Nonprofit Spending in a Low Return Environment: 4 Potential Strategies and Solutions
By: Sloan Smith, vice president, CAIA
For a majority of nonprofit organizations, establishing an adequate spending policy for their portfolios is an important decision. This policy plays a key role in designing the long-term expected rate of return of the portfolio and its strategic asset allocation. The IRS has required that private foundations spend 5% from the portfolios each year in order to keep their tax-exempt status. The 5% spending rule, along with the smoothing method of averaging the value of assets over multiple points in time, have been used as key guidelines for nonprofits and their spending policies. However, with equity valuations at historically high levels, coupled with diminishing yields from fixed income investments, many wonder if a 5% spending policy is suitable going forward. Many nonprofits are facing difficult decisions to avoid the depletion of their portfolios and long-term purchasing power.
In the last several decades nonprofit institutions had few significant challenges attaining a 5% or greater real return, which is the nominal rate of return minus inflation. Due to the relatively strong performance of the markets, a 5% real return could be achieved through a diversified portfolio comprised of stocks and bonds. However, with interest rates near multi-decade historical lows, the yield on the fixed income portion of a portfolio has contributed less and less toward a 5% real return. Therefore, it is important that nonprofit organizations review their spending policies, long-term expected return targets, and strategic allocations to determine if their current spending policy makes sense. If an institution wishes to maintain the purchasing power of the portfolio and make ongoing portfolio distributions, then four choices need to be considered:
Increase the risk in the portfolio in order to generate higher returns
By allocating more toward riskier assets, a nonprofit could potentially increase the portfolio’s long-term expected return. - This decision would likely force the portfolio to have more exposure to equities and less to fixed income. Even though adding more equities can enhance the expected return, the portfolio would experience a greater volatility, steeper drawdowns, and potentially increased year-to-year fluctuations in the dollar amounts distributed from the portfolio. While the option of increasing the portfolio’s risk/reward profile is straightforward, periods of poor returns are likely to test an organization’s patience and resolve to maintain the course of action.
Add more illiquid allocations to the portfolio
Enhancing portfolio returns while potentially reducing total portfolio risk could come from incorporating more alternative and illiquid asset classes, such as hedge funds, private equity, direct real estate, reinsurance, and illiquid credit. The total allocation to illiquid investments needs to be carefully assessed, as such commitments may have little to no ability to contribute cash flow to the portfolio’s distributions. In order to meet the 5% spending policy, cash may need to come primarily from equities and fixed income, which could make it more challenging to rebalance the portfolio’s asset allocation in a timely manner.
Reassess and potentially reduce the spending policy
This option may seem challenging at first, considering the nonprofit’s donors may have contributed with the expectation that the portfolio would make perpetual distributions at a certain percentage of the portfolio’s value. However, the portfolio’s distributions may not keep up with inflation if the distribution percentage rate is too high. Research has shown that a lower spending policy may be a strong solution going forward. For example, decreasing the annual spending from 5% to 4%, and assuming a total return of close to 6%, after 42 years the portfolio would distribute more in dollars, as compared to portfolio with a 5% spending rate. By reducing the spending rate, more assets would be left in the portfolio to grow every year, leading to a larger long-term portfolio values and eventually higher payouts.
Add more capital to the portfolio through fundraising
The significant appreciation in risk assets since the 2008-2009 bear market has provided an opportunity for nonprofits to enhance their fundraising efforts. It is a great time to improve development, marketing, and communication programs to strengthen relationships with all donors, thereby leading to increased contributions. Successful fundraising increases the ability of the portfolio to maintain the spending power of its distributions.
There is no single right approach for nonprofit organizations to address their spending dilemma. Some nonprofit entities may be willing to adopt a higher risk change certain aspects of their portfolio. However, there may be others who cannot due to the restrictive nature of their spending policies and their heavy reliance on portfolio payouts to support their organizations. In the end, lower expected returns would make it difficult for nonprofits to satisfy their spending policy, especially if it is 5% or higher. Therefore, it is important that nonprofit organizations and their investment committees review these choices and determine which solutions may be best. Prudent long-term planning can have significant and lasting benefits to organizations and the causes they support.
For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.
Chart 1: Average Annual Effective Spending Rates for Fiscal Year 2014 and 2015