Spending Policy: Finding Answers Beyond the Endowment

Organizations are still grappling with the effects of the COVID-19 pandemic, and many are turning an eye to spending policy. Is now the time to increase spending or change methodologies? FEG's Vice President, Matt Finke, sits down with Head of Institutional Investments, Nolan Bean, to discuss the role of spending policy and how organizations can find answers beyond the endowment to alleviate shortfalls during challenging times.

Transcript

Matt Finke:

Hi I'm Matt Finke, vice president with FEG Investment Advisors. I'm here today with Nolan Bean, head of institutional investments and leader of FEG's higher education practice. Nolan, a lot of stuff going on in higher education these days, a lot of challenges they're facing. Obviously with COVID 19 virus and how they've had to change operations. We also have challenges to expenses that are going on within the universities, declining enrollments. Maybe a board member, investment committee member has a question, "why can't we use the endowment for some of these resources?" Can you talk about that backstop of what the endowment's purpose is?

Nolan Bean:

It makes sense, but I think the key here is we want to resist that temptation because this is here into perpetuity. We want current generations to get the same benefit from the endowment as future generations. And while there's a need and we're in a very unprecedented times, most times fill in unprecedented and there's a great need. So to be able to maintain purchasing power for future generations, get the same benefit, it's important to stick to your discipline of your spending policy. And if you overlay the investment backdrop with interest rates at zero, equity markets at all time highs, it's hard to see how the markets are going to deliver the types of returns we've seen in the past. So if we need to maintain that balance of the investment portfolio giving us the returns we need consistent with the spend, it seems like the wrong time from a market perspective to be increasing spending to that.

Matt Finke:

As a consultant and you're talking with these committees, I'm sure there's a lot of outside pressures that they face. Are you helping them have that conversation with different constituents from the university or foundation?

Nolan Bean:

Absolutely. So communication here is key. And also recognizing, folks, that there are real challenges. So trying to brainstorm creative solutions of how might we be able to give a little bit more support with an eye towards future generations and maintaining the organization is critical. So I think educating on the need for good spending policy, educating on the regulatory backdrop and UPMIFA, the regulatory Act that governs this, that says "spending over 7% is imprudent." So I think that is helpful to educate. And then anything we can do to be creative. So we've had universities that have sold assets, sold real estate assets, sold power plants to help provide that financial support for new term needs.

Nolan Bean:

Looking at what's the balance between the administrative or development fee versus the spend that's going back to the university to support all the great work they're doing and can you rejigger those? So trying to be thoughtful about recognizing the need, without harming the long-term benefit for the organization and the university.

Matt Finke:

So you mentioned spending policy. All of our clients have spending policies. They're embedded somewhere in an investment policy statement. Would this be the right time to consider potentially a one-time increase or a future raise in spending policy? A lot of the conversation we've had with our institutions over the last 10 years has been decreasing spending policies because of the market situation. Provide some thoughts on which direction potentially you could go with a spending policy to alleviate some of the challenges that universities face.

Nolan Bean:

You're spot on. So the trend has been really one way down. Most folks now in that 4 to 4.25 range, which again, if you think about that plus inflation, 6 to 7%, I think that's achievable. Anything over that I think is tricky from an investment standpoint of seeing how you're going to get there. So again, most folks we've guided to not do those one-time increases if they can avoid it. If there are other sources of funds or doing it with an offset to another fee. Other things we've seen folks do, it's amazing for larger universities in particular, how many endowed gifts that have already been granted back to the university, but are unspent. So going to those folks and saying, "Look at what you have. Are there any unspent gifts?"

Nolan Bean:

If there really is just a big need for cash today, there are a lot of nuances where if it's a restricted gift, you really can't just use that. So then it's working with all of the right parties to look at, are there any quasi endowments where the board may be able to undesignate those and use those? So working through all that, it's not as simple as it seems given the fiduciary responsibility that a board has and some of these other unintended consequences and current contracts with different parties.

