Endowments and Foundations
Challenging the Norm – Debunking Spending Rule Convention

Challenging the Norm – Debunking Spending Rule Convention explores the spending rules most commonly used to govern annual distributions from educational and community foundation endowments. Mercer’s analyses illustrate that the conventional rule of using a 3-year average of prior market values results in distributions that are more volatile from one year to the next than a 5-year/20-quarter average or certain hybrid rules. It is Mercer’s contention that a spending rule that limits year-over-year volatility of distributions is beneficial and, further, that institutions should be able to tolerate more volatility in returns if they use a spending rule that limits the volatility in spending from the endowment.

For most educational institutions, endowments represent the accumulation of gifts donated for the long-term support of the institution, gifts restricted to a specific purpose and those that are unrestricted.  The investment objective is to grow the endowment’s assets at a rate greater than inflation, fees and spending in order to maintain its purchasing power for future generations.  The amount of spending in any year is determined by a spending policy that specifies both the rate (percentage) and the rule governing the base to which the rate will be applied.  For an institution depending on this annual spending distribution for a large portion of its operating budget, the objective of the spending rule should be to provide a consistent growing stream of distributions to support operations in the near term and to maintain the purchasing power of the remaining assets over time for intergenerational equity.  

There are different ways to set a spending rule to accomplish these goals. While studies evaluating the various rules typically use theoretical investment allocations and Monte Carlo simulations to project future wealth, we have undertaken to examine spending rules using published median annual returns of endowments beginning in fiscal 1980.  Our objective is to identify the rules that not only provide reasonable intergenerational equity but also provide the greatest stability in year-over-year distributions from the endowment. We expect portfolio volatility may be higher in the future as allocations to fixed income decline and illiquidity limits are reached. With the appropriate spending rule, this need not lead to an increase in year-over-year volatility of distributions.

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