In early February, a joint letter from the Senate Committee on Finance, the House Committee on Ways and Means and the Oversight Subcommittee of the House Committee on Ways and Means was sent to 56 academic institutions. The letter asks a total of thirteen questions dealing with such subjects as endowment management, endowment spending and use of funds, donations, and conflicts of interest. I have obtained a copy of the letter. In this new post I will discuss some other questions dealing with endowment spending and use. In two previous blogs, I discussed the questions on endowment management.
Questions 6 through 11 of the joint letter are related to how much a college or university spends out of its endowment and how otherwise it uses the endowment.
Question 6 is: How does your college or university determine what percentage of the endowment will be paid out each year? If any, what has been the target endowment payout as a percentage of the endowment's beginning balance each year? If that answer differs from the percentage paid out, please explain why. Please attach any payout policies or guidance.
The writers of the letter certainly have a way of asking a question. The first part of this 3-part questions asks how the institution determined its endowment spending policy. A good response here will mention that the institution’s board (or a committee thereof) makes this decision. In making this decision, the following factors are considered:
(1) The duration and preservation of the endowment fund;
(2) The purposes of the institution and the endowment fund;
(3) General economic conditions;
(4) The possible effect of inflation or deflation;
(5) The expected total return from income and the appreciation of investments;
(6) Other resources of the institution; and
(7) The investment policy of the institution
In addition to these factors being logical and appropriate to the spending policy formulation, they are taken exactly from the Uniform Prudent Management of Institutional Funds Act—the law in most states.
I am not sure why the second part of this 3-part questions starts with “if any,” but the letter is asking for the spending policy stated as a percentage of the endowment’s beginning balance. As discussed in a previous blog, most financial advisers recommend establishing a spending policy as a percentage (e.g. 4 percent) of the average endowment balance calculated over a 3-year period. Such a policy will even out the potential wild swings in endowment spending that might be caused by temporary dips or surges in endowment market values as of a single date in time. If this is indeed what your institution does, simply state that in your response. This question only wants to know your current spending policy. If it has changed over the years, that fact will be brought out in a subsequent question.
The third part of the question wants to know if the spending policy differs from amounts actually paid out of endowment—i.e. amounts transferred from endowment accounts to the institution’s operating accounts. There is room for potential confusion here.
Many of my clients calculate the amount authorized for spending from endowment in accordance with the spending policy—say, for example $350,000. The institution then draws from endowment as needed knowing the withdrawal limit is $350,000. Endowment investments are likely earning the best return of any asset held by the institution and there is no reason to withdraw money from the pool of these hard-working funds until and unless necessary.
At the end of the year, many of my clients who follow this practice find that they have not drawn all of the money authorized for spending from endowment. For purposes of this example, let’s say they only drew $260,000 from endowment funds. In such a situation, one might be tempted to think that the third part of this question asks that they explain why only $260,000 of $350,000 was withdrawn from endowment.
I believe that this is not the case. I believe that the reality of the situation is that the institution planned to use $350,000 of endowment resources. But because of favorable variances in other budget line items, the institution realized $90,000 of unanticipated funds. Had the institution actually drawn the $350,000 authorized spending from endowment funds on the first day of the year, it would find itself at the end of the year with $90,000 of excess funds caused by the favorable income or spending variances. Then, since the institution seeks to maximize its return on temporarily unused funds, it would deposit these into the endowment investment account, but not as part of the endowment itself.
It is just like having one savings account in which you keep both your vacation funds and your Christmas funds until the time that you need them. If Christmas came along and you had sufficient money in your checking account to purchase gifts, you would use that money rather than make a withdrawal from your savings account only to then deposit the additional funds you had in your checking account into your savings account.
Therefore, I believe every institution should not have to address the third part of this 3-part question. Lastly, since your spending policy should be a formal one in writing, the letter asks that you attach the policy to your response.