average (without cap and floor) to a 7 Year Moving Average with a 6% Cap and 3% Floor 1 Gradual increase of 1 additional year per year to formula until 7 years included in calculation Starting year new formula would be 2011: post Credit Crisis, after endowment had 3 year annualized returns of 11% Anchor the transition formula in a period of strong performance Maintain the average effective payout rate 2 Lower year to year volatility in distributions 1 % of Prior Calendar Year End Market Value 2 Dollars Spent Beginning Market Value 25

26 EXECUTION Congressional Budget Officer Chancellors Investment Committee Board CONSENSUS 26

27 EXECUTION ANCHORING TO 2011 Incremental Increase to 7 Year Moving Average CYE Market Value FY Spend 27

28 RESULTS SPENDING FORMULA RESULTS Spending Policy Method Ending 2013 Market Value Total $ Spent 2013 $ Spent Average % Spent Std. Dev. of Spending 4.5% 3 Year Moving Average $227.3 $200.8 $ % 6.6% 4.5% 5 Year Moving Average $233.7 $200.1 $ % 4.9% 4.5% 7 Year Moving Average $240.5 $198.9 $ % 3.5% Constant Growth (CPI) $276.9 $176.8 $ % 3.0% Hybrid $230.2 $202.8 $ % 3.8% Analysis begins in 1990 and assumes an initial value of $100. The Moving Average formulas incorporate a 3% floor and 6% cap. Hybrid policy is 70% of last year's distribution adjusted for inflation and 30% of a 3 year moving average 4.5% policy. 28

29 RESULTS HISTORICAL DISTRIBUTIONS AT 4.5% SPEND RATE $12 $11 $10 $9 $8 $7 $6 $5 $4 3Y MA 5Y MA 7Y MA $8.56 $9.32 $9.86 $10.40 $9.97 $9.93 Shaded areas represent recessions Std. Dev. in YoY Spending: % 4.9% 6.6% Data Sources: University of Tennessee and Fund Evaluation Group, LLC; Data as of 6/30/

30 RESULTS HISTORICAL SPENDING ($) AND HYPOTHETICAL FORWARD LOOKING SCENARIOS 3Y / 7Y Moving Average Spending During Growth / Recession $13 $12 $11 $10 $9 $8 3Y Growth 7Y Growth 7Y Recession 3Y Recession Historical $8.76 $11.47 $8.82 $12.78 $11.22 $9.61 $9.00 $7 $6 $5 $4 $ Data Sources: University of Tennessee and Fund Evaluation Group, LLC; Data as of 6/30/

31 Considerations for a Low Return Environment 31

32 The market s not a very accommodating machine; it won t provide high returns just because you need them. Peter L. Bernstein, Financial Historian ( ) 2014 FEG Investment Forum 32 Confidential. Not for Redistribution.

33 EXPECTED RETURNS EXPECTED RETURN VS. EXPECTED RISK Return Historical Returns of 60/40 Portfolio = 9.1% Current Expectations of 60/40 Portfolio = 4.1% Historical Current Expectations Return Objective Source: Fund Evaluation Group, LLC. Risk 33

34 LOWERING SPENDING RATE AVERAGE ANNUAL EFFECTIVE SPENDING RATE % 4.9% 4.8% 4.6% 4.4% 4.2% 4.0% 4.7% 4.7% 4.6% 4.3% 4.4% 4.5% 4.6% 4.2% 4.4% 3.8% Data Source: NACUBO Commonfund Study of Endowments

35 LOWERING SPENDING RATE: IMPACT ON GROWTH SPENDING GROWTH 4% vs. 6% Spending Rates $140 $120 $100 4% Spending Rate 6% Spending Rate $80 $60 $40 $20 $0 Data Source: Lipper; Data as of 12/31/2013. Returns represented by 70% S&P 500 Index and 30% Barclays U.S. Aggregate Index. 35

36 SPENDING POLICY CONSIDERATIONS IMPACT OF CHANGE IN SPENDING RATES Probability of Meeting Objectives 60% 50% 40% 30% 20% 10% Increased probability of achieving the portfolio s objective 0% 3.0% 4.0% 5.0% 6.0% 7.0% Spending Rate Source: FEG modeling 10 year projection, assuming a global 70/30 stock/bond split and starting market value of $250m. 36

37 SPENDING DECAY IMPACT OF CHANGE IN SPENDING RATES Starting market value of $250m Frequency Higher Spending: Greater likelihood of market value decline Projected Median Market Values: 6% Spending $227M 5% Spending $258M 4% Spending $292M Lower Spending: Higher chance of growing capital base ,023 1,121 Distribution of Projected Wealth Source: FEG modeling 10 year projection, assuming a global 70/30 stock/bond split. 37

38 Conclusion 38

39 SPENDING POLICY CONSIDERATIONS Coordinate asset allocation and spending policies to ensure the long term spending rate is consistent with the investment approach and an institution s risk tolerance, factoring in level of institutional support (% of operating budget funded) Spending policy can be designed to smooth amount distributed from year to year When selecting a methodology, no correct answer, just a best fit solution that addresses institutions varying needs to maximize spending, minimize volatility, or maximize market value Expected returns today are lower this historically consider reducing absolute spending level 39

40 NACUBO: 2015 ENDOWMENT A N D DEBT MANAGEMENT FORU M 2014 FEG INVESTMENT FORUM G A M E O N Questions? : Producing Results in an Unpredictable World v

41 DISCLOSURES This was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directed to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH Attention: Compliance Department. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities. Net Returns Returns net of fees may or may not include the reinvestment of all dividends and income. Results on pages and 19 are based on hypothetical projections and may differ from actual results. Past Performance is not indicative of future results. This report is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or those investors will not incur losses. The information on pages 33 was obtained from the 2013 NACUBO Commonfund Study of Endowments (NCSE). The study includes a survey of 835 U.S. colleges and universities. The study divided the data into six categories according to size of endowment, ranging from institutions with endowment assets under $25 million to those with assets in excess of $1 billion. Data is for the 2013 fiscal year (July 1, 2012 June 30, 2013). The National Association of College and University Business Officers ( NACUBO) is a membership organization representing more than 2,500 colleges, universities and higher education service providers across the country and around the world. Commonfund Institute houses the education and research activities of Commonfund and provides the entire community of long term investors with investment information and professional development programs. NCSE returns are presented net of fees. 41