Spending philosophy built on target returns and endowment base
The theory behind endowment spending formulas is relatively simple. Over the course of the twentieth century (1900-2001), stocks produced nominal total returns (dividends and appreciation) of 10.1% per annum and 12.5% from 1950 through 2001. Over the 1900-2001 period high-quality corporate bonds returned 5.4% annually, about 2.4% above inflation (3%). Many observers believe that equity returns over the next decade are likely to be below the long-term average because even after the bear market of 2000-2002, equity valuations remain historically high and dividend yields are much lower than in the past.
If we assume an asset mix of 75-80 percent equities and the remainder in fixed income securities, one might expect an annual nominal return in the decade ahead of 7.5 to 8%. If one further assumes that inflation averages 3 percent per year, a nonprofit could spend 4.5 to 5.0% of the market value of its endowment each year and theoretically maintain the purchasing power of the endowment, with any new endowment gifts enabling the expansion or enhancement of the institution’s mission.
With a target spending rate set at 4.5 to 5.0%, the second part of an endowment spending formula is the spending rule that sets forth the appropriate endowment base to which the target rate will be applied. It is this spending rule that particularly seeks to address the second objective listed above – to smooth out the inherent volatility in market values. The returns in the stock and bond markets have been highly variable on a yearly basis over time. Since 1926, on a price basis only (excluding income) the best year for the S&P 500 has been a return of 46.6%; the worst year was a return of negative 47.1%. From 1926-2001, there have been 10 years when the S&P price return exceeded 30%; over the same period there have been 17 years when the S&P declined 10% or more. To apply the spending rate to a single endowment market value (for example the 12/31 value prior to the start of a new fiscal year) would produce highly volatile spending amounts from year to year and fail to meet the objective of goal two set forth above.
As a result of this historic volatility, most endowed institutions have included many endowment market values (for example, a quarterly average of the three years prior to the start of a given fiscal year) in their formulas. Other institutions have increased their spending from the prior year’s figure by a fixed percentage each year, with the proviso that the actual spending in any year must not be less than nor exceed a specified percentage range of the endowment’s market value at the end of the prior fiscal year (for example, it must remain between 3.5 and 5.5%). Both of these approaches have their problems. Even a formula with multiple endowment values can produce volatile year-to-year spending; a constant growth formula results in periodic readjustments, when the spending percentage reaches the upper or lower limits of the band, pushing the actual spending up or down, often by large amounts.
“Yale Rule” devised two decades ago
Over two decades ago four members of the economics department at Yale1 helped devise a formula (“the Yale Rule”) that took the best parts of these two approaches to come up with a better smoothing formula. Under the Yale formula, the allowable spending in any fiscal year is equal to:
- Seventy percent of the allowable spending in the prior fiscal year, increased by the rate of inflation, as measured by the Consumer Price Index, for the 12 months prior to the start of the fiscal year; and
- Thirty percent of the long-term spending rate of 4.5 percent (a total of 1.35 percent) applied to the four-quarter market average of the endowments, for the period ending December 31 prior to the start of the fiscal year (almost all universities and colleges have a June 30 fiscal year).
The Yale formula has several good features. By giving a 70 percent weight to current spending, increased by inflation, it greatly decreases volatility of spending and almost always produces an increase each year. On the other hand, by giving a 30 percent weight to the current market value, the benefits of recent gifts and good performance are reflected in the total spending number. Because spending in a given year is partially determined by the endowment’s market value for that year, and one year’s spending is the largest (70 percent) determinant of the succeeding year’s spending, spending is actually a function of endowment levels going back several years in decreasing amounts. For example, whereas the spending level is affected 30 percent by the current endowment value, it is affected 21 percent by the prior year’s endowment value (70 percent x 30 percent) and 14.7 percent by the second prior year’s value (70 percent x 70 percent x 30 percent).
