Raising Your Corpus From the Dead Effective Use of Spending Policy and Investment Strategy for Notfor-Profits in Today s Challenging Markets February 2016 Risk. Reinsurance. Human Resources.
Key Points Reduced capital markets expectations threaten to erode the spending power of not-for-profits Spending policy choices influence the ability to grow the corpus, or total investments, so investors should carefully consider the appropriateness of their spending policies Return enhancement opportunities through diversification and implementation of skills-based strategies such as hedge funds, private assets, and global and unconstrained mandates provide the largest impact on expected corpus growth Peer group analyses indicate that many foundations have historically allocated less to skills-based strategies than their largest peers; that difference in today s markets will impede their ability to grow their corpus in real dollars (after spending) There are now implementation options for most investors to better access skills-based strategies to help achieve their growth objectives Introduction Endowments, foundations, and other not-for-profit entities (collectively known as NFPs ) are facing major headwinds. Most NFPs generally desire to exist into perpetuity, to grow their corpus, and to maintain spending levels after inflation. Investors as a whole have reduced their capital markets expectations over the past few years as bond yields have declined and equity valuations have increased, and Aon Hewitt agrees. Returns provided by the capital markets may not be enough to meet the goals of many private foundations with required minimum annual spending levels of 5% plus inflation expectations of around 2%. In real terms, the effect of a shortfall in returns would be an erosion of both corpus and spending. NFPs have three primary levers to use in managing their investment and spending programs: 1) spending rate (e.g., reducing the spending target from 5% to 4%); 2) spending policy development; and 3) return enhancement. Public charities a category that includes most endowments are not constrained with regulatory minimum spending requirements, enabling more flexibility in designing a spending policy with the option to reduce their spending rate to less than 5% to preserve corpus. For most of this paper, we have assumed that NFPs desire to maintain the most typical spending level of 5% and to exist into perpetuity. This paper focuses on: 1. Today s low-return environment 2. Effective spending policy development 3. Return enhancement opportunities 4. Peer group analysis 1: Today s Low-Return Environment Given low bond yields and the run-up in equity valuations since the financial crisis, expected returns for stocks and bonds have fallen significantly. As of the first quarter of 2015, Aon Hewitt Investment Consulting (AHIC) s 10-year expected return for global equities stands at 6.9% and for core bonds at 2.6%. The hypothetical allocation of 70% stocks/30% bonds provides an expected return of 5.9%, without accounting for alpha from active management. The typical NFP spends 5% of the portfolio (including
administrative expenses) and also intends to keep pace with expected inflation of around 2%. As a result, the typical NFP requires nominal returns of 7.2% just to maintain its corpus in real terms. The standard 70% stock/30% bond portfolio falls short by a whopping 1.3% per year. Using AHIC s capital market simulations, Exhibit 1 shows that the median real value of the corpus is expected to decline by 13% over the next 10 years! As the real value of the corpus declines, real spending also will decline. The results of these projections are alarming, so we examine how adjusting spending policy and investment strategy can offset the impacts of a lower-return environment. Exhibit 1: Real Value of Assets Expected to Decline Real Market Value ($Millions) $120 $110 $100 $90 $80 Real Growth of Assets (Net of Spending) 70% Stocks/30% Bonds (All Passive) 0 1 2 3 4 5 6 7 8 9 10 Years 5% Spending 3.7% Spending $100.0 $87.0 For NFPs with the flexibility to change their spending rate, the obvious solution would be to cut spending from 5% to 3.7% over the next decade to preserve the corpus in real terms. The focus of this paper is to examine potential solutions for NFPs whose goal is to exist into perpetuity, but that cannot or choose not to reduce spending below 5%. 2: Effective Spending Policy Development A successful spending policy needs to balance the desires for stable spending, support of the organization s needs and/or mission, and maintaining/growing the corpus over time (after inflation). Typical factors to consider when setting the parameters for the spending policy include: Whether the corpus is intended to exist into perpetuity Expected amount of donations to be received in the future How much spending volatility can be tolerated Asset volatility Expected investment returns Level of flexibility permitted to respond to changing conditions Regulatory requirements
