A Primer on Nonprofit Spending Policies
A Primer on Nonprofit Spending Policies
You may have heard that your nonprofit would benefit from having a clear spending policy. But exactly what does that mean, and why may you need one for your organization’s endowment?
An effectively designed spending policy links a nonprofit’s endowment with the mission and long-range strategic plan of the organization. How you spend your endowment funds is driven by your organization’s program-related and capital needs and must also reflect an appropriate and sustainable withdrawal rate. Both of these factors are closely linked to your overall endowment investment policy: How much risk can your organization afford to take with its invested funds and still be on track to meet its accumulation and withdrawal targets?
Donors play into your spending policy as well. As you know, donors tend to make gifts to an endowment, during life or as a legacy, with the intent that they will provide long-term support for your organization. Donors likely don’t expect their money to be used up too quickly, nor to languish underutilized. This means that when you’re considering how to invest and spend your endowment assets, it’s important for your board to give serious consideration to individual and collective donor intent.
The benefits of a written spending policy
It’s always wise to have a well-documented approach as to how your endowment funds are to be disbursed. A written policy helps set guidelines for future staff and trustees. It also provides donors with the comfort of understanding exactly how their gifts will be used. However, there is no one-size-fits-all approach to determining spending policies for nonprofit. It can be as unique as the organization itself.
For one, your spending goals are largely determined by the strategic goals and time horizons of your organization. And those two things can change over time. For instance, your nonprofit may believe that its window to implement certain programs or meet specific goals is limited—tied to some upcoming event or an urgent societal need. In that case, your board might decide to deploy endowment assets more aggressively than usual in support of this strategic imperative.
However, our observation is that the vast majority of nonprofits consider themselves to have very long or even perpetual time horizons. As a result, their investment and spending policies will need to reflect that.
Approaches to developing a spending policy
It used to be common for nonprofits to use an income-based spending policy. In other words, how much an organization spent depended on how much interest and dividends its investments earned that year (or over a few years). The shift away from that approach largely occurred in the 1990s and 2000s, as interest rates and dividend yields fell dramatically and caused this method of calculating distributions to lose favor.1
Most nonprofits now use a “total-return” perspective to guide their spending. This approach takes into consideration the long run appreciation potential of investments in addition to the current income. The introduction of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) in 2006 allows nonprofits to spend prudent amounts of their endowment principal based on this concept of total- return investing.2
A commonly used method among nonprofits is to calculate the annual withdrawal amount using between 4% and 5% of the portfolio’s value. Over time, such a withdrawal rate on a balanced portfolio that has 60% to 70% invested in growth assets (such as equities) should leave enough excess return in the endowment to preserve its long-run purchasing power.
The withdrawal may be calculated as a percent of the year-end value, although it may be preferable to use a monthly or quarterly moving average over a three-to-five-year period. The potential benefit of using an average is that it can help smooth out the volatility in market returns and their impact on your annual withdrawal.
This approach also helps balance the natural tension between what are likely your organization’s two primary financial goals: maximizing withdrawals over time to support programmatic growth, and having predictable cash flows in the budgeting process.
Note that if you have a shorter measuring period or a higher allocation to bonds, it may be wise to use a lower-percentage withdrawal rate to help protect long-term sustainability.
Final thought
A well-designed and documented spending policy can help you understand how best to leverage your endowment to fulfill your organization’s mission over generations. A Corient Wealth Advisor can be an important partner in this regard. We can help your organization assess whether the spending policy you have in place is poised to help your nonprofit meet its goals now—and well into the future.
1 The Nonprofit Sector at a Crossroads: How Federal Cuts, Tax Changes, and Trade Wars Are Reshaping the Landscape
2 What Every Nonprofit Should Know About the Uniform Prudent Management of Institutional Funds Act
ABOUT THE AUTHOR
James Sonneborn, CFP, CFA, MBA
Jim is a Partner, Wealth Advisor in our Morristown, NJ, office. He has over 35 years of experience managing investment portfolios and providing financial advice to individuals, families and charitable organizations in the New York metropolitan region.
As a Wealth Advisor and Co-Chair of legacy firm RegentAtlantic’s Neighborhood Nonprofits Group, Jim works with a wide range of clients and has a particular specialty in philanthropic strategies. For donors, Jim works to construct strategies that align with the client’s philanthropic goals. In the nonprofit sector, Jim focuses on helping organizations strengthen their financial position through endowment management and planned giving consulting. Jim currently serves on the boards of The Rippel Foundation and the Environmental Endowment of NJ.
Jim holds a BA in Business from Western Colorado University and an MBA in Finance from Drexel University, as well as the CERTIFIED FINANCIAL PLANNER™ certification and Chartered Financial Analyst and Certified Divorce Financial Analyst certifications.
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