The financial markets provided strong returns in 2020, despite the staggering human and economic impacts of the COVID-19 pandemic. The strong returns and the resulting increase in endowment values have been beneficial to many nonprofits, which continue to see a heightened demand for their essential support services. As the disease has come under greater control, many of our nonprofit clients are looking to the future and discussing with us what portfolio spending rates should apply over the next several years. Our conclusion is that asset returns are likely to be lower over the ensuing years, which presents challenges to the spending rate decision.
In the early stages of the pandemic, a broad-based index of US stocks declined by 35% from the February 2020 high to the March 2020 low, as investors assessed the potential impacts of the Coronavirus. Lower interest rates, government stimulus and monetary programs, and progress on vaccine development were among the factors that helped the broad US market to not only recover from the initial sell-off, but also close the year with an 18% return. An index for the developed international equity markets returned over 10% for the year, while an emerging markets equity index returned over 18%. Responding to the decline in interest rates, an intermediate maturity, government and corporate bond index returned over 6% in 2020. The financial markets provided growth of principal last year and now, particularly for the U. S. equity markets, the 3-year, 5-year and 10-year annualized returns are all well into double digits.
However, while the strong returns of recent years are welcome, past performance is not indicative of future results. Twice a year, Greenleaf’s Research team prepares longer-term projections for the investment markets. We currently forecast that US equity markets could provide a return in the mid-single digits per year, while the projected returns for international equities, particularly the emerging markets, are modestly higher. With interest rates at historic lows, the return on a fixed income portfolio is likely to be in the low single digits per year.
What do these projections mean for a nonprofit’s spending rate decision? A typical asset mix or allocation for a nonprofit is 70% equities, 25% fixed income and 5% cash, while a typical spending rate is between 4% and 5%. Using our team’s projections, this asset allocation would imply a nominal portfolio return of 3.5% to 4% per year over the next ten years. Our longer-term inflation forecast is 1.8% per year, meaning that for some nonprofits, the investment return may fall below the inflation adjusted spending rate and the value of the invested assets, when adjusted for inflation, could diminish over time. Some organizations will need to decide if spending levels should be maintained or if they should be reduced to increase the potential for maintenance of the inflation adjusted value of the organization’s investment portfolio.
For many nonprofits, it may be an opportune time to discuss a reduction in their spending rate. The majority of public nonprofits and many private nonprofit organizations use a spending formula based on a trailing average of their portfolio’s asset value, which generally provides a stable and predictable level of spending. During periods of strong market performance when portfolio returns are well above a spending rate plus inflation, the portfolio can support annual increases in the spending level. A spending rate calculation that uses a rolling average of the value of the investments, will experience a gradual increase in spending, which could allow growth in the portfolio’s inflation adjusted value if the markets are performing well. It is an extended market environment of returns below long-term averages that presents difficulties for planning. If the markets decline and a fixed percentage spending rate formula is used, the year over year decline in spending could be significant. If a spending formula uses a rolling average market value, the dollar rate of spending could rise over the short term, even as asset prices are falling. A spending formula which follows the percentage return of the portfolio, could pose a risk to future spending levels if the markets enter a period of below average returns. Now is an opportunity for nonprofits to discuss the impact of lower returns on their spending levels and portfolio values.
Greenleaf Trust assists many of our nonprofit clients with an analysis of various considerations in the spending rate decision, as well as administrative support in implementation. For example, potential discussion items include portfolio projections under different spending rate decisions and modeling the impact on portfolio values from different asset allocation and investment decisions. We also assist clients with the spendable calculation and tracking the distributions.
Private, non-operating foundations are required to distribute 5% annually. If a low asset return environment persisted for multiple years, the perpetual life of some of these organizations may be challenged.
We are not an advocate for frequent changes to an organization’s investment policy statement target to equities. As the market volatility in 2020 demonstrated, it is difficult to time exiting or reducing an equity allocation and then reentering the market or adding back to stocks. The risk is missing a rise in equity prices. Instead, we advocate establishing a long-term target to equities, with a modest permitted range around that target and then adjusting the long-term target when the circumstances for the organization change. For example, the level of reserves at an organization versus the spending level may encourage a review of the investment policy statement. We help clients with this analysis and decision.
Interest rates are low and annual returns from the financial markets are likely to fall below what we have experienced over the last 5 and 10 years. In an environment with inflation approaching 2% per year, nonprofits could see a decline in the ability of their portfolios to support historical spending rates. A tested spending policy is as important as a sound investment policy in terms of helping an organization meet its financial objectives. We are always available to participate in discussions with clients on addressing this challenge.