In Part I of our series on endowment spending policies, you learned guidelines for how to set a good policy – questions to ask yourself concerning your donors, your other sources of revenue, your mission, and legal considerations. In Part II, you’ll gain a better understanding of different spending rules.
A spending rule is a formula for calculating the amount that can be spent from your endowment year-to-year. After thinking carefully about your spending goals, a spending rule is how you implement a spending policy. There are different spending rules that will act differently, depending on the market environment and inflation and might be suitable for organizations with different goals and expectations.
The “Simple Market Value” Rule
Annual Spending = Spending Rate * Market Value
Spending is a prespecified percentage of the previous year-end market value. The market value can be designated as any single point in time (e.g., a percent of the market value on 12/31/23 will be the spending amount for the 2024 calendar year).
In years when assets perform poorly, annual spending will be lower, and in years when assets perform well, annual spending will increase. By taking a percentage of market value at just a single point in time, this approach can lead to wider fluctuations in annual spending (relative to the average market value rule, for instance). But this also means that in years where the portfolio’s value falls, more assets will be left invested, enabling a faster recovery.
The “Average Market Value” Rule
Annual Spending = Spending Rate * (Yr1 MV + Yr2 MV + Yr 3 MV…Yr n MV/n Years)
Spending is set at a certain percentage of a moving average market value. For example, this rule may be specified as spending 5% of the moving three-year average of year-end asset values. Such an approach attempts to smooth spending from year-to-year relative to what the simple market value approach might deliver. Organizations should note that in poor performing years, this approach will generally lead to more spending than the simple market value rule, leaving fewer assets invested in the portfolio.
The “Inflation Adjusted” Rule
Annual Spending = Starting Spending Amount * (1+Inflation)
This rule takes current levels of inflation into account by spending an initial percentage of the portfolio’s market value and then adjusting that amount for inflation over time. In this way, spending is maintained on a real basis. For example, an endowment may decide to initially spend 5% of assets, then each subsequent year spending is indexed by an appropriate inflation factor.
A variation is that real spending (after inflation) should increase by 2% per year. Obviously, this will cause spending, in absolute terms, to be higher in years when inflation is higher, and vice versa. Downward adjustments to spending will be limited unless there is deflation (i.e., negative inflation). Withdrawals will also not directly have any relationship to the portfolio’s value once an initial withdrawal amount is set.
The “Hybrid” Rule (a.k.a, the Yale Rule)
Annual Spending = (Weight 1 * Average MV Rule) + (Weight 2 * Inflation Adjusted Rule)
This final rule combines elements of all the other methods. Spending for a given year is generally composed of two parts: 1) a moving market value component, and 2) an inflation-adjusted component. The organization will choose a weighting to apply to each part. As an example, a hybrid spending rule may state the amount to spend in a given year is 30% of the three-year moving market value average times 5% plus 70% of last year’s spending indexed by inflation.
In addition to their primary rule, organizations can apply a maximum and minimum rate as a percent of the current market value. For example, spending 5% of the moving three-year market value of assets but not less than 3% of current market value and not more than 7% of current market value. This technique borrows from the pension world and helps to preclude over- or under-spending in the event of significant market volatility.
Some organizations will take a percent of market value not of the most recent prior year or average over several years, but of a single point in time two years earlier. This technique is suitable if your organization begins budgeting for the next fiscal year before the current fiscal year is over since the value from two years prior is known before the budgeting process begins.
The simple market value and average market value rules call for a “spending rate” which is a percent applied to determine the magnitude of spending. The average effective spending rate in the 2022 NACUBO-TIAA Study of Endowments across all institutions in the study was 4.2%, but every organization must take their own situation into account, considering their long-term goals, inflation, investment results, and risk tolerance. Simply put, the higher the spending rate the larger the support your endowment can provide and the lower the assets left invested.
The information in this paper is not intended as legal or tax advice. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation.