You Can't Eat Future Returns on Endowment Funds

An interesting conundrum challenges those of us in the nonprofit field: how do we meet commitments to our constituents while at the same time conducting the organization's financial affairs in a thoughtful and studied way?

Beginning with the following premise, the puzzle begins to unfold. The premise is that the recipients of nonprofit largess depend on a steady and predictable flow of funds irrespective of what the financial markets are doing. This is because nonprofits are created to provide services, not to make a profit. This is most clearly seen in the different accounting systems used by nonprofit organizations as compared to for-profit organizations.

For-profit organizations develop revenue through various combinations of manufacturing, services, sales and distribution, deducting the cost of generating each of these and if successful, having a profit at the end of a given span of time. The profit is then retained for future growth, distributed to its owners or a combination of both.

Nonprofit organizations, on the other hand, receive funds from individuals, other organizations and governmental sources. These funds are expected to be used to deliver a combination of goods, services, and capital projects. If there is money left after a program/project has been completed, then it is said, in accounting parlance, that there is a fund balance remaining. Notice that this is not called a profit, for there are no profits and losses in the nonprofit world, only positive and negative fund balances. If a nonprofit is managed conservatively, it will spend within the limits of funds available recognizing that, because the primary purpose of the nonprofit is to provide services, there are times of emergency when expenditures may exceed resources available, the hope being that additional fundraising will make up the difference.

Right away, a challenge emerges for those experienced in the business world. When serving on non-profit boards, they ask the simple question, "Why can't this organization be run like my business?" Of course, though the answer is never simple, we can begin by saying that for profit and nonprofit organizations serve different purposes. The for-profit exists to make money, to add enough value to its products and services that the public will be willing to pay more than its cost of production and distribution.

Nonprofits were created for an entirely different purpose: to provide a service that is otherwise not profitable to private business. That service may be feeding the homeless, providing a place for religious worship, financially supporting a hospital, school or other institution. Peter Drucker, one of the greatest theoreticians in the field of organizational development and management, added additional insight into the understanding of nonprofits.

"...we know that the non-profit institutions are central to American society and are indeed its most distinguishing feature...the ability of government to perform social tasks is very limited...(and that) non-profits discharge a much bigger job than taking care of specific needs.

They fulfill the fundamental American commitment to responsible citizenship in the community (through voluntary action)" (Peter F. Drucker, Managing the Non-Profit Organization, 1990, p. xiii)."

Mr. Drucker was writing about an essential element in the American character: a desire not to depend upon government but to rely on oneself through individual action as well as voluntary association with others. This had been noted repeatedly by visitors to our shores, most notably that of Alexis de Tocqueville, who traveled widely and was continuously struck by the number of clubs and voluntary associations throughout the land. Americans shy away from government initiatives if they can at all fend for themselves. To paraphrase one of his key observations. "Americans of all ages, all stations of life, and all types of disposition are forever forming associations...In democratic countries knowledge of how to combine is the mother of all other forms of knowledge; on its progress depends that of all the others. (Alexis de Tocqueville, Democracy in America, 1835."

Drucker also took umbrage with the term, nonprofit organization, as the name, by including the prefix non, implied it was against something sacrosanct in American culture, the making of money or profits. Rather he said, the term nonprofit "...is a negative term and tells us only what these institutions are not...It is not that these institutions are "non-profit," that is, that they are not businesses. It is also not that they are "non-governmental." It is that they do something very different from either business or government. Business supplies, either goods or services (for a profit to be distributed to its owners). Government controls (through laws and their application). A business has discharged its task when the customer buys the product, pays for it and is satisfied with it. Government has discharged its function when its policies are effective. The non-profit institution neither supplies goods or services nor controls through legislation, as Drucker's lexicon defines it. Rather, its product is a changed human being. The non-profit institutions, therefore, are human-change agents. Their "product" is a cured patient, a child that learns a young man or woman grown into a self-respecting adult; a changed human life altogether (Drucker, pg XIV)."

Finally, Drucker focused on what he saw as the two main challenges facing the nonprofit world or organizations: converting donors to contributors and giving community and common purpose to the American citizenry.

