Spending Policy: Development and Implementation

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1 January 18 Spending Policy: Development and Implementation Broadly speaking, the founding purpose of most endowment or foundation assets is to support a spending or distribution policy. Investment program success is commonly defined as an investment program s capability to support this spending or distribution policy while preserving purchasing power and allowing for the modest growth of real wealth. With that said, how a spending policy or distribution policy is developed and defined can have a significant impact on an investment program s ability to generate the returns necessary to support the above goal. Here we outline why a spending rule is important, detail several commonly used policies, and consider the implications of different policies on both the investment portfolio and distribution outcomes. Why Have a Spending Rule? One reason to have a formal spending rule is to comply with the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been adopted by many states and applies to the board of trustees or board of directors of the organization. UPMIFA was recently updated to include new language on how an organization s board should prudently consider spending institutional funds, such as endowments. 1 The new language outlines seven guidelines for organizations to use when determining annual expenditures. In our opinion, it is prudent for nonprofit organization boards to implement a formal policy to address these guidelines. It should be noted that UPMIFA generally does not apply to funds held by a financial institution as a trustee, and further, funds held in a trust may be subject to additional spending limitations based on the terms of the trust and applicable state law. Regardless of whether an organization follows the UPMIFA guidelines, our experience working with nonprofit organizations has shown us that having a firmly defined spending rule can help instill discipline into the budgeting and financial management process from an oversight perspective. As an example, consider the difference between going into the grocery store with a budget in mind and a shopping list and going into the grocery store with no predetermined budget or list. In the former case, the outcome is fairly predictable and based on a disciplined process that typically results in spending what you intended and getting the items on your list. Conversely, in the latter case, chances are you could spend more than you intended and leave with both unintended items and missing ones. Carrying the example over to a nonprofit organization, a spending rule can help define the budget (or at least the assets contribution to a budget) which, in turn, can help determine what operations, purchases, or other considerations can be added to the shopping list. This can help keep an organization from overspending in a given year, something that could potentially cause impairment to the purchasing power of the investment assets if they are used to cover the extra spending. From an investment perspective, a spending rule can assist the board of directors and investment committee in determining the investment program s required rate of return and risk tolerance objectives. For example, if the spending policy is set at 4%, and using % for long-term inflation and.% for management and overhead fees, simple math would put the required rate of return at 6.%. An investment manager could then use risk optimization to minimize risk against the return objective of 6.%, allowing the portfolio to meet its investment goal efficiently and effectively. Without the orientation of the portfolio set on a required rate of return, the portfolio (specifically, the asset allocation) could be geared to return too much or too little. In the case of too much, a portfolio created with too high of a return target 1 Prudent Management of Institutional Funds Act Summary, Management of Institutional Funds Act. Please note that the UPMIFA does not apply to corporate trustees or investment managers engaged by the organization to manage the organization s assets.

2 Table 1 Five Types of Spending Policies Policy Definition Simple Spending Rate Spending is equal to the specified spending rate multiplied by the beginning period market value. Rolling Multiperiod Average, or UPMIFA Geometric Spending Rule Inflation-linked Rule Hybrid Rule Source: PNC Spending is equal to the spending rate multiplied by an average of the market values of previous periods. This method reduces the volatility of required distributions from year to year. Spending in the current period is equal to a) the previous year s distribution adjusted for inflation times a smoothing rate (used to further reduce volatility,.7); plus b) the beginning market value of the portfolio times the spending rate and the residual of the smoothing rate (. = 1.7). Begins with a set dollar amount, typically determined by a certain percentage of trailing market value, and the fixed amount is adjusted each year by an inflation index. Part of the annual spending amount is determined by an inflation adjustment of the previous year s spending, while the balance is determined by applying a fixed rate to the portfolio s market value. would be taking significantly more risk than required to meet the goal of 6.%; in the case of too little, a portfolio created with too low of a return target would be taking less risk than is required to meet the goal of 6.%, and consequently would likely fail to meet the return requirement. In our view, the key takeaway from this is that setting a spending policy can help an organization determine an absolute benchmark to serve as a measurement of investment program success. Given its importance to budgeting, financial management, and portfolio management, we recommend that a nonprofit entity clearly define a spending rule as part of the organization s investment policy statement (IPS). We include a discussion of how to create a clearly defined spending rule as part of a nonprofit investment program in our white paper The Discipline to Succeed. Implications of Spending Policies on Portfolio and Distribution Outcomes In our experience, clients defer to five types of spending policies, as defined in Table 1. There is no way to conclude if one policy is superior to any other policy on a general basis, since each has its merits in different situations. We believe the simple spending rule, for example, is perhaps the easiest to calculate and emphasizes current spending. The inflation-linked rule, while focusing on stability of spending, can become disassociated from the market value of the portfolio as a percentage if not recalculated at regular intervals. The rolling multiperiod average, geometric spending rule, and hybrid rule, on the other hand, while more complicated to calculate, can generally help stabilize spending as a dollar amount over the long term. Charts 1 4 (page ) illustrate how the different spending rules affect the amount of spending and the market value of the portfolio year over year. For simplicity, the portfolio was tracked against the S&P from , and a base spending rate of 4.% and long-term inflation rate of % are assumed. In Chart 1, portfolio market value, it is clear the inflation-linked rule resulted in the largest ending value, while the simple spending value ended in the lowest ending value. The reason for this discrepancy is seen in Chart, where annual Assumes $1 million portfolio invested 1% in S&P at the beginning of 1989 and follows the five different spending rules. In the hypothetical example, which is meant solely to illustrate the differences in the spending values over time, the spending rate is 4.%. For the geometric rule, the annual inflation rate = %, and the smoothing rate = 7%. For the inflation-linked rule, annual inflation = %. For the hybrid rule, annual inflation = %, with market value 6% weighted and inflation 4% weighted. Indexes are unmanaged, are not available for direct investment, and are not subject to management fees, transaction costs or other types of expenses that an account may incur. Index performance results do not represent, and are not necessarily indicative of, the results that may be achieved in accounts investing in the corresponding investment strategy; actual account returns may vary significantly.

