How should endowed institutions decide how much to spend? In the linked article from the November 2022 issue of the Journal of Portfolio Management, Larry Siegel and I set forth a method for achieving the desired balance between the obligation to provide for the future and the powerful call of the present. The abstract is below. The article in pdf form is click here.
“The trustees of an endowed institution are
the guardians of the future against the claims of the present.” –James Tobin,
winner of the 1981 Nobel Prize in Economics.
Tobin’s thoughtful admonition that endowment trustees should protect the spending power of the endowment for all time can’t be implemented in practice given today’s aggressive investment policies. But endowments can successfully combine spending policies and investment policies to meet that objective at some engineered level of probability.
We introduce an understandable toolkit for
benchmarking and evaluating any given spending rule. The toolkit is used to
manage the probability that the rule will protect the long-term spending power
of the endowment. We use basic tools of finance—perpetuity math, budget
constraints, economic balance sheets, well-supported assumptions for expected
return, the discount rate, and the growth rate, and a full appreciation of the
ramifications of smoothing efforts--to achieve the institution’s desired
probability of maintaining spending power in the long run. We show how
investment risk determines spending risk, even if smoothing is used to try to
conceal or defer the risk. We use multi-period distribution charts to evaluate
forecast outcomes.
We set forth a rule of “conservation of
risk”: spending risk is set by the risk of the investments used to fund the
spending, not by the spending policy itself. Smoothing doesn’t make risk go
away; it just hides it for a while, deferring it to a later generation: If
markets trend downward, smoothing causes current spending to be much too high,
in turn causing future spending to be much lower than planned.
We’re hoping to hear from you with your thoughts. Please send them to me at barton.waring@aya.yale.edu, or to Larry at lbsiegel@uchicago.edu.
Happy reading!
