You want your nonprofit’s investment portfolio to be around for the long haul. But to help ensure it’s available to fund capital projects and operational costs, you must adopt an effective spending policy. This includes a formula that stipulates what percentage of your investments you may withdraw each year.
There’s no one optimal spending policy. The best option for your nonprofit’s situation will depend on a variety of factors, which you should discuss with a financial advisor who specializes in nonprofit organizations. But the following are common types of spending policies.
Fixed rate method
Also known as the simple spending rule, this approach specifies a fixed annual spending rate applied to the beginning-period market value of an investment portfolio. It’s generally simple to understand and apply.
However, the fixed rate method can result in big swings in spending from one year to the next based solely on the investment portfolio’s performance in the prior year. In a multi-year period of strong investment performance, it may lead to higher spending increases compared with alternative techniques. This can undermine your portfolio’s growth.
Rolling average approach
If you choose the rolling average approach, your organization will apply a spending rate to the moving market-value average of your investment portfolio — usually calculated over a three-year period. A rolling average generally improves year-to-year consistency in spending, but it’s vulnerable to market volatility.
For example, this rule could dictate more spending than would be wise in a year when the portfolio value has dropped substantially. Or it could produce a low spending amount when your nonprofit needs extra financial support.
Inflation-based spending
With an inflation-based method, your nonprofit sets an initial dollar amount for spending, then adjusts that amount annually for inflation. Sometimes the adjustment will involve a cap and a floor based on the portfolio’s beginning market value.
This approach can simplify budgeting, stabilize spending and help grow your investment portfolio because the spending amounts tend to be smaller. It doesn’t account for the portfolio’s market value, but it can facilitate greater spending in challenging times than the rolling average method. Of course, higher spending can also eat into your investment portfolio.
Hybrid rules
A hybrid model generally considers both inflation and market value. A large chunk of your yearly spending is based on an inflation adjustment to the previous year’s spending. The remainder might be based on, for example, the application of a fixed rate to your portfolio’s market value or a percentage of the rolling-average rule amount. Hybrid spending policies tend to result in stable spending, in both dollar amounts and as a percentage of portfolio value.
Another hybrid formula — the geometric approach — reflects movement in both inflation and the market. A geometric rule reduces year-to-year volatility and can lessen the impact of market declines on spending. However, this approach is typically difficult to calculate. There may be another method that’s easier for your organization to work with.
Review and revise?
We can help you understand the different types of investment spending policies. Although following a consistent policy is usually recommended when evaluating financial performance, your nonprofit’s circumstances may indicate that it’s time to review and revise its methodology.
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