Spending Policy: Is Yours Ready for the Next Downturn?

November 7, 2017  | by Timothy T. Yates, Jr.

Governance and Policy | Investment Strategy | Operating Assets | Outsourced Investing

In most Investment Policy Statements there is often a reference to two important, but conflicting, objectives: one, to preserve the purchasing power of the long-term portfolio in real terms, and two, to provide a stable, predictable and hopefully growing source of income to the institution that the long-term portfolio supports. Why the conflict? Because in order to generate returns that will sustain real purchasing power in perpetuity, the portfolio must be exposed to risk which often means volatility and thus potential instability or unpredictability in the income stream. With a perpetual investment horizon, one could argue that the portfolio should take on as much short-term volatility as it can be compensated for. On the other hand, though, many institutions are dependent on these long-term portfolios to fund significant portions of their operating budgets so short-term volatility can have a very real impact on budgets, scholarships, grants, or other mission critical needs. So how do fiduciaries bridge this gap between accepting volatility in pursuit of long-term returns while generating stable income for their institution? One of the most effective ways is through a thoughtfully constructed spending policy.

...both spending formulas produce roughly the same level of aggregate spend yet the paths were quite different...

Given the importance of a spending policy, two things surprise us as we meet with investment committees of non-profits: first, that so little time is spent on something so important and second, how many still use what we view to be a flawed and outdated methodology. Most investment committees spend at least one meeting per year comprehensively evaluating asset allocation policy. They review historical models, analyze stress tests, consider future projections, and evaluate important trade-offs. It is not often that we see an investment committee evaluate their spending policy with the same rigor. Instead, many accept the existing policy, which more often than not is some form of a rolling average where the payout is calculated as a set percentage, often 5%, of an average market value over a set period of time, most often three years. A few years ago, we published a white paper1 that argued that the rolling average spending formula was flawed for precisely the reason that it doesn’t achieve the objective set out in so many investment policies. We argued that institutions should consider decoupling their spending calculation from the volatility of the capital markets and linking it instead to the cost structure of the institution or a growth rate, thus reducing the risk of a shortfall. There’s no question the three-year rolling average spending formula has worked brilliantly for the past ten years. Why? Because there has been very little volatility and the general direction of most portfolios has been up. But anyone who remembers the financial crisis of 2008 or the bear market of 2001-2003 knows the challenges of this formula. A comparison of two different spending policies over the past 20 years illustrates this challenge.

img_chart_spending_policy

This simple model reflects the nominal spending on a $100mm portfolio that invested 70/30 in the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond Indices. The light blue line is the dollar spend calculated using a 5% rolling three-year calculation. The blue line is the dollar spend using a weighted average formula that considers both inflation (CPI +1%) and market value. Interestingly, both spending formulas produce roughly the same level of aggregate spend yet the paths were quite different. The rolling average formula resulted in a decline in spending of more than 20% from 2000 and 2004 and took 13 years to reclaim the high water mark of 2000. The weighted average spend calculation didn’t reach the same heights yet also didn’t experience the same decline. Or more simply stated, it resulted in a more consistent (i.e., less volatile) payout than the rolling average formula.

We are not advocating the weighted average spending formula as the “perfect” formula for all institutions; there are several different formulas and countless variations of those formulas. Like asset allocation, it is a decision that should be considered in the context of institutional objectives, constraints, and risk profile. Like asset allocation, it is also something that should be evaluated on a regular basis. When under consideration, the spending rate (how much you draw) impacts current spending ability on the one hand and long-term sustainability of the investment portfolio on the other hand. The spending methodology (how you calculate that draw) impacts the variability or volatility of the spending stream. These decisions have important ramifications for your institution which are undoubtedly easier to wrestle with at the end of a long economic expansion than they are at the beginning of the next recession or market correction.

1 Commonfund Institute, Endowment Spending: A Look Back, September 2012.

Authors

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Timothy T. Yates, Jr. is a Managing Director and responsible for custom solutions for clients across public and private markets. In this role, he leads a team of investment professionals that advise, implement and monitor custom investment solutions. He is also a senior member of the firm’s private emerging markets portfolio leadership team with a particular focus on Latin America. Tim joined Commonfund as an associate in the Commonfund Capital Associate Program. He later joined the Strategic Solutions Group, Commonfund’s OCIO platform, where he was responsible for the design, tailoring and implementation of total portfolio solutions. Before joining Commonfund, Tim was an instructor of Spanish and Italian at Fordham Preparatory School. He holds an M.B.A. in Finance with a designation in International Business from Fordham University and a B.A. in Modern Languages from Trinity College. Tim is also a member of the investment committee for St. Paul’s Church in Fairfield.
Timothy T. Yates, Jr.
Managing Director
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.