You may have heard that your nonprofit would benefit from having a clear ‘spending policy.’ But exactly what is it, and why do you need one for your organization’s endowment?
To start, an effectively designed spending policy links a nonprofit’s endowment with the mission and long-range strategic plan of the organization. How you spend your endowment funds is obviously driven by your organization’s program-related and capital needs (equipment, facilities, etc.). That’s one aspect of your spending policy. On the other hand, your nonprofit also depends on an appropriate, sustainable withdrawal rate from your endowment. Both of these spending factors are also closely linked to your overall endowment investment policy: How much risk can your organization afford to take with its invested funds and still be on track to meet its accumulation and withdrawal targets?
Donors play into your spending policy as well. As you know, donors tend to make gifts to an endowment, during life or as a legacy, with the intent that they will provide long-term support for your organization. In other words, donors don’t expect their money to be used up too quickly, nor to languish underutilized while the mission of the organization could benefit from the funds. This means that when you’re considering how to invest and spend your endowment assets, it’s important for your board to give serious consideration to individual and collective donor intent.
It’s always wise to have a well-documented approach as to how your endowment funds are to be disbursed. This helps set guidelines for future staff and trustees. It also provides donors with the comfort of understanding exactly how their gifts will be used. However, there is no one-size-fits-all approach to determining spending policies for nonprofit. It can be as unique as the organization itself.
For one, your spending goals are determined by the strategic goals and time horizons of your organization. And those two things can change over time. For instance, your nonprofit may believe that its window to implement certain programs or meet specific goals is limited—tied to some upcoming event, or an urgent societal need. In that case, your board might decide to deploy endowment assets more aggressively than usual in support of this strategic imperative. However, our observation is that the vast majority of nonprofits consider themselves to have very long or even perpetual time horizons. As a result, their investment and spending policies will need to reflect that.
It used to be that nonprofit’s generally used an income-based spending policy. In other words, how much an organization spent depended on how much interest and dividends its investments earned that year (or over a few years) in the market. The shift away from that approach largely occurred in the 1990s and 2000s, as interest rates and dividend yields fell dramatically and caused this method of calculating distributions to lose favor. Most nonprofits now use a “total-return” perspective to guide their spending. This approach takes into consideration the long run appreciation potential of investments in addition to the current income Additionally, the introduction of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) in 2006 allows nonprofits to spend prudent amounts of their endowment principal based on this concept of total return investing.
A commonly used method among nonprofits is to calculate the annual withdrawal amount using between 4% and 5% of the portfolio’s value. Over time such a withdrawal rate on a balanced portfolio that has 60% to 70% invested in Growth assets should leave enough “return” in the endowment to preserve its long run purchasing power. The withdrawal may be determined as a percent of the year-end value, although we prefer to see nonprofits use a monthly or quarterly moving average over a three- to five-year period. The potential benefit of using an average of portfolio values is that it can help “smooth” out the volatility in market returns and its impact on your annual withdrawal. This approach also helps balance the natural tension between your organization’s two primary financial goals: Maximizing withdrawals over time to support programmatic growth, and having predictable cash flows in the budgeting process. The shorter your measuring period and the higher your allocation to bonds, we believe that it is smarter to have a lower-percentage withdrawal rate to ensure long-term sustainability.
As you know, an endowment can be one of your nonprofit’s most important capital resources. Well-designed spending policies for nonprofit help you understand how best to leverage this asset to fulfill your organization’s mission over generations. An independent financial advisor such as RegentAtlantic can be an important partner in this regard. We can help your organization assess whether the spending policy you have in place is poised to help your nonprofit meet its goals now—and well into its future.
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