Matt Finke:

Is it reasonable to say that looking outside of the endowment or the investment committee that there're opportunities elsewhere, say for instance, with development? You mentioned that although the challenges that face higher education are real, the market has gone up and there's opportunity to potentially attract new donors.

Nolan Bean:

Absolutely. This is a been a unique point in time in a lot of fronts. And this is one of them where typically when there's economic hardship and pain for universities, you're in a bear market. And donors typically have the ability to write larger checks and give more when the stock market's at all time highs and their personal accounts are flush. So you're in a unique point where there's a real need, it's easy to articulate that need for the university and donors may be in a better position to step up and support. So I think that that has currently been a push that we've seen. And that can be both endowed gifts, as well as current use gifts. If there's more of an immediate need for the cash today,

Matt Finke:

Nolan, as you think about spending policies and we've seen a lot of industry studies about different methodologies used, is there one that most people should prefer in this type of environment over another?

Nolan Bean:

I think the good answer is no. That as long as you have a reasonable methodology and you stick to it, it's going to work just fine. And the most important decision is the overall level of spending. That's going to drive 80% of success or failure, but the different methodologies that incremental 20% can be an icing on a cake, depending on upon what you're trying to achieve. And a couple of areas that we've seen folks look at today to try to smooth things out, or maybe eke out a little bit more support without doing any long-term damage are two things. One is if you're using a classic moving average spending policy where it's a moving average market value of the last three years, five years, you name it. You can extend that out. So we worked with the university that moved into a seven-year policy because with more data points, it smooths out the spending so that it's more consistent from year to year. So that's something to consider.

Nolan Bean:

The other is what we call constant growth, which is a policy where it's increased at a predefined rate every year. That could be 3%. It can be tied to inflation and then just have bands as you stick to that policy unless that would spend too much or too little of the overall endowment, which again helps for that consistency and de-links The spending from gyrations in the market, which has we've all experienced can be pretty extreme. And have a whipsaw effect of the policies bouncing around. So those are the two that I think are interesting to explore. And again, recognizing it's not magic. It's not going to solve your problems, but it can help at the margins. And I think is worthy of consideration.

Matt Finke:

So how would you want to communicate any sort of changes to spending policy or current policies that's in place when you're having conversations with different constituents, whether it's professors, donors? What are some of the key points you need to make about how the university spends endowment?

Nolan Bean:

Two things that I think are very important. One is, you can't do this quickly and then get buy-in. So there's a lead time of communication with all of the interested parties, that's important. And then two is, people care about themselves. So what's the impact to them and ensuring that you communicate that you're doing this to try to help them, because I think the immediate knee jerk reaction, if you're a Dean and you hear from a finance person on, "Hey, I want to talk about spending policy". You think they're going to try to take money away from me. So if you can communicate, "We're trying to give you more clarity in year to year on budgeting, by smoothing this out and get buy-in". It's going to make your life a lot easier and make that transition much better.

Matt Finke:

So if you're a board member right now, maybe some quick points, closing thoughts on what you think would be important for them to do as first steps as they review spending policy and potentially alleviating operational expenses or challenges they may face.

Nolan Bean:

Most important thing is to understand what's the overall rate. It's easy to nerd out if you're in our industry on what's the policy. Overall rate drives 80% of dollars coming back in success or failure on maintaining purchasing power. So ensure you have the right rate. Are you at 4? Are you at 5? What is it? And is that right for your organization? And do you believe that's achievable in the current backdrop? So that would be one. Two, if there are needs, try to get creative. Are there other ways to drive current use today?

Nolan Bean:

And I think the third is for foundations where you have an administrative fee to help support the development. Looking at that balance of how much is the spend that's going back to the university? And how much is on that development fee? And is that the right balance? And is it appropriate to potentially shift those one way or the other for your organization?

Matt Finke:

Thank you, Nolan. Really appreciate it.

Nolan Bean:

Thank you, Matt.

Matt Finke:

To continue the conversation on spending policy, feel free to reach out to me directly. We've also built a tool that will help you explore different spending policy methodologies. Click the link to learn more.