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A Formula for Sustainable Spending

Today’s harsh economic climate has challenged nonprofit spending like never before. While investment-portfolio values may still be depressed from the financial crisis, spending needs are greater than ever. Continuing to spend at previous levels may appear unsustainable, but cutting spending to preserve assets may be undesirable or even impossible. 

The challenge for nonprofits today is to strike the right balance: directors and trustees must find a formula that enables the organization to meet its ongoing net spending goals while maintaining a prudent rate of asset growth.

As an investment manager for foundations, endowments, and charitable trusts, Bernstein Global Wealth Management recently completed a major research project that examined the way nonprofits’ spending-policy and asset-allocation choices affect long-term asset growth and distribution stability, taking into account the unpredictable nature of capital markets. In this article, I’ll describe a concept we call Total Philanthropic Value (TPV), which has proved to be a useful and practical measure for making decisions about spending policy and asset allocation.

Total Philanthropic Value: Time on Your Side

To analyze the interaction between spending policy and investment returns, we used Bernstein’s proprietary Wealth Forecasting System^SM (WFS),ⁱ  which models probable outcomes over time given various capital markets and inflation scenarios, from poor to excellent. The WFS simulates 10,000 plausible future paths of returns for various asset classes and inflation. While no one can predict the future, this type of analysis provides a reasonable way to consider the probability of results: the median of the 10,000 outcomes can be considered the most likely outcome, while the bottom and top deciles of outcomes illustrate the results of especially weak or strong investment markets and inflation, respectively.

To illustrate the financial trade-offs between short-term and long-term priorities, we used the WFS to model the assets of a hypothetical nonprofit that began with $10 million invested in a very simple diversified portfolio of 70% stocks and 30% bonds and that spent 5% of its assets for 30 years (Display 1). In the median of outcomes, the nonprofit will have given away $15.8 million in today’s purchasing power (i.e., real dollars, or adjusted for inflation). Its remaining real assets are $10.2 million. We derive TPV from the sum of the total giving and the remaining assets—in this case, $26 million, adjusted for inflation. 

TPV is an excellent measure for determining how a nonprofit’s asset allocation and spending policy are likely to affect its longevity, net of inflation, and spending. For example, for a nonprofit seeking to exist in perpetuity, the higher its projected TPV, the better. 

Display 1—Total Philanthropic Value Definedⁱⁱ

Not surprisingly, our research showed that the lower the annual spending rate, the higher the potential TPV. Display 2 shows the potential outcomes for the same hypothetical nonprofit as above, based on different spending levels—3% through 7%—over 30 years. A 7% spending rate results in a median TPV of $22.4 million after 30 years. But with a lower spending rate, the foundation’s TPV grows. At 3% it is $31.3 million—nearly 21% more than the 5% spending rate. And these are just the median cases. If investments perform especially well (above the median), then lower spending could help portfolio assets and TPV grow exponentially higher, thanks to the power of compounding. 

Display 2—Total Philanthropic Value Paradox:
Lower Spending Means More Charitable Impactⁱⁱ  

It makes perfect sense that TPV grows with lower spending rates. Less intuitive, however, is that with more assets invested because less is being spent, over time a higher asset base will result in a higher annual distribution. Display 3 shows this by mapping the annual distributions of the same hypothetical foundation, comparing 5% annual spending with 7%. It shows that in the median case, even though the 5% rate represents lower annual distributions in the foundation’s early years, after about 18 years the 5% rate supports higher annual distributions than the 7% spending rate. Once the crossover point is reached, it is a mathematical certainty that the 5% spending rate will enable the foundation to distribute more wealth annually and still have more remaining assets than it would have achieved with the 7% spending rate. 

Display 3—Annual Distributionsⁱⁱ

Of course, a nonprofit’s mission is the critical starting point. If the philanthropic mission is time-sensitive or if the board feels that part of the nonprofit’s mission is to spend down its assets over time, then a greater level of current spending may be appropriate. But if part of the organization’s mission is to exist in perpetuity, higher TPV is the goal. 

Conclusion

TPV proves to be a powerful measuring tool for making decisions on spending policy and asset allocation. It can show the affect of smoothing policies, for example, or the effect of spending ceilings or floors. In general, creating a spending policy based on disciplined analysis can be a useful exercise for many reasons. It can stimulate a nonprofit’s vitality and purpose by requiring the board to articulate the priorities of the institution. Ironically, difficult financial markets may make the exercise even more productive, because they force board members to address the most challenging questions regarding their institution’s mission and its ability to achieve it with existing resources.

This article was contributed to Blackman Kallick’s Not-for-Profit Edge by Brian Wodar, Director of Wealth Management Research at Bernstein Global Wealth Management. For more information contact Brian at brian.wodar@bernstein.com or 312-696-7886; Leslie Grant at leslie.grant@bernstein.com or 312-696-7848; Gen Burns, Partner in Charge of Blackman Kallick’s Not-for-Profit Practice at gburns@BlackmanKallick.com or 312-980-2910; or your Blackman Kallick representative.

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Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. 

ⁱThe Bernstein Wealth Forecasting System (WFS) uses a Monte Carlo Model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, our forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings, and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

ⁱⁱInitial assets of $10 million. Asset allocation is 65% Global Stocks/25% Intermediate Taxable Fixed Income/10% REITs. Global Stocks are 35% US Value/35% US Growth/25% Developed International/5% Emerging Markets.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.