The most common spending policies fit into two broad categories: market value-based and inflationbased. There are many different variations of these broad types. Elements of both approaches can be combined into a single hybrid spending policy. Some organizations, such as private foundations, are mandated to spend at least 5% of market value to maintain their tax-exempt status which, for them, effectively eliminates all but market value-based spending policy options. Entities without this restriction have more flexibility in their spending policy design. The desire to achieve stable support for the mission will move some organizations toward inflation-based policies. Organizations that have more discretion in spending decisions (e.g., higher tolerance for spending volatility) and want to grow the corpus over time should gravitate toward market value-based policies. Organizations that are somewhere in between may find hybrid policies best serve their needs, and they may also be more comfortable with a significant amount of year-to-year discretion in spending amounts. Market value-based spending methods are most commonly used, particularly by private foundations that are mandated to spend at least 5% of market value to maintain tax-exempt status. This method calculates the spending level based on a percentage of the assets. The market value-based method produces the highest spending volatility; however, most market value-based spending policies employ smoothing by averaging the past three or five years of market value, which reduces spending volatility year to year. On the positive side, the corpus is most likely to be preserved because spending can change in response to market returns. Generally, spending is reduced when markets are poor and increases when markets are good. In this method, portfolio volatility has a direct impact on spending volatility. Inflation-based spending policies use a fixed dollar amount as a starting point and grow with inflation. The greatest advantage of this method is that it produces very stable year-to-year spending levels. The major drawback is that it has the greatest risk of depleting the corpus. If markets experience large declines, spending continues to grow, placing an even greater strain on value of the corpus. Ceiling and floor parameters can be added to either type of spending policy to prevent spending from falling below or rising above certain thresholds. They can be percentages or fixed dollar amounts, and can be adjusted by an inflation factor. Ceilings and floors are additional smoothing mechanisms that help to avoid deep cuts when market values fall, but also restrain spending when market conditions are good. Hybrid spending policies can be customized by combining elements of both market value-based and inflation-based methodologies. Hybrid methods are more often used by large endowments because they have more flexibility in spending policy requirements than private foundations do. For example, a spending policy may be based 50% on the prior year s spending amount (adjusted for inflation) and 50% on some prior years average market value. The net effect is lower year-over-year spending volatility than a purely market value-based policy and lower depletion risk than a purely inflation-based policy. Income-based spending policies include those that are based on the distribution of income and dividends received while retaining the principal. We usually do not recommend these for two reasons. First, most asset mixes tend to produce less than adequate levels of income for spending needs, especially in the current low-rate environment. Second, there may be temptation to allocate toward higher-yielding assets that are not as optimal from a total return standpoint, which can dampen long-term growth potential.
Exhibit 2 provides a decision tree that steers organizations toward the appropriate type of spending policy. Exhibit 2: Spending Policy Decision Tree Public Private Spending discretion low Spending discretion high Corpus preservation not important Corpus preservation important Corpus preservation not important Corpus preservation important Inflationbased Hybrid Hybrid Market valuebased
Exhibit 3: Implications of Various Spending Policies Inflationbased Depletion Risk Hybrid Market valuebased Spending Volatility In Exhibit 4, using our capital market stochastic simulations, we model the impacts that different types of spending parameters have on corpus growth and cumulative real spending in the median case and pessimistic scenario (5th percentile) for the standard 70% stock/30% bond (all-passive) portfolio, starting with $100 million of corpus value. Also, we introduce the concept of economic value, defined as cumulative real spending plus the remaining real corpus value at the end of the time horizon. Given similar initial year spending levels of approximately 5% of assets, we found inflation-based spending policies tend to produce larger corpus declines than standard market value-based approaches. In our example, inflation-based spending caused a median decline of 15.4% in the real value of the corpus over the next 10 years versus a 13.0% loss for a market value-based approach with smoothing. Adding a floor to a market value-based spending policy has the potential to produce the largest corpus losses. In our example, adding a 5% floor (that is, over the next 10 years, spending cannot fall more than 5% in real terms from the initial year spending) produced the largest median real corpus decline of 15.7%. A floor would exacerbate the corpus depletion in a market downturn. Adding a ceiling to a market value-based spending policy has the potential to produce the smallest median corpus losses. In our example, adding a 5% ceiling (over the next 10 years, spending cannot increase by more than 5% in real terms) produced the smallest median real corpus loss of 11.8%. The lower the ceiling is set, the smaller the decline of the corpus. Combining 5% floors and ceilings will yield results somewhere in between. When we examine the effect of pessimistic capital market scenarios for various spending parameters similar to the median case, we find that the inflation-based approach produces the largest declines in the corpus, while market value-based methods with a ceiling produce the smallest decreases. The outcomes of ending real corpus between inflation-based and market value-based become more pronounced in pessimistic scenarios. This raises a question regarding intergenerational equity issues: Should spending continue uninterrupted today at the expense of future beneficiaries?
