Institution endowments are adopting new spending policies designed to make revenue streams more predictable and stable.
By Mimi Lord and Wanda Throneburg
The most common policy calls for spending a pre-specified percentage of a moving average of the endowment value, such as a 5 percent spending rate applied to the recent three-year average of the endowment’s market value. However, according to recent NACUBO Endowment Study data, approximately 20 colleges and universities have changed their endowment spending policies during the past four years to ones that are expected to lessen the impact of pronounced market swings. Increasingly, these institutions are adopting spending policies based on an inflation adjustment or on a formula similar to the Yale University model, which incorporates both inflation and market value.
Adoptions of Yale-Like Model
Yale University’s influence is visible in new spending policies adopted at Dartmouth College, Hanover, New Hampshire, and Queen’s University in Ontario.
Dartmouth’s Web site indicates that its new policy, effective in FY05, consists of a weighted average of two parts: the prior year’s spending adjusted by the consumer price index (CPI), weighted at 70 percent; and a predetermined percentage of the four-quarter trailing average market value of the endowment, weighted at 30 percent.
At Queen’s, the policy was changed from a 5 percent payout based on the three-year average endowment value to a formula that takes the previous year’s spending adjusted for inflation, weighted at 70 percent; and a 4.5 percent payout based on the average endowment value over the past 12 months, weighted at 30 percent. Bill Forbes, the university’s special advisor to the office of investment services, said the investment committee felt more comfortable with the reduction to a 4.5 percent spending rate based on 5- to 10-year-return expectations of 7.5 percent to 8 percent per year, inflation expectations of 2 percent to 2.5 percent, and manager and advancement fees totaling about 0.7 percent.
Concerns about the level of payouts at Queen’s led to reconsideration of the spending formula in 2003. “Donors can be sensitive if they think payouts from their gifts are declining,” says Forbes, indicating that the new formula was phased in over several years, with slight reductions in spending in the first two years. “Now, going forward, we would expect the payouts to increase at a rate higher than inflation,” says Forbes. “It’s more predictable now and people are comfortable with the methodology.”
Support for Generations
Smoothing of endowment spending is the reason given by a number of institutions that have changed their policies. However, according to Dorothy Dotson, vice president for investments at the West Virginia University Foundation, her institution’s primary motivation was intergenerational equity. The goal is for today’s students and future students to have similar levels of support, adjusting for inflation. Says Dotson, “The effect of what we did was to have better balance between the support we provide today and the support we’ll provide in perpetuity.”
The previous spending policy at the West Virginia University Foundation was 5 percent based on a three-year moving average of the endowment value. That was changed to a two-step process: Take the previous year’s spending and increase it by the CPI, and check to see that the spending rate falls within 3 percent to 6 percent of the previous year-end endowment value. “If the market goes either up or down in a material way, we’ll hit those bands,” notes Dotson.
Alan Klug, vice president for administration and finance at the Kansas State University Foundation, says the new policy at his institution is similar to that adopted at West Virginia except that the spending band at Kansas State is a bit narrower, set at 3 percent to 5 percent of the endowment value. The impetus for change developed several years ago when the university experienced inconsistent endowment payouts due to market fluctuations at the same time that state funding was declining. Klug believes that endowments will become increasingly important to institutions as they attempt to achieve greater financial security.
Other Inflation-Based Factors
The University of Virginia adopted a somewhat unusual inflation-related policy that calls for annual spending increases of 3.6 percent—a historical average of the Higher Education Price Index (HEPI)—as long as the actual spending rate is maintained within a range of 3.5 percent to 5.5 percent of the recent endowment value. This change was implemented in 2003 when the university was ratcheting down its expectations for long-term investment returns from the 15 percent to 18 percent levels of the “glory years,” according to Yoke San L. Reynolds, vice president and chief financial officer. Strong returns have continued, however, and since the payout is increasing only 3.6 percent, while growth from performance has been 14 percent annually, the payout is hugging the bottom 3.5 percent band, says Reynolds. “We probably will consider changing the policy in the next year, either modifying the annual increase in the formula to reflect the higher inflation of recent years, or adopting new bands,” Reynolds notes. Another possibility is to change the formula altogether, even though the board likes the simplicity of the current formula.
South Dakota State University’s policy, adopted in 2004, is tied even more directly to the inflation rate and is entirely disconnected from the endowment’s value. Each year, the spending amount is increased by the CPI within a band of 2 to 5 percent. For example, if inflation increased by 6 percent, the spending increase would be capped at 5 percent. However, if significant changes occurred in the endowment value due to large market swings, the spending amount likely would be reset with the subsequent inflation adjustments based on the new spending level, notes David Marquardt, president and chief executive officer of the university’s foundation. For example, if the market produced very strong returns and inflation remained low for an extended period, the university could decide to hike up the spending amount in a particular year and then resume with the inflation-based adjustments from that higher level.
Even Yale has adjusted its spending policy based on changing circumstances. The policy from 1995 to 2004 consisted of increasing the prior year’s spending by the inflation rate, weighted at 70 percent; and spending 5 percent of the previous year’s endowment value, weighted at 30 percent. In FY05, Yale adopted two changes to its policy: increasing the weight of the inflation-adjusted prior year's spending to 80 percent, and increasing the stated spending rate to 5.25 percent of the previous year’s endowment value. An explanation on Yale’s Web site indicates that the reason for the change was to increase the stability of flows to the operating budget: “Because endowment support for operations increased from 11 percent of revenues in fiscal 1985 to 32 percent in fiscal 2005, prospective declines in endowment value carry greater risk for Yale’s activities.”
Observers in the late 1970s and early 1980s might have been shocked to learn that an inflation adjustment could be considered a stabilizing policy. With any luck, the new spending policies being adopted by a growing number of institutions will provide both smoothing of revenue streams and intergenerational equity.
MIMI LORD, an independent financial writer, assumes the chief investment officer position at Spero-Smith Investment Advisers, Inc., Cleveland, Ohio, as of March 1; and WANDA THRONEBURG is TIAA-CREF's administrator of the NACUBO Endowment Study.
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