Elements of Yale formula balance each other
It is a generally accepted observation that in periods of high inflation (the 1970s), equities have not done well, whereas in periods of more modest inflation (since the mid-1980s) equities have done exceedingly well. (In a period of deflation, real returns from high-quality bonds would increase, but the return on stocks and lower –quality bonds would be hurt due to declining earnings and weakened balance sheets.) Thus, the two elements of the Yale formula, inflation and market value, counteract each other. The formula incorporates this reality into its structure in that in the short run, spending reflects inflation, but over time the formula increasingly weighs the reality of endowment performance. To provide some sense of the interaction of inflation and market value, the following is a table that shows the projected change in endowment spending as inflation and market performance vary:
Projected Change in Endowment Spending
Change in Mrkt Value (b) ß Percent increase in inflation (a) à
|
|
0%
|
1% |
2% |
3% |
4% |
5% |
6% |
7% |
8% |
9% |
|
20% |
6.0 |
6.7 |
7.4 |
8.1 |
|
9.5 |
|
10.9 |
11.6 |
12.3 |
|
15% |
4.5 |
5.2 |
5.9 |
6.6 |
|
8.0 |
|
9.4 |
10.1 |
10.8 |
|
10% |
3.0 |
3.7 |
4.4 |
5.1 |
|
6.5 |
|
7.9 |
8.6 |
9.3 |
|
5% |
1.5 |
2.2 |
2.9 |
3.6 |
|
5.0 |
|
6.4 |
7.1 |
7.8 |
|
0% |
0.0 |
0.7 |
1.4 |
2.1 |
|
3.5 |
|
4.9 |
5.6 |
6.3 |
|
-5% |
-1.5 |
-0.8 |
-0.1 |
0.6 |
|
2.0 |
|
3.4 |
4.1 |
4.8 |
|
-10% |
-3.0 |
-2.3 |
-1.6 |
-0.9 |
|
0.5 |
|
1.9 |
2.6 |
3.3 |
|
-15% |
-4.5 |
-3.8 |
-3.1 |
-2.4 |
|
-1.0 |
|
0.4 |
1.1 |
1.8 |
a) CPI for 12 months ending 12/31 prior to fiscal year
b) Change in four-quarter average market value ending 12/31 prior to
fiscal year over same average in prior year.
To illustrate, in a year in which inflation is 3 percent and the market value change is 8 percent, the increase in spending allowed under the formula would be:
- 2.4% from gain in market value (30 percent x 8 percent)
- 2.1% from inflation (70 percent x 3 percent)
- 4.5% total increase
Begin by reviewing structure of funds
A final point needs to be made: An endowment spending formula is designed to apply to endowment and only endowment. Young nonprofits, and some not so young, with modest financial staffs fail to properly segregate endowment from operating and plant funds. Prior to the establishment and application of an endowment spending formula, the typical nonprofit organization needs to review its investable assets and ensure that such funds are properly designated into three basic categories:
- Operating funds – Those funds used for working capital to meet normal, recurring operating needs such as compensation and accounts payable. These funds should be invested in high quality liquid investments such as money market instruments or Treasury bills.
- Plant Funds – Those funds designated for new construction and major maintenance. Plant funds include funds transferred annually as an expense in the income statement in lieu of depreciation to create a major maintenance reserve to meet periodic major maintenance needs such as painting, roof replacement, major system upgrades or replacements (plumbing, HVAC, electrical, telecommunications, etc.). These funds should be invested in short to intermediate high-quality debt instruments with maturities coinciding with the expected need for the funds.
- Endowment Funds - Those funds comprising true endowment, whether restricted or unrestricted as to purpose, and quasi-endowment funds, or funds which have been designated as quasi-endowment by the trustees. Quasi-endowment funds most typically come from unrestricted gifts or bequests and unrestricted operating surpluses that have been transferred by vote of the Trustees to quasi-endowment. Endowment funds should be invested in long-term assets, with the asset allocation mix between equity and fixed income assets, and sub-categories within those asset classes, determined by an Investment Committee established by the Board of Trustees.
Summary
The Yale formula greatly decreases volatility of spending and almost always produces an increase each year, while also accounting for recent gifts and good performance in the financial markets. In addition, the two elements of the Yale formula, inflation and market value, counteract each other. In the short run, spending reflects inflation, but over time the formula increasingly weighs the reality of endowment performance. No method of determining spending will guarantee that a nonprofit institution will reach the four primary goals of an endowment. But the Yale formula has proven to be a workable approach over time and through a wide range of market and economic conditions. For investment committees and trustees seeking a reliable long-term approach – especially in the difficult market conditions of the early 2000s – the Yale formula merits serious consideration.
Yale Formula Sample Calculation for Fiscal Year 7/1/03 - 6/30/04
Assumptions:
Institution has an approximately $100 million endowment in the year ending 6/30/03, spending was 4.5% or $4.5 million CPI increased in the 12 months to 12/31/02 by 2.1%. The average of endowment market values for the four quarters ended 12/31/02 (3/31; 6/30; 9/30; 12/31) is $103,750,000, reflecting performance over the period and additions (gifts, bequests, etc.) to endowment.
Based on the formula, the calculation of the amount to be spent in fiscal year 2004 is as follows:
70% of $4.5 million (FY 2003 spending) equals $3,150,000 -
increased by 2.1% equals $3,216,150.
Four-quarter average endowment market value ending 12/31/02 is $103,750,000.
30% times $103,750,000 times 4.5% spending rate equals $1,400,625.
FY 2004 allowed spending is $3,216,150 plus $1,400,625 or $4,616,775, a 2.6% increase.