Spending policy

What Is Spending Policy?

Spending policy, within the realm of portfolio management and financial planning, refers to the formalized rules or guidelines that dictate how much money an organization or individual can withdraw or spend from an investment portfolio over a given period. This policy is particularly critical for entities with long-term financial horizons, such as university endowment funds, charitable foundations, and individual retirement portfolios, as it aims to balance current spending needs with the enduring goal of capital preservation and growth. A well-designed spending policy seeks to provide a stable stream of funding while maintaining the real value of the underlying assets for future generations, thereby promoting intergenerational equity.

History and Origin

The concept of a formalized spending policy gained prominence with the growth of large institutional endowments in the mid-20th century. Historically, many institutions simply spent the "income" generated by their endowments, primarily dividends and interest, while preserving the original principal. However, this approach often led to unpredictable spending levels and discouraged investment in growth-oriented assets that might generate less current investment income but higher total returns.

A significant shift occurred with the adoption of the Uniform Management of Institutional Funds Act (UMIFA) in 1972, which allowed institutions to consider the "total return" of their investments—including capital appreciation—when determining spending. This paved the way for more sophisticated spending policies aimed at smoothing distributions and preserving purchasing power against inflation. The subsequent Uniform Prudent Management of Institutional Funds Act (UPMIFA), approved by the Uniform Law Commission in 2006 and adopted by most states, further modernized these guidelines, providing greater flexibility for institutions to spend from an endowment even if its market value falls below its historic dollar value, provided such spending is prudent.

Key Takeaways

A spending policy establishes rules for withdrawing funds from an investment portfolio, crucial for long-term entities like endowments and foundations.
Its primary goal is to balance immediate spending needs with the long-term sustainability and growth of the portfolio.
Spending policies often aim to smooth annual distributions, protecting against market volatility and ensuring predictable funding.
The policy considers factors such as expected investment returns, inflation, market fluctuations, and the overall mission or goals of the fund.
For private foundations, there is a legal minimum payout requirement that influences their spending policy.

Formula and Calculation

Many institutional spending policies employ a formula that combines a percentage of the portfolio's market value with a smoothing mechanism to reduce volatility. A common approach is the "moving average" spending rule.

A simplified version of a spending policy formula might look like this:

S_t = w \times (R_{t-1} \times M_{t-1}) + (1-w) \times S_{t-1} \times (1 + \text{inflation rate})

Where:

( S_t ) = Spending amount for the current period (year t)
( w ) = Weight given to the market-value-based component (e.g., 0.70 or 0.80)
( R_{t-1} ) = Target spending rate (e.g., 4% or 5%) applied to the prior period's market value. This rate is often determined based on the portfolio's expected total return and the desire for sustainability.
( M_{t-1} ) = Market value of the portfolio at the end of the prior period (or a moving average of market values)
( S_{t-1} ) = Spending amount from the prior period (year t-1)
( \text{inflation rate} ) = Expected or actual rate of inflation for the period

This formula creates a blend, allowing spending to gradually adjust to changes in market value while also providing a level of stability by factoring in the prior year's spending adjusted for inflation. The use of a moving average for (M_{t-1}) (e.g., a three-year or five-year average) further smooths out market fluctuations.

Interpreting the Spending Policy

Interpreting a spending policy involves understanding the delicate balance it strikes between immediate utility and long-term viability. For an endowment or foundation, the policy’s effectiveness is often judged by its ability to provide consistent distributions for operations or grants without eroding the inflation-adjusted value of the corpus over time. A spending rate that is too high, especially relative to the portfolio's real return expectations, can lead to a gradual depletion of assets, jeopardizing the institution's future ability to fulfill its mission. Conversely, a policy that is too conservative might limit the current impact the institution could have.

Key considerations in interpreting a spending policy include its sensitivity to market downturns, its adaptability to changing economic conditions, and its success in maintaining purchasing power. The policy's chosen "spending rate" (the percentage of assets spent annually) is a crucial metric, reflecting the institution's risk tolerance and long-term financial objectives.

Hypothetical Example

Consider a university endowment with an initial market value of $100 million. Its spending policy dictates an annual payout equal to 5% of the average market value over the preceding three years, with a smoothing component.

Year 1: The endowment's market value is $100 million. Since there are no prior years for an average, the initial spending is often set based on the current value. Let's assume an initial spending rate of 4% of current value: $100 million * 0.04 = $4 million.
Year 2: Due to strong market performance, the endowment's market value grows to $110 million. If the spending policy uses a 3-year average and a 70/30 weighting (70% on average market value, 30% on inflation-adjusted prior spending), with 2% inflation:
- 3-year average (assume $100M for previous two years for simplicity): ($100M + $100M + $110M) / 3 = $103.33 million
- Market-value component: 5% of $103.33M = $5.16 million
- Inflation-adjusted prior spending component: $4 million * (1 + 0.02) = $4.08 million
- Blended spending: (0.70 * $5.16M) + (0.30 * $4.08M) = $3.612M + $1.224M = $4.836 million.
Year 3: The market experiences a downturn, and the endowment's market value drops to $105 million.
- 3-year average: ($100M + $110M + $105M) / 3 = $105 million
- Market-value component: 5% of $105M = $5.25 million
- Inflation-adjusted prior spending component: $4.836M * (1 + 0.02) = $4.933 million
- Blended spending: (0.70 * $5.25M) + (0.30 * $4.933M) = $3.675M + $1.48M = $5.155 million.

