No spending rule is perfect. But many trustees who now base spending on market values would benefit by focusing on asset cash flows instead.


A Cash-Flow Focus for Endowments and Trusts

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Overview

Endowment  trustees could benefit by turning their backs on market values. Basing  spending on investment cash flows, rather than on market values, should  result in more stable streams of spendable cash and should provide other  advantages as well.

Summary

The primary objective of perpetual endowment funds and long-lived trust funds is to generate spendable cash. Ideally, these cash disbursements would be stable from one year to the next and would grow to keep pace with inflation.

Too-high disbursements today would lead to too-low disbursements tomorrow, and vice versa. Setting a proper spending rate is difficult. Trustees often set percentage spending rates based on the real returns they expect to earn from their investments and then link those spending rates to their funds’ market values. But linking spending to market values causes problems.

One problem is that market values of common asset classes, such as stocks and bonds, are volatile. Trustees fight this volatility by averaging market values over time, but averaging does not work very well.

Another problem is that trustees who base spending on market values often understandably come to believe that market values themselves determine spending. In other words, if market values increase (or fall) by a significant amount, then trustees feel justified in increasing (or cutting) spending by similar amounts. This belief is misguided. For equities, the predominant asset class in most endowment and trust funds, the source of returns is not market values but, rather, corporate profits.

This brief argues that, counter to common practice, trustees should turn their backs on market values and instead focus on the real cash flows that their assets can generate. For bonds, this would mean their real interest rate. For equities, this would mean their underlying profits. This focus on asset cash flows, rather than on asset market values, is a better way to go. This brief offers two spending rules based on cash flows. One looks at corporate dividends, and the other at corporate profits.

Trustees who base spending on market values usually include bonds in their funds to dampen market value swings. A 30% bond allocation is not uncommon. Yet the cash-flow spending rules described here lead to less volatile spending, even when applied to a 100% equity portfolio, than that of a 30% bond/70% equity portfolio whose spending is based on market values.

In addition, spending rules based on cash flows free trustees from fretting about market values. Diversification can still be beneficial, but no longer do trustees need to diversify primarily to dampen market downturns. When equity market values decline, as they invariably will from time to time, trustees may be able to say, “We don’t care.”

Furthermore, spending rules based on cash flows enable trustees to keep score. Trustees of perpetual endowment funds and of long-lived personal trust funds often feel obligated to be intergenerationally equitable—that is, to treat current and future beneficiaries the same. The near-universal way to evaluate intergenerational equity is to look at market values. Instead, a spending rule based on cash flows works better.

Finally, basing spending on cash flows, rather than on market values, encourages trustees to focus on something that is very important but often overlooked: the long-term health of the economies in which their funds are invested.

No spending rule is perfect. But many trustees who now base spending on market values would benefit by focusing on asset cash flows instead.

About the Author(s)

James P. Garland CFA

James P. Garland, CFA, is former president of The Jeffrey Company.

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