3 spending is measured in dollars. Between 1989 and 1999, when the market moved significantly upward, the simple spending rate resulted in the largest increases in annual spending. Conversely, the inflation-linked rule resulted in significantly less, albeit stable, increases in annual spending. Because less spending leaves more funds in the portfolio to compound, the rule that results in less distributions (inflation) translates to greater portfolio ending value Chart 1 Portfolio Value Millions of Dollars (over a period of generally positive returns) compared to a rule that results in greater distributions translating to a lower portfolio ending value. With regard to stability of spending, it is worth noting that the geometric-spending rule and inflation-linked rule resulted in the greatest stability of spending in dollar terms, while the hybrid rule and the simple spending rule resulted in the greatest stability of spending as a percentage of portfolio market value. Chart S&P Annual Return Percent Chart Annual Spending Millions of Dollars 1 1 Chart 4 Spending as Percentage of Beginning Portfolio Value Percent The above charts are hypothetical in nature and for illustrative purposes only. Returns in Chart present hypothetical performance of securities for the indicated period (with monthly rebalancing). Back-testing has inherent limitations: it does not reflect economic and market factors that would likely affect a manager s investment decisions; it does not account for trading that an active manager would likely undertake to modify portfolio holdings over time; and it is applied retroactively with the benefit of hindsight. Since trades have not actually been executed, hypothetical results may under or over compensate for the impact of certain economic and market factors that would affect a manager s investment decision, all of which can adversely affect trading results.

4 There are pros and cons to all five of the methods. While the simple spending rule is easy to understand, it can sometimes lead to volatile distributions. The rolling three-year average spending rule can help reduce the volatility of distributions, but it might lead to an outsized distribution in years where the market value has declined significantly. The geometric spending rule can be complicated to calculate but reduces the volatility of distributions even further and, with a smoothing rule, can reduce the impact of a significant market decline on the annual distribution. The inflation-linked rule can result in stable distributions and can help the portfolio grow in value, but it can also cause the distribution to disconnect in relevancy as a percentage of the portfolio s market value. Finally, the hybrid rule, while somewhat complicated to calculate, can lead to stable distributions in terms of dollar amounts and as a percentage of portfolio value. Conclusion We have outlined the importance of clearly defining a spending or distribution policy, discussed five commonly used rules, and examined the pros and cons of those five rules. While it is impossible to identify any one rule as a singular best practice or panacea, we advise that a board of directors consider closely the pros and cons of each rule as it relates to the organization s intention for the distribution. We recommend working with your investment advisor or outsourced chief investment officer provider to understand fully the implications of the different rules on your organization s portfolio and to confirm that, once developed, the spending policy is properly implemented as an input into the asset class allocation and portfolio construction process. For more information, please contact your PNC Institutional Advisory Solutions representative. About Us The Endowment & Foundation National Practice Group The Endowment & Foundation National Practice Group builds on PNC Bank s long-standing commitment to philanthropy and is focused on endowments, private and public foundations, and nonprofit organizations. We seek to help these organizations address their distinct investment, distribution and capital preservation challenges. For more information, please contact Henri Cancio-Fitzgerald at or henri.fitzgerald@pnc.com. 4

5 Results in this material are based on back-tested and hypothetical or simulated information and the assumptions stated herein. Such results are shown for illustrative purposes only and are not investment recommendations. Back-testing has inherent limitations: it does not reflect economic and market factors that would likely affect a manager s investment decisions; it does not account for trading that an active manager would likely undertake to modify portfolio holdings over time; and it is applied retroactively with the benefit of hindsight. Hypothetical or simulated results also have inherent limitations because they are not based on actual transactions, but are based on the historical returns of selected securities and various assumptions of past and future events, which are influenced by hind-sight. Since trades have not actually been executed, hypothetical or simulated results may under or over compensate for the impact of certain economic and market factors that would impact a manager s investment decision, all of which can adversely affect trading results. PNC MAKES NO REPRESENTATION THAT IT WILL OR IS LIKELY TO ACHIEVE RESULTS COMPARABLE TO THOSE SHOWN IN THIS MATERIAL, TO MAKE ANY PROFIT AT ALL OR TO BE ABLE TO AVOID INCURRING SUBSTANTIAL LOSSES. THERE CAN BE SIGNIFICANT DIFFERENCES BETWEEN HYPOTHETICAL AND SIMULATED RESULTS AND ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY A PARTICULAR INVESTMENT STRATEGY. The PNC Financial Services Group, Inc. ( PNC ) uses the marketing name PNC Institutional Advisory Solutions for discretionary investment management, trustee, and other related activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. PNC Institutional Advisory Solutions is a registered service mark of The PNC Financial Services Group, Inc. 18 The PNC Financial Services Group Inc. All rights reserved.