Consistently, Americans give over 2% of the gross national product on a yearly basis, a greater percentage than any other developed economy. According to the Giving USA Foundation's July 2009 report, over $307 billion was donated in 2008. Broken down by sector, the report showed the following examples: Individuals gave directly $229 billion, bequests from individuals were $22 billion, foundation grant-making was $41 billion, and corporate giving came in last at $14 billion. By sector, religion received 35% or $107 billion followed by education at $41 billion, foundations at $32 billion, public-society benefit received $24 billion, health received $21 billion, arts/culture $13 billion, international organizations $13 billion, and environment/animals $6.5 billion.

These, however, are only statistics. As Drucker stated, the success of a nonprofit organization over time is to convert the donor of money into a contributor of the organization. "It is much more than just getting extra money to do vital work. Giving is necessary above all so that the non-profits can discharge the one mission they all have in common: to satisfy the need of the American people for self-realization, for living out our ideas, our beliefs, our best opinion of ourselves. To make contributors out of donors means that the American people can see what they want to see-or should want to see-when each of us looks at himself or herself in the mirror each morning: someone who as a citizen takes responsibility. Someone who as a neighbor cares" (Drucker, Pg xvii).

Giving community and common purpose to the American people is the second great purpose of the non-profit sector. The vast majority of Americans live in large cities or suburbs as a result of which the traditional small town connections and support systems have been left far behind. Non-profit involvement reconnects them with meaningful volunteer work on behalf of a community of likeminded individuals. "It is working as unpaid staff for a non-profit institution that gives people a sense of community, gives purpose, gives direction-whether it is work with the local Girl Scout troop, as a volunteer in the hospital, or as the leader of a bible circle in the local church...Again and again when I talk to volunteers in non-profits, I ask 'Why are you willing to give all this time when you are already working hard in your paid job?' And again and again I get the same answer, 'Because here I know what I am doing. Here I contribute. Here I am a member of a community.' The non-profits are the American community. They increasingly give the individual the ability to perform and to achieve (Drucker,xviii).

Several years ago at the annual Association for Research on Non-Profits and Voluntary Action (ARNOVA) convention (the preeminent professional organization focused on research in the non-profit sector), a Harvard professor reported on his latest research. What he found was that the value of time volunteered by individuals, calculated at the low end of hourly wages, was twice as great as the dollars donated. In other words, the $307 billion dollars reported by the Giving USA foundation as total money contributions in 2008 would be triple, extrapolating from the Harvard researcher's findings, when adding the value of volunteer time donated in the same period. In other words, the total value of money and time volunteered in 2008 would approach one trillion dollars!

That is a statistical monetization of non-profit activity. But, as Drucker so eloquently stated and as the common saying "money can't buy everything" puts in simple language, non-profit volunteering is so much more than the dollar value it brings. Rather, it is the personal satisfaction gained through helping others, the sense of shared purpose that builds community and the opportunity to be part of something much greater than oneself.

So where does the title, "You Can't Eat Future Returns..." fit into all this? The challenge we face as volunteers and particularly those of us as policy makers on non-profit boards, is to decide how best to create a predictable and secure stream of funds for distribution to those we support, whether individuals, institutions or other non-profits, and to manage our resources for the future. This is particularly challenging because it enters into the areas of finance and investment strategy, something few are well versed in and in which most non-profit board members tend to defer to others.

The last few years have been very challenging for non-profits due to collapse in the markets and the commensurate decline in the value of their assets under management. This, in turn, has resulted in cancellation of capital projects, cut-backs in staff with the ensuing reduction in services provided, and a myriad of other consequences that have cut to the core of non-profit activity. As challenging as this period has been, it is not the first time this has happened nor will it be the last. The question then arises, "Can we develop an investment policy that insulates the non-profit from many of the vicissitudes of the market and in so doing allow it to function in a predictable way that gives assurance to its recipients?"

