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May 05, 2017 Article 3 min read
For decades, most endowments and foundations have lived by the five percent payout rule, safe in knowing that such prudent spending safeguarded their financial health.

For decades, most endowments and foundations have lived by the five percent payout rule, safe in knowing that such prudent spending safeguarded their financial health. However, with markets changing, many endowments find adhering to a government rule that demands how much of a portfolio must be spent annually to maintain tax-exempt status no longer makes sense.

The five percent payout guideline was instituted in 1981 by the IRS. While it applies only to private foundations, it was broadly adopted by most non-profit organizations as a sensible baseline for spending. Now, it is the most widely used spending percentage by institutional investors today, setting the return they must exceed annually to ensure the endowment grows.

Employing a five percent spending policy means an organization must achieve a return of five percent plus the rate of inflation to preserve the portfolio's purchasing power and support the organization in perpetuity. Over much of the past 90 years, this has not typically been an issue. A decade ago, when cash was valuable, the five percent rule made sense. Endowments could make 4 percent annually on cash and use those funds as collateral for trading, making another 4 percent from investments such as U.S. Treasuries, top-rated municipal bonds and A-list dividend stocks. That conservative formula was a low-risk strategy to generate annual returns of 8 percent with ease. However, with the return on cash near zero for years, if an endowment generates only 4 percent profit from trading, it would shrink if spending stayed at five percent.

Market conditions now make the five percent rule problematic. According to the Wilshire Trust Universe Comparison Service, on average, U.S. endowments returned -0.74 percent for the year ended June 30, after returns of 2.8 percent for the 12 months ended June 30, 2015. While this fiscal year has definitely started off much better through Feb. 28, the three-year returns will be a far cry from the double-digit gains of the recent, post-recession, past.

Many experts believe strong stock market returns have been inflated for the past seven years by low interest rates and the quantitative easing policies of global central banks. However, due to a number of factors — including current equity market valuations, current long-term interest rate levels and the likelihood that the U.S. Federal Reserve will have a more normalized interest rate policy in the future — many experts expect lower returns on stocks over the coming decade and weak returns for bonds and cash equivalents. That means the sensible move for most endowments is to budget appropriately for the realistic rate of return that can be earned on assets at this point in the market cycle.

Review needed
Investment committees should revisit spending policies, overall investment policies and their strategic asset allocations. That review will lead investment committees to opt for one of three options:

Increase risk for higher returns. Reducing allocations to safer assets (such as investment-grade bonds) and into riskier assets (stocks), can increase a portfolio's expected long-term return. More risk does not automatically yield higher returns (especially in the short term), but it increases the probability of higher returns over the long run. It also exposes a portfolio to higher volatility and larger drawdowns in bear markets.

Accept lower returns. For institutions with portfolios that have built a financial cushion above the core endowment value needed to keep the institution sustainable, investment committees might decide to stick with their existing investment policy and ride out years of lower expected returns in the hope investment gains eventually will return to historical averages. This option won't work for institutions that don't have an excess fund balance.

Cut spending. Many committees overlook this option because it comes with the negative connotation of reducing the benefit to the organization. However, research shows lower spending benefits the longevity of an organization. A comparison of cumulative spending over 50 years of two identical portfolios, one with a 4 percent spending policy and one with a five percent spending policy, shows that after 42 years, the portfolio spending less generates more cumulative income because more assets are left in the portfolio and allowed to compound.

With lower expected capital market returns likely ahead, more and more institutions might find it difficult to fulfill their existing spending policies. While some investment committees might be tempted to increase portfolio risk or attempt to ride out the coming period of lower returns, for organizations not legally obliged to spend 5 percent of their portfolio each year, spending less might be the smart decision. Organizations that can find a way to reduce their spending levels now will ultimately position themselves for a stronger future.

Originally published in Pensions and Investments >>