Adopting a prudent spending policy is essential for colleges and endowments looking to balance short-term needs with long-term sustainability. By understanding the intricacies underlying different spending approaches, institutions can make informed decisions, address budgetary pressures, and position themselves for financial resilience and growth in the face of evolving market conditions.

Key Takeaways:

1. Spending Policies Can Be Diverse: Spending policies for colleges and endowment foundations vary, from very simple to complicated.   Some institutions adopt inflation-linked policies, while others base spending on last year's expenditure plus inflation, while other use a percentage of the rolling average of the portfolio market value.

    

2. Policy Formulation is Key: Crafting a spending policy requires careful consideration and agreement among all stakeholders, including investment committees, boards, and staff.

    

3. Balance Short-Term Needs with Long-Term Impact: Spending decisions have profound implications for future wealth creation and maintenance, emphasizing the importance of a strategic, intergenerational approach able to weather interim challenges such as market volatility and short-term financial needs.

    

4. Determine Your Effective Spending Rate: Effective spending rates may differ from stated policies due to market fluctuations, prompting institutions to reassess and potentially lower spending rates for long-term benefits.

    

5. Address Budget Pressures with Transparency and Documentation: Strategies to mitigate budgetary pressures include embracing risk in investment portfolios, implementing ‘glide paths’ for portfolio realignment, and considering borrowing from the endowment in the manner of a loan. Keep in mind that borrowing from endowments requires transparent communication, constituent buy-in, documented agreements, and adherence to defined spending policies to ensure financial integrity.

    

6. Consider the Role of Portfolio Management: Spending rates inform risk management and portfolio structure, influencing investment decisions and asset-allocation strategies.

    

7. Be Proactive: Market downturns may lead to increased spending rates in the subsequent fiscal year, necessitating proactive budget planning and managing stakeholder expectations. Institutions must prepare for spending fluctuations by having difficult conversations about resource allocation while seeking sustainable solutions.

    

8. Take Advantage of Educational Opportunities: Educational forums like that of NACUBO  provide platforms for deeper discussions on spending policies, sustainable financial strategies, and navigating challenges in the current economic landscape.

Edited for form, concision, and clarity.

Charles Georgalas: Thank you for joining. With me is James Bell, an Investment Director here at Crewcial Partners.

We're going to talk about spending policies today, and how important they are to so many colleges and endowment foundations. So to kick off, James and I will go through and mention the different kinds of spending policies. Caps and floors is one interesting way that spending policies can be calculated; I'm sure James knows of a couple of others as well.

James Bell: Sure. One example is taking an average of the rolling quarters so any one quarter doesn't influence your spending overall, but reflects a bit of the impact of recent gains or changes in the overall value of your portfolio. 

Charles Georgalas: That really is the most common spending policy, taking some form of a three-year rolling average of market values and applying the spending rate to it. But there are other forms as well.

Inflation targeting is another policy, while yet another takes last year’s spending plus inflation and then uses 30% of the rolling average.  

There are interesting issues and differences around each one of them, but I think one of the main things is that this needs to be recorded in your policy. It needs to be thought out in practice, and then agreed upon by all the constituencies, the Investment Committee and board as well as staff.

Approaching the spending policy over a very long period of time can actually have a big impact.  When we're talking about spending policy, we’re focused on this idea of intergenerational capital—that the decisions that people make today can have a long-term impact on future generations.

James Bell: One of the challenges as a long-term institution is facing a series of short-term events—in the case of a university, this could be a new project you need to support on your campus, or it could be a period of market volatility or recent market declines.

If you have a period when you're comparing your spending rate versus the actual portfolio value, and the portfolio value has dropped because the market has come down, you could have a higher spending rate for that moment. The challenge is that, ultimately, what is the overall purchasing power of a portfolio over time? How much capital can we get out of that portfolio?

One of the interesting things we see, if you look at universities, is they have periods of time when they do end up drawing a bit more; in fact, taking Yale throughout the 70s, they actually overspent a little bit during that time period, yet, over time, this reigned this in and let their portfolios grow, ultimately giving them more money to be able to spend on programs. So the challenge of near-term spending versus long-term spending is how that impacts the overall purchasing power of the portfolio.

Charles Georgalas: Another thing to keep in mind in terms of a long-term process is the actual spending percentage. There's a lot of debate about that. There are even different ways to calculate and view the spending rate.

Say you have a 5% spending policy, but when you take the actual calculations and measure the dollars associated with that, then divide this by the market value of the endowment, you arrive at what people like to refer to as the ‘effective rate of the spending.’

And markets tend to move up over long periods of time. So even though you have a 5% spending policy, the effective rate might be closer to 4.5-4.25%, although it is important to know this goes in the other direction as well; if market values decline, your effective rate is going to increase from those low numbers.

