Funding sustainability for endowments and foundations
Lessons in Sustainability
Endowments and Foundations ("E&Fs") typically accumulate assets and disperse income to beneficiaries over extended periods of time, potentially covering several decades. As a result of this long-term focus, E&Fs can be seen to share many of the attributes of traditional defined benefit ("DB") pension plans. Interestingly, the same factors that have produced financial difficulties for DB pension plans in recent years (i.e., volatile investment returns, reduced current fixed income yields, and net negative cash flows) have also challenged the operations of many E&Fs.
While there has been much discussion on the difficulties DB pension plans are presently facing, there has been very little in the way of truly new approaches, with one notable exception. In 2011, the Government of New Brunswick appointed a Pension Task Force ("the Task Force") to review pension programs in New Brunswick and build a solution designed to achieve the objectives of benefit security, plan sustainability, and cost affordability. In its work, the Task Force adopted additional objectives to improve program transparency and intergenerational equity. In response, the Shared Risk Plan ("SRP") model design for DB pension plans has been implemented in New Brunswick. The SRP design has established an innovative way to fund and operate pension plans that addresses the goals established.
During the course of Morneau Shepell’s work as technical advisor to the Task Force in the development of the SRP model, we were struck by the similarities between the SRP approach and what many E&Fs are attempting to do with their own funds. We wondered whether there were some "lessons learned" from the analysis supporting the SRP project that would be applicable to E&Fs and potentially assist in providing financial security for these programs. This white paper summarizes the results of our work in this area.
Simplistically, the retiree segment of a DB pension plan is simply a pool of assets that is used to fund a long-term series of payments of predetermined amounts. The pressure on the funding of a DB plan manifests itself through the desire to support the required payment stream using the lowest asset base feasible while ensuring that the assets are adequate to make all required payments to pensioners. The parallels with E&Fs seeking to fund the maximum amount of annual grants from a fixed asset base while maintaining the long-term purchasing power of the asset pool are clear.
Traditionally, funding of DB pension plans has used long-term average expected rates of return as the basis for funding decisions. Similarly, many E&Fs have based their spending approach on expected real rates of return (i.e., net of inflation). Given prevailing market conditions 10+ years ago and assuming a typical 60% equity/40% fixed income investment strategy, an expected real return of 4% or more could have been a reasonable expectation at that time. Accordingly, many pension plans/E&Fs entered this millennium with funding/ spending programs incorporating an expected real return of 4%+ as a fundamental input. The highly volatile returns actually experienced over the past decade plus today’s reduced fixed income yields have resulted in substantial funding challenges for many DB pension plans. These same factors are impacting E&Fs and affecting their ability to maintain ongoing expenditures at the level established when projected returns were substantially higher than today’s level. The challenge arises from the trade-off between expected returns and the associated level of volatility. While fully guaranteed returns can be realized, the very modest level available under this approach today is unlikely to produce a satisfactory result for either DB pension plans or E&Fs.
The development of the SRP explicitly recognized the risk / return trade-off in a number of ways. Most critical was the required implementation of a sophisticated risk management process with specific, detailed minimum criteria. The main difference between the SRP model and a typical E&F is that the SRP model is reliant on these specific risk management requirements. Any spending or funding is "pre-ordained" through a rigid set of rules designed to remove the emotion and guesswork that may come into play when receiving and disbursing funds. Morneau Shepell took the model built for SRP analysis and tailored it specifically for an analytical look at E&F spending, as described below.
Endowments and Foundations’ Spending Policies
Many boil down the issue of E&F spending to a simple rule of "spend a certain amount and let the markets account for any differences over time." However, history has shown this approach to be problematic as periods of large market gains and losses create uncertainty for those looking to support current spending programs while simultaneously protecting future spending ability. A rigid spending approach effectively leverages the impact of market gains or losses versus the expected long-term rate of return and produces substantial volatility in the effective purchasing power of the remaining fund balance.
Some perspective on this can be gained by looking at an institution like Harvard University, which boasts a massive endowment fund—the largest endowment in higher education in the US. Renowned for its innovative investment strategies for almost four centuries, Harvard nonetheless reported (June 30, 2009) that the University’s endowment was valued at $26.0 billion—29.5 per cent less than the record $36.9 billion reported for the prior fiscal year. That result reflects a negative 27.3 per cent investment return on endowment assets after expenses and fees.
In short, even an institution with this much history and experience can suffer massive losses and constantly needs to adjust its strategies and react to the economic vagaries of the day.
The primary financial goal for most E&Fs is to provide stable year-to-year cash flows to meet established funding commitments while preserving the long-term purchasing power of the fund. The following are two common forms of spending policies:
- Flat Spending Policy ("FSP"): A flat percentage of the fund’s assets are spent each year.
- Rolling Spending Policy ("RSP"): The spending rate is determined by the return earned by fund assets net of inflation averaged over rolling time periods.
We tested three alternative options for each form of spending policy (FSP at 4%, 5% and 6% per year; RSP over 3 years, 4 years and 5 years). We simulated 2,000 trials of 20-year projections encompassing a wide range of potential economic scenarios. For each spending policy, we evaluated the outcomes after 20 years. Specifically, we assumed that the spending policy was maintained unchanged for the full 20 years and analyzed the dispersion of Funding Ratios (fund assets divided by inflation-adjusted value of the initial fund) measured at the end of the 20 years. Note that the model assumed an expected inflation rate of 2.25%, but let it vary stochastically over the trial periods. We also evaluated the dispersion of yearly spending rates over the 20 years (see below). For testing purposes, we assumed an asset mix of 60% equity and 40% fixed income. We then compared results (see Chart 1).
