Positioning Your Nonprofit to Sustain Its Impact
Nonprofits play a key role in improving people’s lives and communities. Whether it is through education, the arts, community improvement or other channels, their work is critically important to their constituents. Yet, the majority of nonprofits use a spending policy that is linked to investment performance, threatening their ability to provide consistent resources during periods of market volatility.
Nonprofits should instead use a spending policy that provides stable support for their constituents’ needs through various market cycles. This will enable them and their affiliated endowments to fund their missions irrespective of market movements.
Which Spending Policy Do Most Nonprofits Use?
According to the 2021 NACUBO-TIAA Study of Endowments, 74% of endowments use a “percentage of moving average” model to calculate their annual endowment distribution. This methodology bases spending on the average market value of the endowment over a specified time period (typically the past three years or trailing 12 quarters).
Annual Spend = Average Three-Year Endowment Market Value x Spending Rate (%)
Using this methodology, spending varies based on investment returns. Spending is reduced after market downturns (when the endowment market value falls). Likewise, spending increases after the markets have had strong returns. This approach can result in significant spending volatility, making it hard for nonprofits to budget and provide stable funding for their missions.
This chart illustrates this effect on a hypothetical $200 million endowment portfolio. Spending would have declined by more than $4 million in the three years following the dot-com bubble in 2001 and by more than $2 million following the 2008 financial crisis. In addition to being volatile, the moving average approach forces nonprofits to cut back their operations at the worst possible time. During periods of stress, their constituents need more, not less, support from operations.
Which Spending Model Should Nonprofits Use?
I often advise nonprofits to consider using the constant growth spending methodology. While fewer nonprofits tend to use this approach, I believe it provides greater consistency and predictability. Endowment spending grows each year at a predetermined rate of inflation and expectations for gift flow.
Annual Spend = Current Endowment Spend x [Inflation Rate (%) + Gift Growth Rate (%)]
The constant growth model separates spending entirely from market volatility. As a result, spending rates can be higher in times of poor market performance when nonprofits likely need additional support and lower in strong markets, when savings can be reinvested and compound at a higher rate of return.
The constant growth model also enables nonprofits to better control spending through adjustments in the inflation factor. (While there are many factors to consider when choosing the inflation rate, organizations typically use the Consumer Price Index, the Higher Education Price Index or a rate that is more in line with the annual increase in their operating budget.)
To prevent a disconnect between endowment spending and market value, floors and caps are often used to set an acceptable spending range. For example, a 6% cap means spending will not be more than 6% of the endowment market value. Similarly, a 4% floor means spending will not be less than 4% of the market value.
Over the past 25-plus years, the percentage of moving average model (blue line) has been much more volatile than the constant growth model (green line), yet both methodologies have the same average spending rate of 4.6%. The constant growth methodology makes annual spending more predictable, smooths revenues and thus facilitates more consistent budgeting for community needs.
The most common criticism of the constant growth methodology is its failure to account for market value fluctuations. If the capital markets have a challenging year, the constant growth model does not dial back spending. Instead, it still allows for the previous year’s spending (in dollars) plus the rate of inflation to be spent. Likewise, in an environment of strong investment returns, the constant growth model will call for spending less than the Moving Average model would.
This criticism is actually the strength of the model. Nonprofits often need to spend more in times of crisis and less in good economic times. The demands of your community are impacted significantly by the market cycle and having your primary revenue source increase when the community needs additional support is essential.
Choosing a spending methodology that meets the objectives of your nonprofit is critical for the long-term health of your organization. While there is no one-size-fits-all approach, I have generally found that nonprofits have greater peace of mind when they use the constant growth approach to endowment spending.
John W. Griffith is a director and endowment specialist with Hirtle Callaghan.
He has more than 30 years of higher education experience. From 2003 until 2014, he was the chief financial officer and treasurer of Bryn Mawr College. As the treasurer, he oversaw an $850-million endowment, managed cash, issued debt, and was responsible for budgeting and strategy planning. He also assisted in modernizing and diversifying the endowment. During the latest recession, Bryn Mawr was one of only a few colleges whose debt rating was upgraded. Prior to Bryn Mawr, John spent 15 years in various financial roles at the University of New Hampshire. John started his career at Coopers & Lybrand.
The information presented in this article is general in nature and is not designed to address your investment objectives, financial situation or particular needs.