This hypothetical example illustrates how the spending policy smooths distributions, preventing drastic fluctuations in annual payouts despite market volatility. Such predictability is crucial for budgeting and planning institutional expenditures.

Practical Applications

Spending policies are fundamental to the long-term viability of various financial entities. For institutional investors like university endowments and large philanthropic organizations, they ensure a stable flow of resources for their operations and grant-making activities. For instance, the spending policy of Princeton University aims to balance current program needs with the long-term preservation of its endowment's purchasing power, typically targeting a range for its spending rate.

Similarly, public pension funds and sovereign wealth funds utilize spending policies to determine how much of their investment gains can be distributed for current benefits or governmental programs while ensuring the fund's capacity to meet future obligations. Furthermore, for private foundations in the United States, the Internal Revenue Service (IRS) mandates a minimum annual payout requirement, generally 5% of their average net investment assets, which directly influences their spending policy decisions. These policies are carefully crafted by boards, committees, and finance professionals who bear a fiduciary duty to the organization's long-term health and mission.

Limitations and Criticisms

While designed for stability and longevity, spending policies are not without limitations. One primary criticism is that fixed-rate or highly smoothed policies can lead to spending that is either too high during prolonged market downturns (potentially eroding capital) or too low during strong bull markets (missing opportunities for greater current impact). Relying heavily on historical returns to set spending rates might not accurately predict future market behavior, particularly in periods of low expected returns or high inflation.

Some critics argue that overly rigid spending policies can detach an institution's financial decisions from its strategic objectives, preventing it from seizing timely opportunities or responding effectively to urgent needs. For example, a foundation might be constrained by its policy from increasing grants significantly during a societal crisis if the market-based formula suggests otherwise. This can create tension between financial prudence and immediate philanthropic impact, leading to calls for more dynamic and mission-aligned spending frameworks, as discussed in various critiques of traditional foundation spending practices.

Spending Policy vs. Withdrawal Rate

While often used interchangeably in broader financial discussions, "spending policy" and "withdrawal rate" carry distinct connotations in professional financial contexts.

Spending Policy primarily refers to the formal, often complex, rules and methodologies employed by institutional endowments, foundations, and large investment funds to determine annual distributions. These policies are designed for perpetuity or very long horizons and typically incorporate smoothing mechanisms, considerations of intergenerational equity, and compliance with specific regulatory frameworks (e.g., UPMIFA). They involve strategic decisions about asset allocation, risk tolerance, and the long-term mission of the institution.

Conversely, Withdrawal Rate generally refers to the percentage of assets an individual retiree takes out of their portfolio each year. While the concept of a "sustainable withdrawal rate" for retirement planning shares the goal of portfolio longevity, it is often simpler in calculation (e.g., the "4% Rule" or "Trinity Study" discussed on the Bogleheads Wiki) and focuses on the individual's lifespan and personal financial goals rather than institutional perpetuity or complex governance structures. The withdrawal rate in individual financial planning is a critical component of retirement planning.

FAQs

What is the primary objective of a spending policy for an endowment?

The primary objective of a spending policy for an endowment is to provide a stable and predictable flow of funds to support the institution's operations and mission, while simultaneously preserving and growing the real (inflation-adjusted) value of the endowment's principal for future generations.

How does a spending policy account for market fluctuations?

Many spending policies incorporate smoothing mechanisms, such as using a multi-year moving average of the portfolio's market value in their calculations. This helps to dampen the impact of short-term market volatility on annual spending amounts, providing more stable distributions even during periods of significant market swings.

Are there legal requirements for spending policies?

Yes, particularly for certain types of organizations. For example, private foundations in the U.S. are generally required by the IRS to distribute a minimum percentage of their assets annually. Additionally, state laws, such as the Uniform Prudent Management of Institutional Funds Act (UPMIFA), provide legal guidance on how institutional funds, including endowments, should be managed and how spending decisions should be made.

Can a spending policy be changed?

Yes, spending policies are typically reviewed periodically by the governing body (e.g., a board of trustees or investment committee) and can be adjusted. Changes might be prompted by significant shifts in market conditions, changes in the institution's financial needs, or evolving understanding of best practices in portfolio management and sustainability.

How does inflation impact a spending policy?

Inflation is a crucial consideration for a spending policy because it erodes the purchasing power of money over time. Effective spending policies often include an inflation adjustment to ensure that the real value of distributions is maintained, allowing the institution to sustain its activities at a consistent level even as costs rise. This is vital for long-term capital preservation.