A lot of institutions have been considering lowering the rate from 5% to a lower number, because it does have a longer-term impact on that intergenerational gap. If you lower from 5% to 4.5%, and you're spending policy is calculated on a three-year rolling basis, over a 20- to 25-year period, you’d get to a point where the spending rate crosses over—it seems slightly counterintuitive, as you're spending less today, but you're banking that money, allowing it to grow in the endowment, then around year 22, the actual dollar amount to be spent is actually higher than it would have been if you’d kept the 5% spending policy.

However, I think over the last 12 to 15 months, the inflation rate has been double spending policies, which is a really difficult situation for budgets. And we understand that. So sitting here today, and telling you to lower your spending rate in today's environment, we know sounds a little hollow, but I think everyone can understand the long-term intergenerational benefits.

But there are other issues that need to be satisfied, like paying the bills at your institution. And so we'll talk about some ideas for consideration to fill the gap on your spending issues instead of lowering your spending policy, which, as we all know, is difficult to do in today's environment.

James Bell: A great analogy for thinking about the portfolio and your endowment is you have a bucket, and it's full of water, and more water is coming into it every year; and the bucket swings around, going back and forth.

Over time, as you take water out of that bucket, draining it down, this becomes your spending rate; the water coming in each year represents how much your portfolio grows from market performance, while the bucket swinging back and forth is volatility.

One of the tools you can use to put a little bit more in your bucket is embracing some risk in your portfolio; by increasing the water in the bucket, you can help offset some of the extra draws. Now this is not going to cure everything, and it certainly has to be in the context of your overall portfolio and goals as an organization. The other thing is planning around a ‘glide path’ for bringing your portfolio back in alignment over time, so you're spending back into alignment with your portfolio’s performance over time. Having a situation in which you need to spend more money now is not necessarily the end of the world, but you have to have a plan over a couple of years to bring it back.

Charles Georgalas: A lot of schools are struggling with their budgets and thinking about ways to try to alleviate some of that pressure. One way is to actually borrow from the endowment. While it is unusual, we have seen it done. I understand that that is a complicated strategy and constituents need to approve the decision, and we would further suggest that it gets documented and treated as a true loan. And the spending rate should remain the spending policy of the endowment so the college’s draw isn’t materially impacted. It's like paying yourself back, with an understanding that eventually the school has to repay the endowment alone.

We have seen this work reasonably well for several reasons. First, it is transparent; all constituencies must buy in. Additionally, it includes a loan document with an interest rate that is equated to your spending policy. I think those elements are vital to provide the potential benefit.  It's not going to work at every institution; it could be viewed as unusual. For example, a state program, college or university, may have difficult executing it based on potential laws that may not apply to a private institution.

James Bell: For us, in our role working with any of our non-profit clients, spending rate is a key aspect behind the scenes; it really plays a role in helping define some of the risks that we're able to take in a portfolio. It also plays a big role in the structure of the portfolio for each institution.

One of the things we've observed more recently in the NACUBO data, at least the first cut of the data from last year, is that smaller institutions significantly bumped up their spending rates over the last fiscal year. Of course, this is partly due to what happened with the market. Generally, whenever there is a market correction or setback, you see a higher draw rate from the portfolios the following year. Because spending rate, as reported, is really just reporting the dollars out over the portfolio’s value; that is not necessarily the same thing as the overall spending policy that an organization adopts.

Charles Georgalas: The focus on that difference is really very helpful in understanding the patterns of spending over different calendar years when trying to prepare yourself, such as seeing certain market actions and knowing that next year’s spending is going to be slightly elevated because of a market downturn in the previous calendar year.

It’s about managing those expectations throughout the college, and preparing budgets that try to understand what's coming.  Some of the preparations can include difficult conversations about the dollars spent on certain parts of the mission, alongside what can be pushed into the next calendar year. But many colleges and universities are obviously struggling with this debate; how to actually work towards some solutions is really what we're trying to focus on for our NACUBO presentation on April 4—not just the educational aspect of spending, but the world of things you can proactively bring to your organization to help alleviate some of the stress you may be feeling around the spending policy today.

Thanks for joining us today. We hoped we helped shed some light on the intricacies of spending policy and rates. Ultimately, it's about finding what works for you and weighing any short-term gains against the long-term consequences of those decisions.

James and I will be hosting a panel on exactly this topic at the annual NACUBO endowment Leadership Forum on April 4 at 2PM. We plan on going a bit deeper into how educational endowments can better position themselves for sustainable spending choices in what has been a challenging and extended environment marked by rising costs and falling enrollment.

The link to the conference will be included below. Until next time.