In the not too distant future, many endowed institutions may face a significant spending gap that could threaten their long-term ability to generate sufficient cash flow. The strong performance of capital markets over the last 10 years has allowed many non-profit organizations to employ a rate of spending that is likely to prove unsustainable over the next 10 years. According to BNY Mellon Wealth Management's latest outlook for capital markets, longer-term market returns, driven by demographic headwinds, are forecasted to be below prior decades. Thus, well-intentioned non-profits with overly optimistic spending rates may end up endangering their long-term ability to generate enough cash to cover their spending needs into the future.
While there are viable spending options, it is important to first understand how we got to this point, and why this is such a pivotal time for endowments.
Forecasts Point to Lower Returns
Every year, BNY Mellon develops capital market return assumptions for approximately 50 asset classes around the world.
The assumptions are based on a 10-year investment time horizon and are intended to guide investors in developing their long-term strategic asset allocation. The team behind the assumptions consists of more than 30 investment professionals, including investment strategists, economists, financial advisors, research specialists and portfolio managers. Back testing has shown that these assumptions have a strong correlation to the future 10-year annualized returns for U.S. equity markets outside of isolated, extreme market conditions.
Our 2019 capital market assumptions demonstrate that investors should expect lower returns relative to more recent historical results, particularly for equities.
This marks a meaningful divergence from the equity-friendly environment of the last decade, when returns were enhanced by the Federal Reserve's stimulative monetary policy. For example, in the 10 years ending June 30, 2018, the S&P 500 returned 10.2%. Endowments that build their spending policies around robust historic returns — which are unlikely to be repeated — would be on sounder footing with an approach based on the expected lower-return environment.
In this environment, we forecast that a traditional portfolio with a 60% equity/40% bond allocation will produce an annualized return of 5.2% over the next 10 years. Additionally, we expect that U.S. annualized inflation will remain around 2.2%, which is slightly above Federal Reserve targets but in line with market-implied rates and consensus estimates.
The Perils of Market-Value-Based Spending
Nearly all endowed organizations use a form of "market-value-based" spending, in which annual spending equals a fixed percentage (the "draw rate") of the market value of the organization's portfolio. Most committees recognize the inherent volatility of a cash-flow stream based on market value, and attempt to smooth that volatility by employing a rolling average (typically three- or five-year) of market value. A three- or five-year average may serve to moderate the equity market's shorter-term fluctuations, but it does not protect against the larger, historic waves experienced by stocks.1
While a market value-spending methodology is simple to understand, implement and communicate to others, it is also rather unstable and unpredictable. Fluctuations in the market can have a significant impact on spending, and there's no way of evaluating whether the rate of spending is sustainable in the long term. For endowments that locked into their draw rate when market returns were high, the forecasted lower-return environment could pose a significant problem.
According to the 2018 NACUBO Survey, the average annual effective spending rate for endowments with portfolios of $100 million or less was 4.3%.
With a forecasted 5.2% rate of return for a portfolio allocated 60% to equities and 40% to bonds, and 2.2% inflation, it's clear that a spending rate of 4.3% would result in a significant shortfall for an endowment using a market-value-based approach to spending:
A spending gap of -1.3% could be crippling for a non-profit organization; even if the impact is not felt immediately, such a shortfall could call into question the long-term viability of the portfolio. To address this issue, one option for endowments is to move beyond a market-value-based spending formula, and instead explore a spending policy that is more stable and rooted in the fundamental characteristics of the assets that make up the portfolio.
Focus on Fecundity
As described by James P. Garland in "The Fecundity of Endowments and Long-Duration Trusts," the term "fecundity" is used to denote the ability of an endowment to spend a particular amount of cash without endangering its ability to spend similar amounts, adjusted for inflation, annually in perpetuity. As a strategy, fecundity proposes that the first duty of any endowment is to safeguard its ability to be productive into the future, and that all other things should revolve around that duty. This responsibility to be "generationally neutral" is especially critical for non-profits with a perpetual time horizon.
Fecundity differs from the market-based approach in that it uses the underlying characteristics of the assets held in the portfolio to determine an appropriate spending rate: dividends for equities and real coupons or real yields for bonds. In its most straightforward form, a spending methodology based on fecundity would suggest the following equation:
130% of Equity Dividends + Real Yields from Bonds
Garland's research has shown that the spending rate this formula suggests is more stable and predictable, and better suited to maintaining the long-term viability of an endowment portfolio.2
Shifting an endowment to a fecundity-based spending policy may not be easy. For most non-profits, the spending rate that results from this cash-flow-based approach will be materially lower than what most organizations have grown accustomed to. At many organizations, difficult spending conversations regarding reduced budgets will invariably result. Furthermore, while the fecundity spending rate is logically based on the characteristics of the underlying assets, this method is not necessarily intuitive and may prove difficult to explain; certainly more difficult than the simplicity of the market-value-based approach. This is a particularly acute challenge, as the success of the fecundity approach depends primarily on a long-term consensus among the non-profit organization's staff, board and investment committee. Each must buy into the approach and be ready and willing to defend it against the continual pressure to increase spending that many endowments face.
The Importance of Discipline
Exercising such discipline and restraint in the face of current spending demands is critical to protecting the future of the endowment. Fecundity offers a means of logically responding to changes in the market in a way that serves to preserve the long-term sustainability and intergenerational equity of the endowment.
While the challenges of shifting to this model may prove daunting in the near term, they are modest compared to the difficulties that endowments could face by plunging headlong into the lower-return market environment without reconsidering their spending policy and draw rates.