During the last half century, there has been a significant shift in how non-profits invest their surplus funds and endowments. During the fifties (and before) it was thought prudent to invest in bonds that would deliver a predictable cash flow the non-profit could depend on. As a result of inflation, however, it was recognized that though the cash flow from bond interest was predictable, the value of the bond declined due to the effects of inflation and the commensurate loss of the dollar's buying power.

For instance, we all recognize that a dollar today buys less today than it did ten years ago. Look at how the cost of housing has increased or what we pay for fuel. In the fifties, a fifty thousand dollar salary put you at the top of the wage earning pyramid. Today, that same fifty thousand puts you in the middle of wage earners.

Non-profits have to think of this and plan accordingly, especially if they have an endowment fund or plan on creating one. During the second half of the last century, and as a consequence of research done in the 20's and 40's, it was statistically demonstrated that investing in the broad market of equities would outperform the return from bonds, adjusted for inflation, over time.

In the case of equities, there is great volatility in the change in value from one decade to the next, yet over time, as the chart shows, equities have produced an inflation adjusted return of 6.8% over more than fifty years. Keep in mind that this return is based on reinvesting all dividends and tracking the market perfectly. Broad market index funds attempt to do just that. The returns also assume no transaction or management costs as well as no income or capital gain taxes.

The argument for bonds hinges on a different perspective. Given that equities have outperformed bonds over the last fifty+ years (and more according to numerous studies), bonds haven't done all that badly.

For the period 1919 to 2008, the average rate for AAA rated bonds was 6% per annum. However, there was no change in the face value of the bonds so at maturity only the original amount invested was received back with no allowance for inflation.

What is interesting to note, however, is that during certain periods of time bonds did outperform equities, adjusted for inflation. From 1973 to 1992, AAA rated corporate bonds averaged 10% return. By comparison, during the same period of time NASDAQ went from a value of 115 to 600, returning on average about 9% per annum. In other words, corporate bonds outperformed equities by 1% per year. The same can be said for the period 1990 to 2009 as demonstrated in the table below

US real investment returns by asset class (% per year) (source: Barclays Capital)

Equities returned -2.7% the last ten years and 5.6% for the last 20 years
Treasuries returned 5.5% the last ten years and 6.8% the last 20 years
Corporate bonds returned 2.3% the last ten years and 4.9% the last 20 years.

Anna Lees-Jones, co-manager of the Investec Sterling Bond Fund, wrote in Money Week, "... bonds have not been the boring investment they're often assumed to be over the past 15 years. Anyone who invested £100 in corporate bonds at the end of 1990 would now have £538, with gross income reinvested, compared with only £393 in gilts and £373 in equities. The compound return after inflation over the last ten years has been 8.5%, 6.5% and 5% respectively, according to Barclays Capital."

Many observers have predicted that, bonds having done so well and equities so poorly during the last twenty years, it is time for equities to outperform bonds. They say this for technical reasons as well as fundamental ones: technically, because historical statistics would predict it is equities' time, fundamentally because of the dramatic increase in market liquidity (all that money being printed by governments).

However, a contrarian perspective might be the following: 1) market liquidity is offset by a reduction in private investing and reduction in the velocity of money (how many times a dollar is used in the economy), 2) over the past quarter of a century there has been a dramatic increase in asset prices, far outstripping inflation, so deflation of asset prices is in order (a significant reason why the Federal Reserve Bank did not intervene in the asset class bubbles at the turn of this century), and 3) the aging of the U.S. and other developed nation's populations mitigates towards more conservative investing which favors bonds over equities. The saying in the financial industry is that when young, there is time to make up for market "adjustments" but as people age, steady and reliable income takes precedence as they may not be around long enough to make up for losses in the equities market.

"Demographic change will continue to help corporate bonds perform well. The developed world has an ageing population, with the 'baby-boomers' generation approaching retirement. As it does, it will be encouraged to buy bonds to receive a good, low-risk income in retirement, and this could drive the price of those bonds even higher. Many pension funds have already been increasing exposure to corporate bonds as they look for ways to increase their income." (Anna Lee-Jones)

Now for the conundrum: What does the volunteer sitting on a non-profit's board and investment committee decide when faced with investing the assets of the organization? Do they go with the seventy-five year averages and choose equities for their historically long term total return that outperformed bonds, do they choose bonds for their steady and predicable income stream with assured return of original capital at a time certain, or do they choose a balanced portfolio by investing in both? For most non-profits and their endowment funds, a balanced portfolio is followed. What, however, is the result in the light of the swings in equity values over time?