Exhibit 4: Economic Value at End of 10 Years (70% Stocks/30% Bonds) Market Value-Based (3-Year Smoothing) With 5% Ceiling With 5% Floor With 5% Ceiling + Floor Inflation-Based Real Dollars ($ Millions) $150.0 $100.0 $50.0 $0.0 $133.4 $46.4 $87.0 50th $75.5 $35.0 $40.5 5th $133.2 $45.0 $88.2 50th $75.5 $35.0 $40.5 5th $132.6 $48.3 $84.3 50th $75.2 $45.6 $29.6 5th $132.5 $47.2 $85.3 50th $75.2 $45.6 $29.6 5th $132.1 $47.5 $84.6 50th $75.2 $47.5 $27.7 5th Real Corpus Cumulative Real Spending In Exhibit 5, we show the impact of lower spending levels (4% instead of 5%) for the most common market value-based spending policy. Lower spending levels increase economic value by preserving the corpus, which creates the potential of greater spending capacity in the future. Exhibit 5: Economic Value at End of 10 Years (70% Stocks/30% Bonds) $150 Market Value-Based (3-Year Smoothing) $135.2 $133.4 $120 $90 $38.5 $46.4 $60 $30 $0 $96.7 $87.0 4% Spending Rate 5% Spending Rate Real Corpus Cumulative Real Spending 3: Return Enhancement Opportunities In addition to the choice of spending policy, improving investment returns increases the likelihood that the organization will achieve its long-term objectives. We believe there are two primary methods of return enhancement: 1. Diversifying assets 2. Skills-based investing There are two major sources of investment returns beta and alpha. Simply having passive exposure to asset classes through index funds is referred to as beta exposure. We can diversify our sources of beta
to generate higher returns without increasing risk. Alpha is generated by exceeding benchmark returns through active management that relies on skilled managers. Diversifying assets. To diversify our sources of beta, we look to add assets that have relatively low correlations to equities and provide relatively high expected returns versus low-risk investment-grade bonds and cash. These assets may include high-yield bonds, bank loans, emerging market debt, commodities, and real estate. Diversifying assets expands the risk budget by allowing for higher returns with the same level of risk. In other words, smaller allocations to low-risk/return bonds are necessary to keep portfolio volatility constant. Based on our capital markets modeling, by adding 21% diversifying assets exposure to our standard 70% global equity/30% core fixed income all-passive portfolio, we can increase annualized expected return by approximately 0.3% to 6.2% over the next 10 years without increasing volatility (Exhibit 7). However, the increased return will still fall well short of the 7.2% needed to maintain the corpus after 5% annual spending and inflation (Exhibit 8). Skills-based. Finding active managers that can deliver alpha net of fees is no easy endeavor. We have found that selecting managers with high levels of conviction (as expressed through holding more concentrated portfolios and/or taking larger active bets) are more likely to provide alpha net of fees. 1,2 Closet indexing strategies tend to underperform, while high-conviction managers with high active risk are more likely to outperform (Exhibit 6). Exhibit 6: High-Conviction Strategies Generate Alpha Average Annualized Alpha 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.3% -0.3% -0.5% 1 (Lowest) Past performance is no guarantee of future results. 1 Sebastian, Mike. Go Big or Go Home: The Case for an Evolution in Risk Taking. The Journal of Investing. Summer 2014, Vol 23, No. 2. 2 Sebastian, Mike and Sudhakar Attaluri. Conviction in Equity Investing. The Journal of Portfolio Management. Summer 2014, Vol. 40, No 4. Alpha by Level of Active Risk (Manager s Chosen Benchmark) Closet Indexing Strategies 2 3-0.1% -0.1% 4 5 0.2% 6 Deciles of Active Risk 0.0% 7 0.7% 0.8% 8 High-Conviction Strategies 9 1.0% 10 (Highest)
We have found that global or unconstrained mandates, hedge funds, and private assets provide the best opportunity for skillful managers to add value because there are fewer restrictions, broader opportunity sets, and greater financial incentives to outperform. In addition to alpha potential, private assets provide an illiquidity premium for long-term investors. Further, finance research has demonstrated that opportunistically rotating among asset classes may be another reasonable approach to try to improve portfolio returns. 3 For organizations that have greater flexibility, access to skilled managers, more patience through their governance structure, and a willingness to accept more illiquidity, complexity, and potentially longer periods of underperformance, skills-based strategies provide a good way to increase returns and lower risks, over the long-term. As an illustrative example of the potential impact of skills-based strategies, we modeled the impact of shifting half of the public equities to skillful active managers and the other half to a combination of private assets, hedge funds, and diversifying assets, as shown in Exhibit 7. Based on our capital markets modeling, we found that this change increases expected annual returns to the 7.2% needed to maintain real corpus after spending (Exhibit 8) and actually reduces total portfolio volatility. Exhibit 7: Improving Portfolio s Risk/Reward Characteristics 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 30% 70% 70/30 Passive (5.9% Return, 13.1% Volatility) 21% 15% 64% Add Diversifying (6.2% Return, 13.1% Volatility) 12.5% 25% 12.5% 15% 35% Add Skill-Based (7.2% Return, 10.9% Volatility) Public Equities Core Bonds Diversifying Assets Private Assets Hedge Funds 3 Friedman, Eric. Asset Allocation in a Changing Market Environment: Varying Asset Allocation with Risk Premiums. Aon Hewitt, 2015.
