In light of the current economic conditions and the decreased value of most endowments, many organizations are re-examining their investment strategies. Often overlooked: Spending policies must have not just the proper annual spending amount but also be adequately defined.

A spending policy should balance principal preservation, budgetary stability, and intergenerational equity. Yet, no spending policy can simultaneously maximize all three objectives. The tradeoffs are stability vs. utility maximization and spending vs. portfolio growth. Utility is the real value of spending plus the current portfolio value.

Understanding when money is spent is critical. This concept ties into the idea of intergenerational equity, or balancing the needs of today’s endowment beneficiaries against those of the future.

Adopting a rule to fulfill spending objectives can help in better overseeing an endowment’s performance. Spending rules generally emphasize budgetary stability (“stable”) or total utility at the expense of volatility. A secondary objective is balancing spending vs. portfolio growth (“adaptive”). Adaptive rule utilization is driven by the desire to spend more during years of plenty; stable rules reallocate higher returns to offset years with lower returns.

## Stable Rules

*UPMIFA:*The most commonly utilized spending rule is defined in the Uniform Prudent Management of Institutional Funds Act. It averages (at a minimum) the 12 most recent quarter-end portfolio values and spends a percentage of that average. The rule is simple to apply and provides a relatively stable spending amount. Any anomalous returns will impact spending for three or more years.

Understanding how much is spent and when is critical in assessing any spending policy.

*Inflation-Linked Rule:*This rule also begins with a spending amount (e.g., 5 percent of existing portfolio value) that’s adjusted annually by an inflationary index.

## Adaptive Rules

*Yearly Spending Rule:*A percentage of the portfolio value is spent at the end of the fiscal year. This is the UPMIFA rule applied to a single point in time, not an average. Its failure to account for other factors makes it less than ideal.*Milevsky-Browne Rule:*This and the Alpha/Beta rule (below) have yet to be widely adopted due to relatively volatile spending patterns. In simulations, they’re effective at preserving corpus in real terms and in maximizing utility. But it’s a probabilistic approach with a complex formula. The aim: Achieve a certain endowment value within a certain time frame. A simple example: an endowment that aims for a 99 percent, 95 percent, or 90 percent probability of achieving returns of 6 percent per year over 30 years with a spending rate that ensures the target value is reached.*Alpha/Beta Rule:*Here, a small percentage of the real initial value of the fund (Alpha) is spent. A higher spending rate (Beta) is applied to assets in excess of the real initial value. A $10 million portfolio might have a real value after five years of $13 million, while the portfolio’s market value might be $16 million, leading to an excess of $3 million. The Alpha spending rate would apply to the $13 million and the Beta spending rate to the $3 million.

## Hybrid Rules

*Yale Rule:*Part of the spending amount is determined by the previous year’s spending; the other part is a fixed target percentage of market value.*Yale & Alpha/Beta Hybrid Rule:*The previous year’s spending component used in the Yale rule is combined with the standard Alpha/Beta rule, with 70 percent of spending dictated by last year’s spending adjusted for inflation and 30 percent dictated by the Alpha/Beta rule. This combination protects corpus, but allows for significant spending in strong markets.

## Balancing the Objectives

A well-defined, tailored spending policy tends to reduce the number of periodic revisions and provide for fulfillment of an endowment’s specific goals. Applying rules can help balance the objectives of endowment preservation, budgetary stability and intergenerational equity.

*Adam J. Smith, CFA, CAIA, is the investment strategist at Lancaster Pollard Investment Advisory Group, an SEC-registered investment advisor specializing in investment advisory and investment management services to education and other nonprofit organizations. His experience is focused on manager research, asset allocation, and portfolio structure. Lancaster Pollard Investment Advisory Group can be reached at info@chiefinvestmentofficer.com or (614) 224-8800.*