RECommended Reading

by Alan Cantor

Reposted from http://alancantorconsulting.wordpress.com/author/alancantorconsulting
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Twice in recent months, I’ve gotten into heated discussions with nonprofit leaders about the spending rate from their endowments.

As you may know, the spending rate is the formula that determines how much an organization pulls from its endowment each year. The federal government requires that private foundations distribute an amount equal to at least 5% of the end-of-year principal. Public charities (that’s everyone from the University of California to the local Boys and Girls Club) have more flexibility. Most adopt a spending rate that is a fixed percentage of a 12- or 20-quarter “trailing average.” That is, they look at the ups and downs of their endowment over the last three to five years, and take out, for example, 5% of the average value of the endowment during that period. The theory – a generally solid one – is that this keeps the pay-out rate fairly steady. The rate doesn’t drop precipitously simply because of one bad fourth quarter. Nor does the pay-out rate veer suddenly higher because of one strong fourth quarter. Purchasing power would be preserved for the long haul. And over time – at least until a few years ago – the yield at most institutions has been fairly consistent and predictable, and it has trended up (with the markets) as the years went by.

But these are not ordinary times. Those trailing averages in many cases are still digesting the huge market drop in 2008, and this, in addition to the flat year in the market in 2011, means that the payouts at many nonprofits in 2012 are going to be lower than last year. Meanwhile, funding sources for nonprofits are drying up. Government support is down across the board. Foundation support (largely for the same investment and spending rate reasons) is weak. Competition for donors and funders is fierce. So nonprofits need more income from somewhere if they are to provide their services – demand for which, not coincidentally, is rising.

What strikes me as counter-intuitive is the refusal of nonprofit boards to adjust the spending rate formula to create more income from their endowments. Just the reverse, in fact, is happening: there’s a trend to lower the spending rates still more. I heard one Investment Committee member say, “Our investment advisors tell us that even if we lower our spending rate, we’re spendthrift by the standards of the big universities!”

My reaction:

• First, how a well-endowed university manages its endowment is irrelevant to how a small nonprofit manages its endowment. It’s not even a case of comparing apples and oranges. It’s apples and lamb chops. On one hand you have a huge institution with billions in endowment and property, a world-wide reputation, a vibrant and affluent alumni pool, and thousands of students and parents willing to spend significant amounts on tuition and fees. On the other hand, you have, say, a human service organization with a budget of $500,000, an impoverished clientele, and an endowment of $1 million. What works for Yale does not have any real relevance to the small nonprofit.

• Second, the major universities have not exactly covered themselves with glory in their endowment management. The Center for Social Philanthropy at the Tellus Institute and Joshua Humphreys (lead author) did a remarkable study in 2010 about the investment policies of six major universities. It’s an exhaustive examination that describes many characteristics to avoid: hubris, conflict of interest, lack of transparency, illiquid assets, and significant negative impact on the institutions (in reduced services and halted initiatives) and on the community (higher unemployment and reduced economic activity, along with others).

• Third, we need to stop treating the endowment and the established spending rate as sacred. A terrific article, “Endowment for a Rainy Day,” by Burton A. Weisbrod & Evelyn D. Asch in the Stanford Social Innovations Review advocates that we should increase the spending rate from endowments in difficult economic times. Weisbrod and Asch essentially ask if the endowment is there to serve the institution, or if the institution is there to serve the endowment. Unfortunately, the latter is often the case. The prevailing notion is that the most important thing is to build up the value of the endowment so that it can then provide an income flow in the future. Weisbrod and Asch say: not if that means gutting the programming today.

Let’s look around. We have people who need to be housed and fed and treated for illness – now. We have kids who need to be educated, environmental challenges that need to be addressed, and illnesses that need to be cured. Aren’t we better off spending money today to cure the ill, feed and clothe and educate children, slow down global warming, stave off environmental disaster, and cure illnesses like AIDS? If we hoard the money (traditionalists would say, “preserve the purchasing power”) until, say, 2042 – won’t it be too late to do much about these immediate needs? Won’t we have perpetuated some problems while allowing others to spiral out of control – while unnecessarily permitting human suffering?

I’m not advocating raiding endowments or “spending them down.” But spending only 4% of a trailing average, as is the standard at many institutions, is too low. This is the rainy day. Pay out 6%. (Most states allow you to draw up to 7% without violating the rules governing endowment management.) This is what we have endowments for. Spending rates are arbitrary and can be changed. Human suffering cannot be ignored in the name of building up the principal of an endowment.

But I know I’m in the minority on this one. What do you think?