A flat spending plan (FSP) results in high volatility, or dispersion, in the Year 20 Funding Ratio (i.e., the inflation-adjusted value of the fund after 20 years varies substantially from what it was at the beginning). While there is some potential for upside results (increased real fund value), the probability of a significant reduction in value exceeds 50% (conversely, in a few scenarios, the fund value substantially increases). The fundamental problem with the FSP is that it spends at a level that does not reflect the fund’s financial results. In times of poor returns, it spends too much, which depletes the value of the fund; in times of good returns, it spends less than it could, resulting in significant net fund growth. (Although this may be rationalized as being conservative, current E&F beneficiaries may have difficulty believing this to be in their best interest.)
The volatility associated with the FSP approach has resulted in some E&Fs adopting a spending policy that reflects market returns; specifically, the RSP approach. As illustrated above, an RSP is much less volatile in terms of the Year 20 Funding Level but is highly likely to deplete the value of the fund over time. The problem with an RSP is the fact that adjusting the spending rate to reflect recent market returns does not allow any surplus to build up in the fund to cushion against market reversals. As a result, the fund spends all surpluses but remains susceptible to downturns in the market. We observe that under both the FSP and RSP approaches, the possibility of depleting the fund’s real value is very high.
Next, we evaluated the stability of the spending rate over the 20 years. While the FSP uses a constant spending rate as a percentage of the fund every year, variation in the balance of the fund means that the actual dollars paid out will vary by scenario over time. The result is that the FSP will not actually produce a constant amount of real dollar support (except in the highly unlikely event the fund earns exactly equal to the spending rate plus inflation each and every year).
In order to capture the value of payments provided to the beneficiaries, we examined the inflation-adjusted value of the payments made over time under each of the spending approach policies. For each policy option, we had 20 years × 2,000 scenarios = 40,000 years of payments. To provide a consistent yardstick, we expressed the range of results as a percentage of the opening E&F fund balance.
The results produced are illustrated in Chart 2 below.
As Chart 2 shows, there is a large dispersion in the spending rate over the years, even under the FSP approach (as the fund value varies substantially over time). Under the RSP, the volatility of spending rate is even more pronounced and includes a large number of years where the spending rate is unacceptably low. In the event that the rolling real return for a period is negative, the spending rate is floored at 0%. In practicality, this is not feasible for most E&Fs as they have obligations to meet each year; they generally require a minimum level of spending, regardless of fund performance.
Looking at the above results together, the FSP method appears to produce unacceptable volatility in the Funding Ratio while the RSP approach results in excessive volatility in spending rate. The obvious question becomes—is there a better way?
Insights Arising from SRP Work
As one would expect, we have confirmed that the volatility of outcomes under an SRP can be reduced by diversifying investments across a broad range of asset classes. In addition to this, our work on SRPs has identified the substantial synergies available by optimizing the inter-relationship between the minimum plan security (Funding Ratio), the desired benefit level (Spending Rate), and the target investment policy. We have found that substantial opportunity exists to improve the financial outcomes for SRPs (higher expected benefits and improved fund security) by looking at the program attributes in a holistic manner. Each combination of benefit level and fund security objective has a unique optimal investment strategy and there is substantial added value in identifying and adopting this policy. Further, changing any of the target criteria can have a substantial impact on the others and necessitate a review of all factors. All attributes must be modeled and optimized together.
We have extended these insights to the circumstances of E&Fs. Recognizing the limitations inherent in both the FSP and RSP approaches, we designed a hybrid spending policy approach to better balance the ongoing dollars of spending and the maintenance of fund purchasing power. This required us to make specific assumptions regarding the relative importance between the focus on maintaining Funding Ratio and supporting a consistent spending rate. We then optimized the asset mix to best balance between these two competing elements. The results of this analysis relative to the FSP and RSP approaches previously shown are illustrated in the following Charts 3 and 4.
The contrast between the results produced by the FSP and RSP approaches and the new spending policy and investment policy are clear. This new hybrid spending/investment policy does a far better job of protecting the inflation-adjusted value of the fund than any of the FSP or RSP approaches. Further, it produces far greater stability in spending rate than any of the RSPs (and is even comparable to the FSP approach). While the rolling spending rate has some possibility of spending at a higher rate, as we saw earlier, the high level of spending possible with the RSP results in the depletion of the future fund value under many scenarios. The new spending policy provides enhanced security in the spending rate and for the fund’s future value.
The preceding represents one approach with a specific assumption regarding the desired trade-off between consistency of spending rate and maintenance of Funding Ratio. Different objectives would necessarily produce different projected results and target asset mix but the conclusion is clear: substantial opportunity exists to improve the range of outcomes available by taking a holistic approach to E&F finances.
Effective oversight of E&Fs requires facing the contradictory goals of maintaining a target spending rate and preserving the real value of the fund while operating in an environment of unpredictable markets. An E&F’s spending policy should be carefully designed to keep up with spending obligations while supporting the fund’s desired long-term growth. Some common approaches to establishing a spending rate do not adequately protect future fund values and expose the fund to degradation of value over the long term. It is important to design an asset mix policy that interacts with the spending policy to provide the desired level of security in both the purchasing power of the fund as well as stable inflation-adjusted cash flows. Using the SRP model, pension plans are protecting their futures with enhanced risk management. E&Fs likewise have an opportunity to improve their results by incorporating a similar holistic approach.