Endowment spending
Make your plan work for you

Endowment funds are used to supplement funding currently available to not-for-profits. They can also be used to supplement future annual budgets. The success your organization has with its endowment efforts will be affected by investment performance, inflation, future endowment gifts, operational changes and your endowment spending policy.

You most likely have only limited control over most of those factors. But you can control your endowment spending policy. It’s just a matter of balance.

Endowment restrictions

A spending policy defines how much of your endowment fund’s income can be spent on operations each year. It doesn’t explore how that money should be spent within operations, such as whether payments should go toward existing debt or toward a particular program or initiative. 

This discussion of spending policies assumes the funds in your endowment are self-generated — that is, received without donor restriction on the use of the income, or the agreement with the donor was silent as to how investment income is defined and determined. (Endowments made up of funds donated by outside contributors may contain restrictions as to how the income on those funds can be used, how income is determined, and how it can be spent. Therefore, your spending policies with respect to those funds must defer to those imposed by the contributor.)

The Uniform Management of Institutional Funds Act allows your nonprofit to include appreciation of the invested funds as part of what is “spendable” in addition to realized gains, interest and dividends. So, you can define your spending policy in terms of a percentage of the total endowment assets invested.

Percentage of investments

Most organizations define their spending policy as a percentage of a rolling average of the endowment investments, generally averaged over three to five years. This helps even out the ups and downs of better vs. poorer investment returns, preventing the endowment’s contribution to any one budget year from being significantly lower than contributions to other years. The percentage used for this purpose has generally been between 4% and 7% — in many cases much lower than during the halcyon investment years of the 1990s. 

While that approach may help smooth cash flow currently available to operations, it doesn’t address whether the endowment fund will be able to maintain a similar level of funding for future operations. Also, because investment returns don’t necessarily correspond to rates of inflation that affect your organization’s operating budget, your spending policy shouldn’t be based only on recent returns.

Investment return and inflation don’t correspond in general, and they correspond even less when inflation rates for specific sectors that nonprofits often operate in must be taken into account. For example, inflation rates for health care and higher education have outpaced inflation indicated by changes in the Consumer Price Index (CPI) in recent years. 

Factor in inflation

With that in mind, you may wish to take another approach when developing your spending policy: Start with a relatively conservative, inflation-free investment rate of return and then adjust it for inflation to arrive at a spending rate you can apply on a year-by-year basis.

For example, if you determine that an inflation-free rate of return should be 3%, and the inflation rate appropriate to your sector is 2.5%, your effective spending rate to apply to your asset base would be 5.5% for that year. 

One of the pitfalls that nonprofits encountered with their spending policies in the bullish 1990s was that they increased their spending rates in step with the high investment returns being experienced at the time. This type of spending policy doesn’t provide for enough accumulation of investment income in the endowment to offset the effect of leaner investment years. It also has a compounding effect when actual investment returns are significantly higher than the norm. The asset base increases based on actual returns, so the actual dollar amount available to be withdrawn from endowment increases, even though the spending rate as a percentage may not have.

Because of this, it’s important to keep a spending rate policy that isn’t directly linked to fluctuating investment rates of return. In other words, don’t allow your withdrawals from endowment to go up just because investment growth on those funds has spiked up.

Developing a spending policy that’s dynamic enough to take these effects into account and that won’t cause you to pull funds out of an endowment beyond what is budgeted and needed for operations will allow your asset base to grow and, therefore, increase the fund’s chances of maintaining or growing real spending power for future budget years, when investment returns may drop. 

Develop a sound policy

Expectations for investment returns and related investment allocations are factors that interrelate and influence the determination of a spending policy, along with expectations for future gifts to be made to the endowment. Make sure your spending policy doesn’t react too directly to current investment returns. •