Exhibit 8: Expected Real Corpus Growth After Return Enhancements Real Market Value ($Millions) $102 $100 $98 $96 $94 $92 $90 $88 $86 $100.0 $90.3 $87.0 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 70/30 Passive Add Diversifying Add Skills-Based Projected performance is no guarantee of future results, and is for illustrative purposes only based on Aon Hewitt Investment Consulting, Inc. calculations as of the date this analysis was first published. 4: Peer Group Analysis We were curious to see how NFPs were positioned with respect to spending policy and asset allocation. Based on the 2014 NACUBO Commonfund Study of Endowments, Exhibit 9 examines the spending policy and asset allocation practices of 832 peer group institutions. Exhibit 9: Prevalence of Spending Policy Types (multiple responses allowed) 100% 80% 79% 60% 40% 20% 16% 8% 5% 4% 3% 1% 0% Market Value- Based (w/smoothing) Decided Each Year (No Formal Policy) Hybrid Ceilings and Floors Market Value- Based (No Smoothing) Income-Based Inflation-Based
In Exhibit 10, we examined asset allocation practices for large endowments (more than $1 billion in assets) and compared them to smaller ones ($101 $500 million). We also estimated the expected return and volatility of each peer group based on Aon Hewitt s capital markets assumptions. We found that only the larger endowments are expected to earn more than the 7.2% required to maintain the corpus in real terms (assuming a 5% spending policy with three-year smoothing). Smaller endowments tend to lack diversification, holding too much in public equities and traditional bonds and not enough in private and diversifying assets. Some differences are due to limited opportunities to invest in private assets, stemming from asset size constraints and lack of resources for oversight. However, investment markets have changed. Many strategies that were previously difficult for smaller investors to access efficiently are now viable possibilities, such as managed account platforms for hedge funds and private equity strategies with less of the extra layer of fees found in fund-of-funds. Exhibit 10: Peer Group Asset Allocation 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 20% 17% 28% 10% 11% 31% > $1 Billion (7.4% Expected Return, 12.4% Risk) 11% 6% 18% 48% $101 $500 Million (6.9% Expected Return, 12.0% Risk) Public Equities Bonds/Cash Diversifying Assets Private Assets Hedge Funds Conclusions NFPs face challenging times, considering that many asset classes have low future expected returns. Growing the corpus after spending and inflation requires focus on both spending policy and return enhancement opportunities. Spending policy type has some influence on the ability to grow the corpus. Market value-based policies reduce the likelihood of depleting the corpus, but they come with greater spending volatility. Return enhancement opportunities potentially can provide large impacts on expected corpus growth. Moving beyond a standard 70% global equity/30% core fixed income (all-passive) allocation is required in order to increase investment returns without undue risk. Adding diversifying asset classes such as high-yield bonds, bank loans, emerging debt, commodities, and real estate provides higher return potential without increasing the risk profile. However, diversifying assets
alone are not enough to bridge the gap. Incorporating skills-based strategies can further improve the prospects of the portfolio. These include traditional active managers with high levels of conviction and wide latitude to add value, as well as alternative assets such as hedge funds and private equity. Many organizations have already embraced these ideas. Through peer group analysis, we found that the largest endowments are positioned for corpus growth (albeit only slight) in this low-return environment. Their smaller brethren have not embraced alternatives to the same degree. We found that smaller foundations lack sufficient skills-based strategies to be able to grow their corpus into the future. However, there are now implementation options that enable most investors to access these strategies to help achieve their objectives.
Contact Information Zoltan Karacsony Senior Consultant Aon Hewitt Investment Consulting, Inc. +1.312.381.1322 zoltan.karacsony@aonhewitt.com
About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE: AON), is an SEC-registered investment adviser, and provides investment consulting services to over 480 clients in North America with total NA retainer client assets of approximately $1.8 trillion as of 12/31/2014. More than 280 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $1 million to $310 billion. For more information, please visit aonhewitt.com/investmentconsulting. About Aon Aon plc (NYSE:AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world s best broker, best insurance intermediary, best reinsurance intermediary, best captives manager, and best employee benefits consulting firm by multiple industry sources. Visit aon.com for more information on Aon and aon.com/manchesterunited to learn about Aon s global partnership with Manchester United. Aon plc 2015. All rights reserved. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC s understanding of current laws and interpretation. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document.