Are E&Fs Jeopardizing Their Missions?
By Seth Masters
November 29, 2012
Many US endowments and foundations (E&Fs) still plan to spend 5% of their assets each year, despite unusually low expected returns. We think few understand how likely it is that this will limit their ability to fulfill their missions in perpetuity.
Given current economic and capital market conditions, we now project that global bonds will have very low annualized returns of 1.9% over 10 years in the median case, far below our estimate of 5.8% under what we deem to be normal conditions. We also project that under today’s conditions global equities will have annualized returns of 7.2% in the median case, somewhat below our normal estimate of 8.8%.
The green line in the first Display shows our current estimates of the median impact of various net annual spending rates over 30 years on the inflation-adjusted value of a portfolio with a starting value of $100 million. The blue line shows our estimates under what we deem to be normal economic and capital market conditions. We project 10,000 plausible outcomes for each spending rate under both current and normal conditions; the median is the point where half the outcomes are higher and half are lower.
With no net annual spending (if fundraising were to offset all spending) we project that a fund with 60% invested in global stocks and 40% in global bonds would quadruple its inflation-adjusted assets to $406 million in the median case, under normal market conditions. Under today’s conditions, we project the fund would still nearly triple its inflation-adjusted assets, to $289 million, in the median case.
Of course, under US tax law, private nonoperating foundations must spend at least 5% of their assets each year. Public foundations and endowment funds with more flexibility typically spend a set percentage of each year’s starting asset value, perhaps using a smoothing formula to eliminate the disruption to programs that may be caused by big swings in annual spending. Either way, low expected returns are likely to take a big bite out of future assets and spending power, unless the entities maintain a robust fund-raising program.
We estimate that an endowment or foundation with a 60/40 portfolio that wants to maintain inflation-adjusted asset values and spending power would have to limit net spending to just 3.5% under today’s conditions, far less than the 4.5% during more normal times. Given lower expected returns, a fund that spends 5% of assets before fund-raising would have to raise 1.5% of its assets a year, rather than 0.5% a year, to maintain its spending power, in the median case.
Today, the risk of eroding future assets, and thus spending power, is much larger than under more normal conditions. The second Display shows that in our median projection today, a $100 million fund with a 60/40 asset allocation and a net spending rate of 5% will see its assets fall to $79 million after 10 years and to $62 million after 30 years, after adjusting for inflation, in the median case. Under normal conditions, we project it would fall to $93 million after 10 years and to $87 million after 30 years.
Shifting to an asset allocation with higher potential returns could help. We project that if a fund were to change its asset allocation to 90% global stocks and 10% global bonds (from 60/40), it would bring median 10-year and 30-year outcomes close to the outcomes for a 60/40 allocation in normal times. But that, of course, would increase the risk of experiencing a deep loss at some point along the way.
As the third Display shows, we estimate that under current conditions, there’s a 35% chance that a fund invested 90/10 would experience a 20% loss at some point over the next 10 years, rising to a 72% chance over the next 30 years. With a 60/40 asset allocation, there’s only a 13% chance of a 20% drawdown within 10 years, rising to a 33% chance over 30 years.
So there’s no easy solution. But we think funds should recognize that acting as if conditions are normal is, in effect, opting to accept a very high risk that they will seriously erode their assets and spending power—or go a long way toward doing so before they are forced to take corrective action.
The better course, we think, is to explore what combination of actions makes sense for the particular entity. The menu includes cutting spending somewhat; increasing fund-raising; accepting somewhat higher risk of a large drawdown from an increased allocation to assets with a higher potential return; and accepting somewhat higher odds of eroding assets over time.
The projections above draw on the AllianceBernstein Capital Markets Engine, which uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation, and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.