Here we have to factor in human nature. Nonprofits want as much predictability as possible. They are providing services and goods to those in need and swings in the financial market should be mitigated against as much as possible; the ups and downs in the equity market should not be a factor in the help nonprofits provide to others. Furthermore, when equities are doing well, recipient organizations begin to build into their budgets the high returns earned and come to expect more of the same. When the market "adjusts" downward, they are left with no choice but to take drastic action by cutting services to those least able to withstand the change.

They may also, following the commonly followed three-year "smoothing rule" take a bite out of capital, eating one's crop seed as they say in agriculture. With the three-year smoothing rule, distributions are based upon the average value of the funds under management during the most recent three-year cycle. The assumption is that, following this rule, most down markets would be averaged out with up markets so there would be no radical changes in fund distribution. During ordinary times, this is an elegant and effective way to determine the amount to be distributed on an annual basis.

However, during a major readjustment in finance where a significant portion of the fund's assets decline, the smoothing rule goes out the window and a major contraction in endowment distributions either takes place or funds continue to be distributed at the old rate, dropping the endowment below its original value at the time of its inception. A number of states and non-profit organizations have tried to prevent this "dipping below par" by requiring endowment funds to stop all distributions once the value of their assets under management fell below the original value of the amount contributed to the fund. With the devastation to so many funds as a result of the 2007-9 crash, these rules are being revised to allow such invasion of principal, something many contributors have been dismayed by.

The debate, then, between fixed income and equity investing, should consider not only the statistical returns over time but also human behavior. When first established, certain assumptions were made regarding how much would be earned on the endowment fund. During the days in which returns exceeded projections, funds available for distribution increased leading to recipient's expectations (and budgets) also increasing. Following the three-year smoothing rule, more funds were available for distribution so the endowment's increase in assets meant more money could be distributed. When the inevitable market correction took place, everyone was left flat-footed, short of budget, and the three-year smoothing rule automatically adjusted by decreasing distributions.

The variable of human expectations and "head in the sand" behavior when it came to budgeting and forecasting as well as the natural desire not to drastically reduce support for needy causes during times of crisis undermined the long term analysis showing equities outpacing fixed income investments. Of course, strong leadership can mitigate against this, but over time leadership changes, good budgeting loses out to the pleas for more from worthy recipients during the up market part of the cycle, and the endowment fund winds up "eating its next year's seed" which undermines the rationale for investing in equities over fixed income.

In other words, a fixed income portfolio, though it earns less over the long run (more than two decades), provides a natural budgetary restraint irrespective of who is leading the organization. If distributions are limited to interest earned from the bond portfolio, capital becomes sacrosanct and is returned for reinvestment upon maturity of the bond. With equities and the three-year smoothing rule, you never know if you are spending capital or income for they are intertwined and there are no inbuilt budgetary restraints other than the quality and strength of changing leadership.

In a previous paper, I have argued that a fixed income portfolio provides certitude of income stream, a guaranteed return of capital at a known time, an opportunity to adjust for inflation through the use of a laddered portfolio, and diversification through investing in a number of different fixed income assets including convertible bonds as well as bonds that track the broad market allowing for some equity market exposure. To maintain an inflation adjusted value of the portfolio, additional fundraising would be required, the amount averaging 3% per annum, not an insurmountable figure. In fact, if the distribution rate is 1% less than the interest rate earned, then the amount needed to be raised in new money would only be 2% of the corpus of the fund, a reasonable goal for the organization's fundraising.

To sum up, then, portfolio management should focus not only on historical statistics but also human behaviour and the variability of management over time suggests that an external and objective constraint such as only spending income earned will best preserve the value of the endowment fund, acknowledging that additional fundraising will be required to offset the effects of inflation. Is that such a bad idea?

Michael Pinto

December 2009